Build to Rent

Australia needs the right footings for a successful industry

Build-to-rent (BTR) is an innovative and exciting opportunity for the Australian property sector. It is no secret that the country's rental market demand is increasing. Combine this with declining home ownership rates and BTR becomes an attractive alternative for investors and lodgers alike from the traditional "build-to-sell" and "one unit one landlord" structures.  BTR also presents unique opportunities in Australia for job creation, housing affordability, domestic and foreign investment and renter satisfaction.

BTR is not however without its challenges. Achieving the correct legislative and policy balance is necessary for ensuring its success in Australia.

What is BTR?

You've probably already heard the Build-to-Rent buzzword floating around the water cooler - but what is it?

"BTR housing is purpose built, institutionally owned and professionally managed private rental accommodation"

It is distinct from traditional private rental accommodation in that BTR usually involves one landlord of the entire development who retains long term ownership and rents the units long term. BTR usually involves the following:

 

The success of the model depends on the long-term retention of tenants.

BTR developments differ from the built-to-sell model, traditionally favoured by developers. The build-to-sell model enables investors to provide upfront capital and gain a relatively expedient return. By contrast, BTR is designed for longer term return carrying a lower risk.

Who is doing it?

BTR is not a new phenomenon and its success can be seen abroad.

What are the benefits?

The BTR model offers a broad range of benefits to the Australian market.

Tenant demand

Provides attractive options for those unable or unwilling to buy their own homes, allowing people to live near the jobs and services they need in well-located areas.

Jobs and Growth

New industry to drive jobs and growth.

Housing stock

BTR investors will often look to build larger schemes than traditional unit and house builders in order to drive economies of scale, resulting in high housing stock.

Foreign investment

Attracts foreign investment from established UK BTR and US "multi-family" developers and funds familiar with the ready build sector.

Faster delivery

BTR housing can be delivered faster than housing for sale as it does not have the same issue of market saturation risk as build to sell developments.

Less volatility 

Because BTR investors are looking for returns over a period of decades, investment would be less sensitive to economic cycles than traditional buy-to-sell development.

Renter satisfaction

Single ownership avoids patchwork management as there is one manager responsible for the whole building.  This would increase the quality and services of the rental stock available to the Queensland public.  Market competition would ensure these service levels are maintained. 

New capital sources and investment vehicles

BTR is a way of attracting alternative sources of capital into the Australian home building market. Traditional home building - with high-risk and short investment cycles - does not appeal to super and managed funds seeking long-term income whereas build-to-rent is ideally suited to them.

Investment stability

"The nature of BTR investments provides for lower risks and lower yields over the long term."

This makes BTR attractive for superannuation, pension funds and risk adverse investors sourcing risk adverse long term investment options.  

Because BTR investors are looking for returns over a period of decades, investment is less sensitive to economic cycles than traditional build-to-sell developments. The BTR model is ideal for superannuation funds that have the upfront capital to acquire land, utilise their members' funds to construct the development and hold on to the property for long-term returns. We have already seen superannuation funds utilise the BTR model in Australia.  

First State Super has recently announced that it will construct 61 units in Sydney. In Queensland, developer Property Projects Q has recently lodged plans to build 36 residential units as part of a mixed-use development project in the inner CBD hub of West End. In line with a BTR model, Property Projects Q will develop, own and manage all units. This reflects developer appetite to implement BTR in the Australian property market.

New capital sources

"The BTR model attracts alternative sources of capital into the Australian building market."

Traditional home building can be subject to high-risk and short investment cycles. 

BTR would be an attractive investment for superannuation and pension funds seeking longer term and less volatile income streams, and as a result, has the potential to attract new sources of capital into the housing market. 

Housing affordability

"BTR will increase Australian housing stock."

BTR investors will often look to build larger schemes than traditional unit or house builders in order to drive economies of scale.

An increase in housing stock means more cost-effective housing and a boost for the construction industry. 

Crucially, BTR investments will provide attractive options for those who are unable or unwilling to buy their homes. Because of high rental demand, BTR does not have the same issues of market saturation risk as build-to-sell developments.  Accordingly, introducing the BTR model will result in increased affordable housing for people to live in well-located areas.

