Financial Due Diligence for Australian Property

By Andrew Clugston, Partner – Business and Assurance, Baker Tilly Pitcher Partners, Melbourne

Australia’s property market is providing huge opportunities for foreign investors, keen to place their investments in offshore assets. However, without the right advice and expert guidance, property can be risky and may well ‘blow up’ in your face.

Andrew ClugstonAs with any investment, investing in property is rife with risks, but today’s property market is especially demanding and getting the right advice has become all-important.

Demand from the investment market is “running rampant” at a time when some of the property rental and leasing markets are softening, especially the office market.

While investor demand is at an all-time high, finding tenants can be extremely difficult. If you own an office building your rental levels have to be well priced, your building has to be put to current requirements and well maintained and upgraded, and you’re still going to be in a very competitive market with many other building owners in trying to secure tenants.

Unlike the hotel or entertainment sectors, commercial office buildings, shopping centres and industrial premises are areas where investors have greater control, are highly sought after asset types with investors, especially those with low cost money from overseas.

While office block tenancy demand tends to be driven by the state of the business economy, shopping centres are driven by population growth and discretionary and non-discretionary spending, while industrial premises tend to have longer term leases and are generally cheaper to acquire, making these two property sectors a safer bet for many investors.

Despite internet shopping, shopping centre performance continues to improve, people still need clothes and they need to eat, while the bigger industrial properties are considered very blue chip, possibly with 2- year leases, a low risk form of investment.

 

Accessing investment funds

Ascertaining the best way to finance your purchase is key to maximising returns on your investment.

The cheapest form of debt is through the mainstream banks, but at the same time the banks are also reasonably conservative, so they will go through every significant lending application in detail, look at property profile structures, including how secure is the income and the tenants. Their loan to value ratios (LVRs) will be much softer, probably around 50% – meaning the investor will have to provide around 50% equity.

Most property financiers these days will look at what cash flow the property will generate, where are its potential risks, where are the holes and what are the strategies to manage the problem, where will the tenants come from, and what is the business structure moving forward. These are all questions the banks are likely to seek answers to in considering a lending application.

There are, alternatively, second tier lenders such as GE Capital, which has gone out of mainstream property ownership and into property lending, often with an LVR of up to 70%, but charging a premium on the interest.

They tend to be very hands on, working with people to monitor what’s going on and providing assistance if necessary with issues that arise.

After that you get into areas such as mezzanine finance, which is definitely at the riskier end of the lending spectrum when you consider interest rates that are charged for this type of debt funding. The mezzanine lenders tend to be extremely hands on, but they are also charging at the very high end of the interest rates range. You would need a very good plan on the future direction of the property, what you planned to do with it and how you would progress forward before you approach a mezzanine funder.

Syndicated loans are a possibility as well, but are generally quite rare and usually only for very large projects that might involve a number of banks and very large sums of money.

 

A tax perspective

Foreign investment is a common feature of Australia’s property landscape and this is a trend which is only set to continue. Factors such as Australia’s low sovereign risk levels, high yields and close geographic proximity to growing Asian wealth present an attractive opportunity for foreign investors.

When considering how to finance a property investment into Australia from overseas, it is important to consider Australian tax laws, as the overall rate of return from the investment can be significantly affected by the tax implications.

Property investments often involve some degree of leveraged finance, whether it be traditional loan funding, mezzanine finance or more exotic arrangements such as Islamic finance. The characterisation of the financing arrangement as equity, debt or some other type of arrangement for tax purposes is crucial in understanding the tax implications. The characterisation is especially important when the funding is from offshore sources as additional rules will apply.

Broadly, returns on equity funding will be treated like dividends whereas returns on debt funding will be treated like interest payments. Dividends are generally not tax deductible and represent a return of post-tax profits. In contrast, interest payments are generally tax deductible and represent a return of pre-tax profits. Arrangements such as Islamic finance present a particular challenge as there is currently no specific regime in Australia to cater for such arrangements. As such, each arrangement will need to be analysed individually and may result in vastly different outcomes.

The tax implications can be both positive and negative. Current tax rules in Australia actually provide offshore investors with some tax planning opportunities that are not available to domestic investors. Appropriate structuring of funding arrangements can result in a significant reduction in the effective tax rate for investors. Conversely, a lack of planning and non-compliance with various tax rules will be detrimental to the tax efficiency of the funding arrangements.

Some examples of Australian tax rules that offshore investors and funders need to be aware of include:

The thin capitalisation regime, which is designed to deter investors from excessively funding their investments with debt. The regime limits the Australian tax deductions which can be claimed where debt to equity ratios exceed certain thresholds.

Transfer pricing rules, which can apply to adjust the pricing of debt finance for tax purposes where the interest charged is not considered to be arm’s length.

Withholding tax rules, which apply to interest and also dividend returns. Withholding tax rates can be reduced (sometimes to nil) under Double Tax Agreements (DTAs) where applicable.

Specific rules regarding foreign currency gains and losses, which apply to non- Australian dollar arrangements.

Ultimately, it must be remembered that although funding arrangements are primarily influenced by commercial factors, consideration of the tax implications is crucial to ensure the tax-efficiency of the overall structure.

Baker Tilly Pitcher Partners has built a reputation among property investors as possessing the right skill sets and commercial knowledge to assist its Asian clients successfully enter the Australian property market by considering the key aspects of cross border funding, finding the right property type for their finances and, as always, the inherent tax implications.

We have a dedicated Property group which accesses experts for the benefit of our clients and have become the leading accounting and advisory firm to the property industry in Australia. Over recent times we have delivered a series of events in Malaysia, China, Singapore and other South East Asian countries, aimed at bringing the two property industries together, by educating offshore clients on property development in Australia and vice versa.

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