1 Warwick Row Rt Hon Alistair Darling MP 7th Floor SW1E 5ER Chancellor of the Exchequer HM Treasury T: 020 7828 0111 F: 020 7834 3442 One Horse Guards Road London E: [email protected] SW1A 2HQ W: www.bpf.org.uk

The following are our largest member companies or are represented on our Board or Policy Committee:

8 April 2009 Annington Homes Ltd Argent Group plc Aviva Investors AXA REIM UK Ltd Bank of Scotland Corporate Banking Bee Bee Developments Limited Dear Chancellor Plc The Company PLC Brixton plc British Property Federation – Budget 2009 Brockton Capital Canary Wharf Group Plc Capital & Regional Plc The British Property Federation (BPF) is the voice of property in the UK, CB Richard Ellis representing businesses owning, managing and investing in property. This Credit Suisse includes a broad range of businesses comprising commercial property Cushman & Wakefield Delancey Real Estate Asset owners, financial institutions including pension funds, corporate landlords, Management Ltd plc local private landlords and those professions that support the industry, Dorrington PLC including law firms, surveyors and consultants. The UK’s commercial DTZ F&C Property Asset property stock was worth over £450 billion at the end of 2008 and it Management plc Frogmore Property Company Limited represents both a major factor of production and an important investment Goodman Property Investors asset class. Plc Grosvenor Plc While the property industry has developed a generally constructive dialogue Helical Bar Plc with Government in recent years, we have decided to submit a Budget Henderson Global Investors Hermes Fund Managers Limited representation in the light of the risks, opportunities and challenges that the Hunter Advisers Invista Real Estate Management Limited property industry both faces and poses to the wider economy in the current Jones Lang LaSalle economic environment. While most of the issues identified in this letter are KPMG LLP Land Securities Group PLC issues on which we are already engaged in active and constructive dialogue Legal & General Property Ltd Lend Lease Corporation Ltd with Government, we think it is important to place those issues in context. Liberty International PLC Linklaters LLP Lovells LLP The current downturn and the property sector Macdonald Estates Morgan Stanley Prudential Property Investment The financial crisis that began in late summer 2007 in the United States had Managers Ltd Quintain Estates and its roots in the way in which the financial sector had become over-exposed to Development Plc Redevco Uk property. Concern about the true value of financial assets secured on real Regeneration Investments Limited property crossed the Atlantic, with the result that the UK property sector was Residential Land Schroder Property Investment quickly impacted by the crisis. Over a period of just 19 months, capital Management Ltd Scottish Widows Investment values for commercial property in the UK have suffered unprecedented falls Management of around 40%. The market appears to expect significant further falls. plc St Martins Property Corporation Ltd Standard Life Investments Ltd Stockland Collapsing property values have a number of important implications: Threadneedle Property Investments Limited Warner Estate Holdings Plc • Around 7% of the total assets of UK insurance and pension funds are Westfield Group PLC invested (either directly or through investments in collective investment schemes or property company shares) in UK commercial Registered number: 778293 England property, making such institutions, and the individuals whose insurance and pension funds they manage, the biggest owners of Registered office: 1 Warwick Row 7th Floor London SW1E 5ER such property. It is essential that equity investors in property, having already seen the value of their investments collapse, do not flee the sector, whose core attributes of a strong income return and a risk and volatility level somewhere between equities and gilts should remain fundamentally attractive as part of a diversified portfolio.

• It is estimated that over £200 billion of outstanding debt is secured on UK commercial property alone. Capital adequacy requirements mean that it is highly unattractive for banks to see loans default or to enforce security and have to recognise property on their balance sheets. At the same time, fire sales of property assets would force prices down even more, further damaging the value of bank assets. The property sector has a structural need for debt finance (albeit not at the exaggerated levels seen over the last few years), so the sharp fall that we are already seeing in the willingness of banks to lend or to renew existing loans will present huge problems if, as seems likely, it persists. The problem is particularly pronounced in relation to property development.

• Commercial property employs many hundreds of thousands of people (chiefly in the construction, development and management of buildings, letting and other transactional work and investment management sectors). It contributed some £62 billion to the UK’s GDP in 2008, representing some 4% of GDP. On average over the last ten years, some £15 billion worth – representing 1% of GDP – of new commercial space was created each year by development activity. Almost 5% of UK GVA comes from commercial property. A marked and prolonged withdrawal of capital from this important sector will inevitably impact on the ability of the economy to recover from the current recession.

