YIELDS AND CAPITAL GAINS TAX - PwC

EASTERN EUROPE RESEARCH

YIELDS AND CAPITAL GAINS TAX

TACTICAL REPORT | JANUARY 2012

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

TABLE OF CONTENTS

Executive Summary

3

What's in a Yield: Introduction

4

Factors Impacting Gross to Net

5

Pricing Impact of Latent Capital Gains Tax (LCGT) Liability 5

Warsaw Scenarios

6

Budapest Scenarios

7

Market Impact

7

Contact Details

7

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EXECUTIVE SUMMARY

As we start 2012, the prospect of economic decline across Europe coupled with the restricted ability of banks to fund real estate investment for at least the first half of the year will shift the balance of market power once more in favour of purchasers. This position could last longer than just six months i.e. until the European Banking Authority (EBA) capitalisation targets have been met in full.

Only in the core, more liquid markets of Poland, Russia, the Czech Republic and to a degree Slovakia is the more balanced market position, as witnessed in 2011, likely to continue.

Outside of these markets, the balance of power will certainly be shifting to the buyer as the availability of senior debt dries up. While other forms of funding (notably equity) will be waiting in the wings, the more expensive nature of this funding is bound to have a softening impact on yields.

Other than the obvious impact on quoted yields, this shift in power is of additional importance when one factors in the impact of latent capital gains tax (LCGT) to yield pricing. LCGT brings with it two major considerations when acquiring a property:

A) how to treat CGT on any future asset sale, and

B) the loss of the tax shield of an asset over time, which results from the ongoing depreciation of an existing asset relative to the purchase price. The longer an asset is held, the greater the size of the LCGT.

As things stand, a seller of a property held in an SPV (Special Purpose Vehicle) is more likely to require a sale through a share deal. This allows the seller to avoid latent capital gains tax and transfer taxes, and thus command higher net proceeds. Furthermore, this allows the seller to extinguish any ongoing involvement with the company which owns the real estate.

A buyer, on the other hand, is more likely to prefer an asset deal, as this avoids buying a company with a long tax and financial history. Buying a property as an asset would also reset the tax base of the property, providing an increased tax shield going forward. With older companies, the tax shield is likely to be much lower, as the acquisition cost will be the historical purchase cost and a number of years of tax depreciation are likely to have already been utilised. As such, a buyer's tax position is likely to be better going forward if the purchase is realised through an asset deal.

FIG 1. YIELD PREMIUMS AND DISCOUNTS

12.00% 11.00% 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00%

2000 2001

2002 2003 2004 2005 2006 2007 2008 2009 2010

2011

Warsaw Yield: CGT Discount

Warsaw Yield: CGT Premium

In a balanced market, careful negotiation is required to agree on the price in order for a transaction to be successful for both parties. Even though an asset deal is the preferred buyer model, this could mean a lower exit price for the vendor. A share deal is more likely to be the agreed method for the purchase of real estate, as buyers will not have sufficient power to influence the choice of model. One size never fits all. Getting the right, experienced advice is paramount and it starts with knowing the position of your market.

If you see a number of deals reported at say 6.5%, the chances are that there will actually be quite a wide variation in returns around that number, dependent on the deal structure - existing market reporting of yields doesn't reflect this.

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

INTRODUCTION: WHAT'S IN A YIELD?

Since 2000 we have been able to track prime yields across markets in eastern Europe. Figure 2 below highlights the extent to which prime yields in the four office markets of Warsaw, Budapest, Moscow and Bucharest have reacted to changing market conditions.

Each market, of course, is subject to its own unique political, economic, legal and property market risks and opportunities just as much as they are influenced by international market conditions.

We can see these local and national dynamics showing through as yields continue to trade at a relative premium or discount to one another, reflecting inherent market risk and liquidity levels. We can also see how risk and market sentiment has changed in favour of one market over another - Poland now `out-performs' Hungary, for example, which is the reverse of 10 years ago.

The international influence of money markets is collectively visible, as yields have converged closer to western European prime market rates (of sub 6%), then softened between 2007 - end 2008 as a result of the global financial crisis, prior to compressing again as of 2009.

