Contributed By Baker McKenzie
Switzerland was regarded as a stable investment environment with a steady regulatory landscape for a long time. However, in recent years, regulatory insecurities have increased due to a range of political initiatives, which touch upon several areas relevant to the real estate sector. As an example, political efforts to limit the free movement of people have led to a significant decrease in immigration into Switzerland. Additionally, a tax reform intending to abolish the federal tax on the imputed rental value of properties is currently under discussion. Other popular initiatives deal with the phenomenon of urban sprawl and, in this context, intend to restrict construction activities.
Real estate investments
Nevertheless, in 2018, the Swiss economy continued to grow, not least due to prevailing low and even negative interest rates. In this environment, real estate investments in Switzerland continue to be attractive, in particular because prevailing negative interest rates put pressure on institutional investors. According to a report published by JLL Switzerland, in the first three quarters of 2018 Swiss real estate investment funds collected approximately CHF2.2 billion of fresh capital, 45% more than in the previous year (JLL, Report: Büromarkt Schweiz – 2018). At the same time, however, according to data published by UBS, for the first time since 2013, the value of interest in Swiss real estate investment funds has declined and the average distribution yield has decreased to 2.6%, compared to 3.5% in 2008 (UBS, Real Estate Focus 2019). The net return for residential property and retail spaces is, again, lower than in the previous year.
For office spaces the net return has been, for several years now, at a record low, but increased significantly in 2018 compared to the previous year. According to UBS' analysis, this trend is expected to continue due to an increase of employees in office sectors, which leads to a higher demand for office spaces. Moreover, although construction activity stayed lively in 2018, requests for construction permits have declined significantly (around 10%). As a consequence, rents and, thus, return rates, are likely to increase, though only after 2020 when construction activities are expected to decline.
The net return of commercial properties in Switzerland was, on average, close to 5% over the last five years, thus significantly lower than for residential properties. However, the demand for commercial spaces increased in 2018 and, according to an analysis published by PwC, this trend is expected to continue (PwC, Immospektive Q4/2018). As a consequence, the oversupply starts declining, which allows property owners to increase rents for commercial spaces. In Zurich, for instance, vacancies in the Central Business District, according to JLL Switzerland, have been cut in half since 2014 (JLL, Report: Büromarkt Schweiz – 2018). Already in 2018, rent for commercial properties in Switzerland increased 4.4% compared to the previous year. This does not, however, change the fact that rents for commercial properties are still at a record low in Switzerland.
Prices paid for residential properties are on the rise in Switzerland. Thus, the prices for condominiums show an increase of 2.6%; for single-family homes, the increase is even higher at 7.2%. According to an analysis published by PwC, this trend is expected to continue due to a strong economy, a falling unemployment rate and continuously low costs for financing (PwC, Immospektive Q4/2018). Moreover, indications for a real estate bubble in Switzerland decreased in 2018 and, for the first time since 2012, the UBS Swiss Real Estate Bubble Index is not in the risk zone (0.87 index points). In the rental residential sector, vacancies continue at a record high (1.7%), mostly due to an excess in construction of rental apartments, and rents are declining. There are, however, significant regional differences. In major Swiss cities, the number of vacant rental residential properties has even decreased.
Legal and Tax Implications
General trends and developments in transaction structures
A clear trend in larger Swiss real estate transactions is increased legal and structural complexity. There are several elements that contribute towards that increase.
One reason is the fact that in the current sellers' market, share deals are playing an important role as this transaction form is typically more tax-efficient for sellers. Share deals require both parties to look at a transaction, not just from a pure real estate perspective, but also to bring tax and accounting expertise to the table. If structured correctly, for example, as a tax fee quasi-merger, share deals have high cost-saving and tax-saving potential. A recent example of a share deal that was eventually structured as a quasi-merger is the acquisition of Immobiliengesellschaft Fadmatt AG by Mobimo Holding AG in June 2018 for CHF183 million.
Another reason for the increased complexity is that sophisticated M&A market practice is increasingly penetrating real estate transactions, both for share deals and for regular asset deals. For example, detailed warranty limitation concepts with de minimis amounts, thresholds and liability caps are becoming more widely used. At the same time, buyers try to push for extended warranty catalogs. See also Warranty Insurance for Real Estate Transactions, below.