In the last few months, we have seen business and consumer confidence evaporate and job insecurity and uncertainty combine with a scarcity of finance to stifle investment and the prospects for growth. This economic crisis has of course also increased the risk of borrower defaults and business failures, forcing lenders to scrutinise ever more closely the assets that secure borrowers’ obligations to them. It has also added to the direct challenges faced by landlords, as the health of the market they serve – the commercial occupier market – is crucial to their own survival.

Specific impacts for the property sector

Even more than many other businesses, landlords are being pulled very hard in different directions by these conditions.

• Lenders: Most landlords have used debt secured on their property assets to finance their business, and the loan documentation will generally contain financial covenants specifying a minimum loan to value ratio (LTV) and/or a minimum interest cover ratio (ICR). Breach of such financial covenants allows the lenders to enforce their security or to insist on accelerated amortisation of the debt. The value falls mentioned above have piled enormous pressure on LTV covenants over a very short period. Renegotiating financial covenants to avoid breach can be very expensive, because lenders will use the opportunity to charge substantial fees and to increase the interest rate payable on the loan.

This has implications for the UK’s REITs’ ability to comply with the UK REIT rules and may also lead to broader, fundamental issues for the UK economy if the UK property sector sees significant failures and its assets are taken over by the banks.

• Tenants: Tenants are struggling to survive and may be seeking to renegotiate the terms of their leases as one way to reduce their costs. To the extent that landlords are able (having regard to other pressures, including their position as borrowers), they generally seek to be flexible to help struggling tenants to survive. Our members tell us that not all tenant demands for landlord concessions are reasonable when

2 subjected to scrutiny. We have heard reports of unjustified delays in payments of rent by tenants, leading to cash flow problems for landlords who need to service their own debt and pay their own suppliers. Landlords are desperate to keep their property occupied and avoid having to bear security, maintenance and other costs (including empty rates) while a property is empty, and are having to seek new tenants who are only likely to be available in return for substantial incentives as well as reduced rents – with inevitable strain placed on landlords’ existing financing arrangements and business models. In many cases, tenants are simply failing, or using administration to shed the weaker part of their business. In such cases, landlords may find themselves with empty property on their hands even though the relevant lease may have had many more years to run.

This has particularly iniquitous implications on the business rates front.

• Investors: The investor base in UK property is broad, but the lion’s share is held by insurance and pension funds and investors in collective investment schemes and REITs and other listed or unlisted property companies. Inevitably, investors have taken big losses, and that, coupled with the relationship between the financial crisis and financial institutions’ exposure to property, has placed some strain on their willingness to remain invested in property (although the success of recent REIT rights issues shows that many continue to recognise value in the sector). We recognise, of course, that the commercial property sector will simply have to compete alongside other sectors for capital and investor loyalty – but it is critical that its ability to do so is not compromised by Government measures which unfairly penalise it.

The next bullet point identifies two key areas where existing law is currently having a particularly problematic and distortive effect on the property industry’s ability to retain and attract capital from investors during the current downturn.

• Government: Two sets of rules, in particular, both of which were conceived in very different economic times, are causing real problems.

o The restriction of relief from business rates for empty property which took effect in April 2008 has inflicted enormous additional pain across the economy, on businesses (both owners and occupiers of property) which are already struggling to find an economic use for their assets and survive in extremely difficult economic conditions.

o The UK’s REITs are exposed not only to the cost of empty rates on the non- productive parts of their estates, but also to a tax and regulatory regime which severely constrains their ability to conserve cash and which can impose penal tax charges on them for seeking to reduce and restructure their debt and make sensible plans in anticipation of recovery. In the current context, rules which inhibit REITs’ ability to make the right commercial decisions for their survival and longer term health need to be relaxed.

Principal issues

This section discusses three particularly important areas in which action is urgently needed from the Government against the backdrop of the situation outlined above. In the following section, we briefly summarise a number of other issues on which we also hope to see the Government take swift action.

Empty rates

First, we urge you swiftly to reinstate relief from business rates for empty properties. As economic conditions have continued to deteriorate over the last year and a half, the harm, both short term and longer term, that this tax on hardship is inflicting on the occupiers of

3 commercial property as well as on those who develop or own it is becoming ever more apparent. Businesses paying empty rates are, almost by definition, struggling to cope in the current environment, with property assets failing to deliver the returns for which they were acquired. Charging full business rates in these circumstances is a unique example of the tax system operating in a damagingly pro-cyclical way and ignoring the economic position of taxpayers.