Tenant focus

"The inherent focus of BTR developments is to provide renter satisfaction. The nature of BTR is that the success of the return is dependent on long-term tenancies."

The BTR model is reliant on occupancy and steady rental growth. This objective incentivises landlords to deliver high quality products and services. Generally, the building quality of BTR facilities is improved, as landlords wish for the premises to be used long term. 

Control by one owner further avoids patchwork management as there is one landlord responsible for the whole building, which enables the single landlord to efficiently provide services and other amenities to tenants. For example, it is not uncommon in the USA for BTR projects to provide services such as dry cleaning, pet and child care on top of the usual gyms, pools and high quality shared areas we see in new Australian apartment developments. 

This increases the quality of the rental stock available to the general public, while also reducing the number of poorly maintained dwellings, unexpected rent increases and landlords unexpectedly selling the premises.

These are decisive benefits for the tenants and drives a sense of community for tenants.

Social investment

"The BTR model has the potential for Australian governments to provide affordable and social housing to disadvantaged members of the community."

It can address housing barriers for people in situations of domestic and family violence, reduce rates of youth and Aboriginal and Torres Strait Island homelessness, and  provide improved access to quality housing for individuals receiving social security payments. 

BTR, as an intersection between the government, private, and non-for-profit sector, will also enable service providers to more effectively target the complex needs of individuals who live in public housing. Members of these complexes will have improved facilities, better access to health and education providers and opportunities for employment.

What are the shortcomings?

Taxation Issues – income and capital gains tax

"The current taxation regime in Australia does not make BTR projects attractive for investment, particularly for foreign investment."

It is common for long term investments in real estate to be structured through unit trusts. The primary advantages associated with investing in real estate through trusts include:

• Greater flexibility with respect to cash repatriation.In particular, to the extent that cash exceeds distributable profits, it is easier (from a legal perspective) for a trust to distribute the available cash than a company, which is subject to restrictions on reductions of share capital that do not apply to a trust.  Such distributions also may be "tax deferred distributions" which do not trigger the recognition of any immediate taxable income or capital gains, but reduce the cost base of the units in the trust (and thus can defer the tax until the units are disposed of or otherwise realised).
• The capacity for the trust to qualify as a withholding managed investment trust (MIT). In order to qualify as a MIT, there are a number of requirements that must be satisfied, including that the trust is widely held and not closely held and that it is not carrying on a "trading business". If the trust is able to and does qualify as a withholding MIT, then distributions of rental income (and capital gains) are generally subject to a 15% withholding tax when distributed to non-residents.   In addition, the trust is eligible to make an election which deems certain assets to be held on capital account, which can provide greater certainty for investors, particularly to resident investors eligible for CGT discount treatment.  

However, as a result of the Treasury Laws Amendment (Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Act 2019, the rate of withholding tax on distributions of rental income and capital gains arising in respect of BTR investments that are made by withholding MITs in respect of most residential housing (other than as noted below) to foreign residents is now 30%, regardless of whether the recipient is a resident of a jurisdiction which has an effective Exchange of Information arrangement with Australia. 

The 15% withholding rate remains available for investments in residential housing that constitute "affordable housing", certain disability housing, or residential dwellings that qualify as "commercial residential premises", which is generally limited to investments in hotels, motels, hostels, inns or boarding houses (which may be eligible to be held by a withholding MIT where they are let to a third party operator) or equivalent premises, or certain forms of student accommodation. BTR premises are unlikely to qualify as "commercial residential premises" or any of the other categories of residential housing to which the 15% withholding tax rate applies.

In other words, foreign residents investing in real estate such as commercial office buildings or shopping centres through a withholding MIT may be eligible for a 15% withholding rate, whereas all foreign residents investing in BTR through a withholding MIT will generally be eligible only for a 30% withholding rate. Considering that many foreign investors are familiar with the investment class (as a result of multi-family and similar investments in foreign markets), the differential treatment afforded to withholding MITs by reference to the underlying passive investments (e.g. commercial office as opposed to BTR) is considered a serious impediment to the development of BTR as a significant asset class in Australia.

Generally speaking, resident investors in BTR should be eligible for the same treatment as for other investments in real estate.