As 2012 rolls on, with grounded concerns over the reduced availability of debt finance outside of the `core' markets of Poland, Czech Republic, Russia and Slovakia, we may well see prime yields soften outside of these markets. Yields on secondary assets will also likely bifurcate further from their prime counterparts.

FIG 2. EASTERN EUROPEAN PRIME OFFICE YIELDS OVER TIME

16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00%

2000 2001 Warsaw

2002 2003 2004 2005 2006 2007 2008 2009 2010

Budapest

Bucharest

Moscow

2011

FROM GROSS TO NET

Whilst an investor can accurately determine the availability and cost of debt on a specific asset, in order to truly determine the return potential and cashflow an asset can generate one needs to look beyond the typical prime `gross yield' quoted (often referred to as a prime `net initial yield').

The gross yield figure (or `net initial yield') equates to the first year's net income divided by the purchase cost, exclusive of any other purchase costs.

There are two main areas of a deal where additional discounts/premiums need to be accounted for, which will adjust the actual yield figure.

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

TAX RATES BY COUNTRY

Country

Bulgaria Czech Rep. Hungary Poland Romania Slovakia Ukraine

CIT/CGT

10% 19% 10-19%* 19% 16% 19% 23% ****

Stamp Duty/ Transfer Tax 0.1% - 3%

3% 4%**

0% *** 0% 1-2%

Source: PWC/Colliers International

* for Hungary, the 10% rate applies up to ca. 1.7million,19% for the residual value above the 1.7million.

** typically carries a transfer tax equivalent of 2-3% *** variable rates apply for Romania **** set to decrease from 2012

FIG 3. CEE: SHARE VS. ASSET DEALS

2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999

0% Share Deals

Source: Colliers International

50% Asset Deals

100%

FACTORS IMPACTING GROSS TO NET

The two main areas where additional discounts/premiums can be applied to gross yields are:

1 At the asset level - such as non-recoverables, required capital expenditure, service charge losses and upcoming voids to name but a few.

2 In relation to the actual purchase cost - notably from taxes and professional transaction fees.

This report explores the impact of the second category - purchase costs, specifically the impact of latent capital gains tax (LCGT) liability and the subsequent triggering of profit & transfer taxes which may emanate from a deal as a result of LCGT being crystallised.

By analysing the impact of LCGT on the gross (net initial) yield under different transaction scenarios, we will highlight the extent to which a gross yield can range significantly from a quoted `spot` gross (net initial) yield figure.

TRANSACTION COSTS - TAXES AND PROFESSIONAL FEES

Every transaction carries with it costs and fees, which are not accounted for in a gross (net initial) yield.

In all markets a percentage fee will be paid towards agents/advisors and fixed fees are payable towards legal advisors as part of due diligence and other deal costs. Depending on the size of the deal this will typically range from 0.15% for large deals up to 2% for small lot sizes.

In addition, other taxation costs ? notably LCGT, property and other transfer taxes - may apply which could significantly alter the price position.

CAPITAL GAINS TAX

Depending on the legal structure of the transaction, the actual incidence of LCGT can be, and is often, diversified. This depends on whether a transaction is conducted as either:

> an `asset' deal i.e. the sale of the actual physical property, or

> a `share' deal i.e. the sale of shares of the special purpose vehicle (SPV) in which the physical asset is held.

In asset deals, taxes are always crystallised as a result of the transaction closing. In share deals, the SPV structure is created to utilise the numerous planning opportunities and exemptions available in most tax jurisdictions in order to defer away or minimise any such crystallisation of taxes on the sale.

The chart opposite highlights the extent to which share deals have been by far the most popular form of investment vehicle across the region for the past ten years. In almost every year, bar 2009, shares have been the preferred medium for property investment trading in the region.

Tax, however, doesn't go away. All you can do is defer it. That is why it is prudent for the pricing of any share deal to always account for an LCGT provision.

In order to highlight the impact that LCGT may have on investment pricing in different markets, we have created scenarios of how LCGT can impact on a yield on an `identical' hypothetical prime office deal in the markets of Warsaw and Budapest.