The Government never consulted properly on its reform of empty rates – it simply announced a policy extrapolated from proposals made by Barker and Lyons in reports on different topics. We doubt that the reform would have achieved its stated policy objectives even in the rising market before summer 2007, because the reform was not directed by a sound understanding of how the commercial property market works. However, in the falling market of recent months it has been hugely damaging, extracting additional tax from those least able to pay it.

Moreover, this situation has been exacerbated by an epidemic of tenant failures against which landlords cannot protect themselves and which are made selectively worse as a result of the use of pre-pack administrations. While tenants are enabled to survive by walking away from a proportion of their leases, the landlords of abandoned properties have to live with the loss of rent, the need to bear the carrying cost of empty property (security, maintenance, contribution to service charge on multi-let sites, etc.) and the need to find a new tenant in extremely challenging market conditions. That they should also bear the cost of empty rates on top of all that is grossly unfair, and inevitably increases the risk of failure among landlords. That, in turn, will further impact on the banks whose loans are secured against such property.

The Government should reverse the reform and consult stakeholders properly before reintroducing better targeted measures when the economy and the property sector recover. Alternatively, the Government should use the power reserved in 2007 for relief to be reintroduced at 50% – a power reserved to allow a flexible response to changing conditions in the property market. It is hard to imagine in what conditions Parliament intended this power to be exercised if not the present.

The relief announced in PBR 2008 for properties with a rateable value of less than £15,000 for the period from April 2009 to March 2008 deserves a brief mention. We were disappointed by the limited scope of this relief: the logic that justifies it for low value properties is no less powerful in relation to higher value property. We nevertheless welcome the relief, because it will provide some respite for those who hold sufficiently low value property to benefit from it. We urge the Government to extend the relief, in time as well as to higher value properties.

We should clarify that we do of course appreciate that business rates are under the care of DCLG. However, we know from conversations with Ministers and officials at DCLG and at HMT that decisions in this area cannot be made without HMT agreement. It is for that reason that we have included representations about business rates in this letter.

Strategic REIT liberalisation and the current crisis

The REIT regime in the UK is very young and, while the introduction of the regime in January 2007 saw a rush of early conversions by many large listed commercial property companies, both the onset of the financial crisis from late 2007 and the structure of the regime itself have made its further growth and development very difficult. We have sought in recent months to make the case to Ministers and officials for a strategic liberalisation of the UK REIT regime in the short term with two key medium term objectives:

• encouraging new entrants and the growth of the sector generally so that (once economic conditions permit) it can continue to attract capital from a wide range of sources – domestic retail investors and institutions, and overseas capital, including from dedicated REIT funds; and

4 • facilitating the emergence of residential REITs, which are so far probably the greatest missed opportunity for the UK REIT sector. The value of UK residential property is between £3 trillion and £4 trillion. Some 30% of that is rented, with 13% being in the private rented sector. That represents a vast pool of assets in which residential REITs could invest, potentially transforming the PRS with greater institutional investment and more professional management.

There is a wealth of international experience that shows how REIT sectors grow in response to increased flexibility and liberalisation, with France’s constant reinventing of its SIIC regime in recent years a good example. Failure to act in this area could greatly diminish the potential rewards for the UK from the investment it made in implementing a REIT regime in the first place. The most important measures that we recommend in this area are removing the listing requirement and allowing those selling property to a REIT in return for shares in the REIT to defer the obligation to pay tax on any gain until they dispose of the shares.

Failure to act could also make the recovery more difficult. There is evidence from other countries, including the United States and Australia, that REITs can play an important role as a vehicle for facilitating the recapitalisation of the property sector after a crash, and at the same time cleansing the balance sheets of banks whose exposure to real estate is felt to be too great. We intend to carry out further work in this area more broadly within the property industry and in collaboration with colleagues in the banking sector and capital markets with a view to putting specific proposals to Government in due course.

On the residential side, common sense suggests that, with the right legal framework, it should be possible to overcome doubts about the yield from residential property: the enormous appetite of the public for exposure to residential property through direct investment (no doubt partly based on the anticipation of capital appreciation) is one reason for that; another is the secure, reliable and inflation-proof income that residential rents can offer to insurance and pension funds in particular. However, the regime introduced in 2007 does not readily accommodate residential property for detailed commercial and technical reasons that we have sought to explain to Government.