Taxation issues - GST

"Another impediment for investors is the increased GST cost. While no GST will be payable by landlords/tenants in respect of rental payments due to the leasing of residential premises not being subject to GST, the landlord will also be unable to claim back any GST that it incurs on third party costs that are associated with its leasing activities (e.g. construction costs, maintenance costs and operational costs)."

The effect of this is that the landlord's costs will generally increase by 10% which, in turn, will adversely affect the landlord's returns. 

The same issue does not arise for developers of commercial buildings such as hotels or office buildings or developers of "build-to-sell" projects as developers are able to claim back all GST incurred as a credit, such that GST is not a "cost" to developers. Although GST is generally payable by purchasers of build-to-sell projects, the application of the margin scheme often reduces the net GST payable.

Taxation issues - state taxes

BTR projects also attract State-based taxes such as stamp duty and land tax. Where the landlord is considered to be "foreign" in certain States, a surcharge will also in addition be payable to the standard stamp duty and land tax rates (up to 8% for stamp duty and 2% for land tax).    

While stamp duty is a one-off transaction cost that arises on any property-based investment, land tax is an ongoing annual charge to the owner of the land. Unlike commercial leases where the owner is able to pass on the cost of outgoings to the tenant (such as land tax and rates), landlords are generally prevented from doing this under the relevant residential tenancy legislation. In turn, this affects a landlord's rate of return due to the increased annual cost. The same issue does not generally arise for investors who own a small number of houses or apartments as their value may be below the land tax threshold. However, in a BTR project where the landlord owns each apartment, the threshold will clearly be exceeded.

The surcharges can potentially affect the returns of domestic investors in a BTR project if the presence of foreign investors results in the landlord being regarded as "foreign" in the particular jurisdiction where the project is located. 

Exemptions from foreign surcharges are available in certain States where the developer can evidence that it is significantly contributing to the availability of housing stock in the relevant State, and the developer is making a contribution to the economy by utilising Australian-based employees and contractors. However, the exemptions vary between the jurisdictions and are quite narrow in their application. Currently, Victoria is the only State which has recognised that a BTR project may qualify for an exemption.

Debt vs equity 

"BTR is likely to require higher equity investment."

In order for developers to obtain finance for build-to-sell projects, they are required to secure a high numbers of pre-sales. The BTR model of securing long-term tenancies prior to and during construction of the project is more onerous compared to build-to-sell projects.

This will require BTR operators to offer flexible tenancy arrangements. In our experience, although finance institutions will support BTR projects, they may require the debt-to-equity ratio to be less.  Moreover, developers and funds are likely to scrutinise lock-in capital long term and offset high construction costs under the BTR model.  This may deter developers.

State tenancy legislation

State residential tenancy legislation imposes hurdles for the BTR model as this legislation tends to be tenant-friendly. For example, State residential tenancy legislation tends to restrict a landlord's ability to:

• recover land holding costs from a tenant; and
• terminate residential tenancy agreements except in accordance with precise time frames and circumstances.

State governments must recognise the dynamic nature of BTR tenancies and that BTR may require standalone legislation in this regard.

Distressed operators

The nature of the BTR model is that it imposes significant restrictions on the disposal of the asset if the landlord faces liquidity problems. Landlords who face liquidity problems will find it more onerous to dispose of the entire asset as there are fewer buyers in the market (due to the nature and size of investment) compared to the build-to-sell model. This may result in undesirable outcomes for both landlords and tenants and ultimately deter developers from investing in the BTR sector.

Where to from here?

In order to harness the BTR industry and encourage investment while minimising risk to developers, government is required to complete several policy reforms.

First, there must be formal recognition of the BTR model in a separate legislative regime (similar to retirement villages). Given BTRs are multi-tenure developments, the schemes offer longer agreements and are professionally managed, therefore a balanced approach to the tenancy arrangement is required. This sensible approach will encourage investment in the industry.

Secondly, a rebalancing of the tax system is required. At a minimum:

• foreign investors investing through withholding MITs into BTR should receive equivalent treatment to comparable asset classes, such as commercial office or retail investments for rent;
• clear exemptions from foreign surcharges where the investors are providing a significant contribution to housing stock and a positive contribution to the economy; and
• equivalent GST treatment to commercial residential premises.