Tax. It’s been identified by many property pundits as one of the key impediments to the development of a flourishing build-to-rent sector in Australia.
But to what extent is Australia’s tax regime holding back the floodgates? And what will the flow on effect be for the underlying performance of the sector?
These are some of the issues explored in a new CBRE Viewpoint report: A Taxing Time for build-to-rent, which analyses the impact of land tax, the Goods and Services Tax and withholding tax for different ownership structures, and the steps required to put the sector on a level playing field.
Report author, CBRE’s Head of Capital Markets & Forecasting Research, Ben Martin Henry said the paper had been developed following limited movement in the build-to-rent sector over the past 18 months following an initial flurry of interest.
“We know the sector works otherwise it wouldn’t be the second largest property sector in the US, the largest real estate market in the world; it wouldn’t have the highest risk-adjusted returns; it wouldn’t attract capital from the largest funds in the world and it wouldn’t have generated the level of discussion in Australia that it has,” Mr Martin Henry said.
“What we’ve sought to do with this paper is analyse the main tax issues and seek to qualify their impact on returns in a hypothetical project to assess whether changes are required for the build-to-rent sector to flourish.
The hypothetical model* was developed with assistance from CBRE valuers, external stakeholders and taxation experts. It highlights the following:
Land Tax The current regime favours the existing build-to-sell model. Land tax obligations are a key consideration because the underlying profit margins of build-to-rent investments are relatively tight. In the hypothetical model (which applies NSW land tax laws), this knocks 89bps off the 13-year internal rate of return (IRR).
The treatment of the GST is another example where developing a residential asset or commercial asset is more favourable than build-to-rent. In the hypothetical model, the impact of GST is quote significant and the IRR falls 99bps for both foreign and domestic investors.
Withholding Tax In July, 2018 the Australian Government announced draft legislation that (once enacted) will permit institutional investors to invest into build-to-rent residential through a Managed Investment Trust (MIT). Currently, MIT entities are precluded from acquiring residential assets unless they are considered “affordable housing”.
The purpose of holding assets in an MIT is to take advantage of a lower tax rate - halved from 30% (the company tax rate) to 15% - provided certain criteria are met, which has given non-resident investors a strong incentive to invest in Australian property.
However, Mr Martin Henry said the proposed new rules for build-to-rent housing within MITs specified that the lower 15% tax rate would be applied to local investors only, with non-resident investors to be taxed at 30%.
“Non-residents will still receive the 15% tax rate for investing into commercial real estate such as office, retail and industrial, so the higher tax rate for BTR marks a clear point of difference,” Mr Martin Henry said.
“We hold the view that for the sector to flourish there needs to be deep buyer pools that would support investor demand and remove illiquidity risks. Foreign investors would deepen these buyer pools, however doubling the price of admission would prevent many from putting a toe in the water.”
CBRE’s hypothetical model highlights that increasing withholding tax from 15% to 30% results in an IRR decrease of 54bps.
Conclusion Factoring in all three taxes, the total IRR is reduced by 2.42 percentage points, delivering a return 25% lower than if those taxes were more supportive of build-to-rent developments.
“While this modelling is based off just one hypothetical build-to-rent development, and results would differ from development to development, the overarching results would be the same: land tax, GST and withholding tax all reduce returns on build-to-rent investments, yet these are not equally as punitive on other real estate asset classes,” Mr Martin Henry said, noting that the IRR for the build-to-rent project would be 7.43% under the current regime versus an IRR in the vicinity of 12%-14% for a build-to-sell project.
So, what does this mean for the future of build-to-rent in Australia?
CBRE’s Pacific President & CEO, Ray Pittman, said CBRE’s view was that a level playing field – rather than concessions – was required for the sector to flourish, so that preference wasn’t skewed towards one part of the market or another.
“As it stands, the build-to-sell market has an advantage in that developer returns aren’t eroded by land tax and GST costs while commercial real estate receives GST and withholding tax concessions,” Mr Pittman said.
"Meanwhile. the proposed new legislation for residential assets in MITs is likely to temper demand for BTR assets from overseas investors, resulting in shallower investor pools, a smaller BTR market and potentially lower levels of new housing stock.”
Overall impact on the 13-year IRR of the hypothetical project
Mr Pittman also noted that there was a shortage of housing options in many capital cities across the country due to considerable increases in prices, most notably in Sydney and Melbourne.
“Build-to-rent could potentially add to housing stock and ultimately make the cost of housing more affordable while providing more choice for consumers,” Mr Pittman said.
He also noted that if build-to-rent was to generate the returns required by investors, it was clear that changes were required.
“These could be in the form of changing existing tax rules to even out the playing field; through a shift in the investor mindset to focus on the risk-adjusted returns generated by build-to-rent; or by developing a new Build to Rent model, which is different to what currently exists in other countries. The future of a viable build-to-rent model in Australia could depend on a combination of these three changes and more,” Mr Pittman concluded.
*Parameters for CBRE’s hypothetic model:
A 3-year development and construction period followed by 10-year hold as a standing investment. Returns quoted are IRRs derived from a 13-year discounted cash flow model. The asset contains 125 one-bedroom units, 100 two-bedroom units and 25 three-bedroom units. Occupancy was 88% year 1 post practical completion (PC), 94% year 2 post PC and then 97% for the remainder of the DCF. Land value and rents adopted were taken from market evidence and are consistent with rates in an inner to middle ring suburb of Sydney
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