The state of the market today is not an excuse for inactivity. On the contrary, the current hiatus in activity and the positive impact of falling capital values on yields offer a unique opportunity for Government to prepare the legislative environment ahead of the recovery, enabling investors to take advantage of cyclically low prices.

REIT survival

In the current economic environment, it is essential for UK REITs to conserve cash in the short to medium term. In particular, that is because the rapidly changing economic outlook means that LTV covenants remain very sensitive and it remains highly uncertain when it might make sense to begin investing in new assets again. New debt is both difficult to obtain and far more expensive than it has been in recent years, and the availability of new equity capital is likely to be constrained following major capital raisings from property companies, financial institutions and others in the UK and beyond. For those reasons, it is important to maintain higher cash reserves than would be commercially appropriate in normal circumstances.

However, the UK’s REIT rules contain a number of conditions which severely limit flexibility – and in some cases may even prove fatal – when it comes to allowing REITs to manage their resources in the way best calculated to ensure their survival and position them to prosper as the economy recovers.

Certain other REIT jurisdictions have already taken steps to ease applicable rules to help their REITs through the downturn. We strongly urge the UK to do so as well, in line with detailed proposals which we have put to, and discussed with, officials. Some of the key areas identified as problematic are:

5 • the inflexibility of the 90% distribution requirement (an ability to defer the obligation and allowing stock dividends to count towards it would be particularly welcome);

• the operation of the profit : financing cost ratio in an environment where volatile fair value fluctuations in the pricing of financing costs can have a dangerously distortive effect; and

• the way cash raised other than from property disposals is treated for the purposes of the balance of business test.

Other issues

Tax increment financing (UK TIF)

The Government should actively explore the introduction of UK TIF pilot schemes in partnership with local authorities to help kick start urban regeneration. TIFs are a mechanism widely used in the US to fund urban renewal by using anticipated increases in tax revenues to fund infrastructure which cannot otherwise be funded. In the current financial climate the ability of developers to make a contribution to infrastructure through ‘planning gain’ has been greatly reduced if not completely wiped out. A UK TIF would help to bridge the infrastructure gap, working on the basis of ‘no new tax and no lost tax.1

Privately rented residential sector (PRS)

There is likely to be more demand for market rented housing for the foreseeable future. In a more constrained lending environment, however, buy-to-let investment is likely to decrease significantly, which could have a very negative impact on housing development output. The Homes and Communities Agency (HCA) is therefore carefully considering how institutional investment in the PRS could be increased. We welcome this focus on aiding the growth of an institutional PRS, which could help support housing market recovery and provide a source of long-term investment and professional management in private rented housing. Modelling work carried out by the BPF has shown that greater institutional investment in housing can be hindered by the profile of risk and returns. The impact of property voids in particular means that pure market renting is often less attractive than investment in commercial property or property such as student housing.

Today’s market conditions provide the best opportunity to grow institutional investment in the housing sector. However, it is important that any model that is put in place is sustainable, and we believe that the HCA is taking the right approach in seeking to establish a model that focuses on securing long-term investment with sufficient scale. We have already discussed above the role that residential REITs could play as a potential investment vehicle. There are, however, other tax and regulatory changes that would encourage increased investment, better management and ultimately a more professional PRS.

The Government should change the way in which stamp duty land tax (SDLT) is charged in transactions involving bulk purchases of residential property. Currently, unconnected purchases of individual properties are taxed at the marginal rate for the price at which they are purchased (which may be 0%, 1%, 3% or 4%), but bulk purchases are taxed at the rate applicable to the aggregate price, which will almost invariably be 4%.

That position represents a structural disincentive against larger scale investment in residential property, which should in fact be encouraged, because it is more likely to be linked to more professional and efficient management and delivery of rented property in the residential sector. We would like to see bulk purchases of residential property taxed at the

1 For more information about tax increment financing, please follow this link: http://www.bpf.org.uk/topics/document/23520/tax-increment-financing---a-new-tool-for-funding-regeneration. 6 marginal rate applicable to each unit, levelling the playing field between individual purchasers and those seeking to make larger scale investments.