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

CALCULATING LCGT LIABILITIES

Property Particulars Gross (Net Initial) Yield Net Operating Income Remaining Lease Term Purchase Value Book Value Capital Gain Capital Gains Tax Rate: Capital Gains Tax Liability

6.5% 3.5 million p.a. 5 years 53.8 million 37.0 million 16.8 million 19.0% 3.2 million

Source: PWC/Colliers International

Scenario 1: Buyers' Market

> Share deal > Seller accepts an 80% LCGT discount > Effective Discount: 2.56 million > Yield Impact: 6.82%

Scenario 2: Balanced Market

> Share deal > Seller accepts a 50% LCGT discount > Effective Discount: 1.6 million > Yield Impact: 6.70%

Scenario 3: Sellers' Market

> Share deal > No discount/premium applicable > Yield remains: 6.5% > *Hidden premium of 3.2million (reduces

actual yield to 6.14%)

WARSAW - PRIME OFFICE EXAMPLE In order to highlight the impact that LCGT liability may have on investment pricing, we have developed three scenarios for the sale of a prime office building in Warsaw. Each scenario is based on a `hypothetical' transaction being conducted for the same property, but differs according to the balance of the market (in favour of vendors or purchasers); and the type of legal structure used for the transaction i.e. share or asset deal.

The specifics of the deal are identified in the Property Particulars table, opposite. Essentially this deal would create a capital gain of 16.8 million for the vendor, which in turn would generate a capital gains tax liability of 3.2 million (at a CGT rate of 19.0%).

Firstly, let's consider the position of the seller as to what is most ideal for them. Ultimately they want the highest price and capital return they can achieve, so how they configure their LCGT (and other tax) obligations will be a big part of this.

Secondly, even though any LCGT is non-payable using the share/SPV structure, the current/ future owner must consider that at some point in time they may/will have to pay the CGT owed.

SCENARIO 1: BUYERS' MARKET, SHARE DEAL

Negotiations take place when market conditions are most favourable to the buyer. As a result, the buyer can command a sizeable discount to the purchase price in lieu of the LCGT liability they are likely to face, as owners, in future. It is not, however, such a strong buyers market allowing them to cajole the vendor into an asset deal.

In this instance, the vendor agrees to assume 80% of the latent capital gains tax liability. This equates to a discount of 2.56 million off the purchase price.

In yield terms, the subsequent re-pricing softens the yield by 32 basis points, equating to a new `LCGT net' yield of 6.82%.

SCENARIO 2: BALANCED MARKET, SHARE DEAL

In scenario 2, negotiations take place in a more balanced market such as those of most of 2011. In this case the buyer and seller agree to split the potential LCGT liability 50/50, resulting in a pricing discount for the buyer.

The subsequent re-pricing softens the yield by 20 basis points, equating to a new `LCGT net' yield of 6.70%.

SCENARIO 3: SELLERS' MARKET, SHARE DEAL

Going back to the good old days of 2005-2007is the last time we had classic (aggressive) sellers markets. `Gross prime yields' were down to sub 6% and vendors were able to offer no LCGT discount to purchasers in the market.

It is unlikely we will see such circumstances again for some time, but if we did ? as per this example - the vendor would seek to maximise the sum received from the sale of the property and effectively pass the entire LCGT liability position on to the buyer.

In effect the purchaser pays a flat gross yield of 6.5%, as they are in no position to negotiate a discount ? there is no yield spread at all. On the other hand no premium is payable either (although there were some examples of buyers paying premiums in the market at the time, but these were one-off cases).

However, it is worth considering that the purchaser has actually inherited a 3.2million `hidden premium' comprised of the existing LCGT liability. In future if they cannot pass this on to the next purchaser, or at least part of it (which will be partly determined by the balance of the market at the time), the worst case scenario for the purchaser is that they have paid an effective net yield of 6.14% taking into account this hidden premium.

SUMMARY

While the total yield spread from these three scenarios is only 32 basis points, this still represents a fair quantum of cash. If we take into account the `hidden premium' factor, the spread could be as much as 69 basis points from this deal.