Support for the SDLT measure outlined above and the encouragement of residential REITs are two of the recommendations in the recent Review of the PRS. We are very supportive of the Review and the package of measures set out by Dr Julie Rugg and Dr David Rhodes to improve standards and professionalism in the sector. An important recommendation is landlord registration, which would rely for enforcement on the various ways in which landlords interact with Government, including the tax system. Having a database of landlords would help local authorities enforce standards in the sector, and would also assist various other Government agencies and departments that interact with landlords. We hope HM Treasury and HMRC will be supportive.

One of the reasons that the Review has broad stakeholder support is its coherence as a package. To reinforce a professional and business-like approach in the sector, Drs Rugg and Rhodes suggest some other changes to the tax treatment of landlords:

• Tax on income – Immediate tax relief is not available on substantial improvements. Landlords are only able to obtain tax relief when the property is sold, when investment in the unit can be offset against capital gains tax. However, landlords would prefer a more immediate tax relief that would be offset against their rental income. This change would encourage letting to be viewed as a business rather than an investment and landlords to incur expenditure on property improvement.

• Capital gains – Landlords would be encouraged to upgrade their portfolios to take on a better standard of property if rollover relief were made available to them.

• VAT – The PRS has a high proportion of older housing in need of repair and improvement, a significant part of which fails to meet the decent homes standard (for example, because it does not have central heating). Now that European Union agreement has been reached to allow this, the Government should consider introducing a reduced rate of VAT for residential improvements, perhaps for accredited landlords only.

SDLT on rent and partnership transactions

In the longer term and more generally, the Government should take steps towards the root and branch simplification of SDLT, particularly in relation to the taxation of leases at rent and the taxation of transactions involving partnerships. Five years after the introduction of SDLT, we believe the time is right to remove the excessive and unnecessary technical and administrative complexity that has emerged in those areas with a view to a significant reduction of compliance costs for business. Doing that would also restore credibility to a tax which is structurally prone to compliance breaches and extremely difficult to police effectively.

Foreign profits reform

We strongly support the introduction of a tax exemption for foreign dividends and have welcomed the Government’s recognition in recent months that what had previously been viewed as a single package of reforms can be separated into different workstreams to be taken forward at different speeds. However, the legislative solutions for the first phase of the reform are complex and need to be got right. An important example is the exclusion from the worldwide debt cap for REITs, which does not work as originally published.

We urge the Government not to rush through legislation for the worldwide debt cap in a form which may prove very administratively burdensome for many businesses and very unattractive for inbound investors. We also hope that, in taking forward the second phase of the reform, the Government acknowledges the nature of property investment income as

7 fundamentally ‘good’ income which is genuinely earned, in the case of property located overseas, outside the UK.

REITs and SIPs

We encourage the Government to proceed with changes designed to facilitate the use of share incentive plans by REITs following the consultation carried out by HMRC during 2008.

VAT anti-avoidance

We would welcome continuing clarification and relaxation of VAT law and HMRC practice in a number of areas which we have explored with officials. One particular problem is the potential scope of the anti-avoidance rule that disapplies the option to tax even in ordinary commercial transactions, simply because a financing party happens to occupy a small part of the property over which an option has been exercised. The impact of those rules has been made worse by the emergence of connections between different banks through Government shareholdings, increasing the risk of problematic VAT consequences as a result of entirely commercial financing arrangements. The Government should extend the existing safe harbour from that rule so as to avoid restricting access to debt (something that is especially unwelcome at a time when access to debt is very difficult as it is), and amend the VAT legislation to allow bank connections resulting from Government shareholdings to be ignored in the operation of this rule.

Business rates

The BPF welcomes the Chancellor’s recent announcement that the impact of the steep RPI increase for 2009/10 can be spread over the next three years, although we are concerned that the proposal that has been announced is unnecessarily complex and could have been far more effectively and more easily implemented if it had been put forward a few weeks earlier. We hope that good use will be made of transitional relief in connection with the 2010 revaluation to allow businesses to push the impact of rate increases to the back end of the period 2010-15 with the minimum of administrative cost and complexity.

We would welcome the opportunity to discuss any of the recommendations made above at your convenience.

Yours sincerely

Liz Peace Francis Salway Chief Executive Land Securities Group PLC British Property Federation President, British Property Federation

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Jonathan Thompson James Aitchison KPMG LLP Hammerson plc Chairman, Finance Committee Chairman, Tax Committee British Property Federation British Property Federation

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