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

WARSAW & BUDAPEST: SCENARIO OUTCOME

Country

Warsaw

Budapest

Yields Net of LCGT Liability

Scenario1

6.82%

6.81%

Scenario2

6.70%

6.69%

Scenario3

6.14%

6.15%

Yields Net of LCGT Liability & Stamp Duty

Scenario1

6.82%

6.64%

Scenario2

6.70%

6.53%

Scenario3

6.14%

5.98%

Source: PWC/Colliers International

BUDAPEST - PRIME OFFICE EXAMPLE

The same property particulars apply to this hypothetical deal happening in Budapest, but we have to take into account a different tax regime within the market. In Budapest, CGT is currently applied in two tranches: 10% on the a tax base of up HUF 500 million (ca. 1.68 million) then 19% on the residual amount.

We also have to account for ca 2.5% stamp duty payable on sizeable real estate deals, such as this one.

On the whole we have a very similar outcome to deals in Budapest as to those in Warsaw, when applying the three scenarios to `LCGT net' yields (i.e. there is only 1bp difference as a result of the twin-CGT rate applied in Budapest).

The only noticeable difference in yields between the two markets results from the application of stamp duty rate in Hungary, hardening the net yield by 17 basis points in each scenario.

Overall, we get a similar yield spread in Budapest of 66 basis points (to the 69 basis points of Warsaw) taking account of the potential impact of LCGT.

FIG 3. LCGT DISCOUNT/PREMIUM IMPACT

100% 90% 80% 70% 60% 50% 40% 30% 20% 10%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

50

Non-CGT adjusted price

52

54

56

58 60

Euro Millions

Source: PWC/Colliers International

CONCLUDING COMMENTS

The key message here is that an effective gross yield can be significantly impacted by the amount of CGT absorbed by both the buyer and seller. As the LCGT allocation is not disclosed in quoted yields, it is imperative that all vendors and purchasers understand what is included in the yield being quoted, and what other factors can and will have an impact on the final price/yield payable.

In order to achieve the best yield and price possible, whether you are a buyer or seller, you need to understand:

> The market position now, and the likely position in the near future.

> The existing legal structure and tax position of the asset.

For now the advice is always make sure LCGT liability is factored into the pricing equation, but take advice.

While some may think they can avoid LCGT with clever structures, there is a growing trend where a number of governments are doing their utmost to close these legal loopholes as a way of increasing tax revenues and reducing government deficits.

If this kind of governmental review gains traction, especially with talk of a move toward fiscal union for a number of EU states, the risk of LCGT crystallizing at the date of sale moves from possible to probable in future.

Premium

Discount

Disclaimer This report gives information based primarily on published data which may be helpful in anticipating trends in the property sector. However, no warranty is given as to the accuracy of, and no liability for negligence is accepted in relation to the forecasts, figures or conclusions contained in it and they must not be relied on for investment purposes. This report does not constitute and must not be treated as investment advice or an on offer to buy or sell property.

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EASTERN EUROPE RESEARCH | YIELDS AND CAPITAL GAINS TAX JANUARY 2012

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Colliers International Galerie Mysak Vodickova 710/31 Prague 1, 11000 Czech Republic

TEL +420 226 537 624 FAX +420 226 013 579 EMAIL damian.harrington@

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Our proven system of investment sales takes into account each investor's unique priorities and weighted concerns for price, closure and risk. The outcome of our specialized approach is strategic development of the property's competitive profile, speed to market and careful negotiation to ensure a smooth closure and investment return.

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RESEARCH WHITE PAPERS

Colliers eastern European research team has been working on a number of articles, reports and white papers on all matter of events impacting the real estate market. Topics we have covered include:

> The future role of Banking and the impact on the real estate industry

> Generational change and the impact on office space demand and supply

> The market positioning of the Business Process Outsourcing industry in eastern Europe ? scope for change and growth and the impact on real estate.

> Infrastructure change and the impact on the logistics industry, and logistics space demand

Feel free to get in touch if you would like to know more.

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