Complexity is further added when entire portfolios are being sold. When the seller is a legal entity registered in the commercial registry in Switzerland, portfolio transactions are typically done by way of a so-called 'asset transfer' under the Swiss Merger Act (Vermögensübertragung). Different than a regular asset deal, an asset transfer allows for the transfer of an entire real estate portfolio, even if located in different cantons, in a single public deed. The transfer of title is then perfected by registration of the public deed in the commercial registry at the domicile of the seller. The registration in the land registry is made subsequently, with declaratory effect only. Depending on where the properties are located and where the seller is registered, substantial cost savings can be obtained compared to a regular asset deal. Examples of recent large asset transfers are the sale of a portfolio consisting of 38 Swiss real estate properties by Swiss Life AG for approximately CHF500 million in December 2018 and the sale of a portfolio of 35 Swiss real estate properties by Bâloise for approximately CHF275 million.
Warranty insurance for real estate transactions
Taking out warranty insurance has been a trend for several years in the M&A market and has now passed over to the real estate market. With the real estate market having become a competitive sellers' market, buyers are able to offer sellers a better deal by shifting warranty risks from the seller to the warranty insurance. For example, we have seen sellers' liability caps being reduced to as little as CHF1. In a competitive bidding, a buy-side warranty insurance can often be the decisive difference between winning or losing a bid. Furthermore, we see warranty insurance particularly useful where the solvency of the seller is questionable, for example, because it is a special purpose vehicle, a foreign company or a large number of individuals with no joint liability. In terms of transaction structure, warranty insurance can be used in share deals and asset deals. The typical minimal insured sum is CHF10 million. Insurance premiums vary from tender to tender but typically range between 0.9% and 1.5% of the minimal insured sum.
In terms of insurance coverage, one can get coverage for standard representations and warranties in a real estate sale and purchase agreement with the exception of certain environmental matters, which have to be looked at on a case-by-case basis. However, no coverage is provided under a warranty insurance for matters that have been identified as material risks following due diligence. This means that a warranty insurance is not a substitute for an indemnity.
The insurance policy usually provides for a waiver of subrogation of the insurer against the seller, except for willful deceit and intent.
Share deals for pension funds and investment funds
Traditionally, pension funds and investment funds are reluctant to engage in share deals. There are various reasons for this, including: (i) share deals are often more complex than asset deals; (ii) share deals are somewhat 'unknown territory' for funds; and (iii) most importantly, pension funds are exempt from income taxes and investment funds are subject to lower corporate income tax rates than real estate companies in many cantons. As a result, from a tax point of view, at least at first glance, it does not make sense for a fund to acquire real estate via a share deal and hold it indirectly through a corporation, as the tax burden of such indirect holding is higher than that of a direct holding. The downside of this attitude is that funds often miss attractive opportunities: as outlined before, there is a trend towards share deals, at least when it comes to larger transactions and portfolio transactions. These transactions are often the most attractive as they allow significant volumes of real estate to be purchased and internal and external efforts and transaction costs to be minimised at the same time; these efforts and costs are often the same in a small and in a large transaction, as a result of which larger transactions provide opportunities for synergies and cost savings.
What pension funds often miss is the following: in recent years, the Swiss Federal Court has clearly stated that pension funds can also rely on certain legal provisions regarding the reorganisation of corporations (cf BGer 2C_199/2012). As a result, it is often possible for a pension fund to acquire real estate in a share deal (and, therefore, catch an opportunity) and later reorganise the indirect holding of the real estate into a direct holding without any negative tax consequences. As a result, the pension fund can then take advantage of tax exemption in the future. While the situation for investment funds is not exactly the same, there are acquisition and structuring opportunities which yield the same or a similar result as for pension funds.
To sum up: funds should become less conservative when it comes to share deals. Unless they change their approach, funds will miss opportunities, in particular, in a market which has become more and more competitive in recent years. They can seize these opportunities without having to incur any (tax) disadvantages if they have a more open mind regarding alternative transaction structures.
Sale and lease back
Despite the entry into force of the IFRS16 standard on 1 January 2019, which requires lessees to recognise assets and liabilities for most leases, there are still a number of sale and lease back transactions done every year. The main reason for that volume of transactions probably lies in the fact that yields are still very low and the market is, therefore, very attractive for divestments. At the same time, the economy is going strong, allowing sellers to pay high rents, which disproportionally increases the sales price.
There are two main types of sellers in sale and lease back transactions. First, there are the large corporates, typically banks and insurance companies, who want to divest real estate for capital and liquidity reasons. Transactions from these sellers are also often linked to an envisaged reduction in used space, be that through shared offices or job cutting in Switzerland. Therefore, the lease back period on large corporate sale and lease back transactions is often shorter in nature, which typically can be compensated by a high re-usability of the respective buildings. The second type of seller in sale and lease back transactions is the small-to-medium-sized manufacturing company. Such sale and lease back transactions are often initiated by their private equity owners, who use this as a technique to free up some liquidity in their investment.
In sale and lease back transactions, the lease agreement is typically in the form of a triple net lease. These lease agreements shift basically the entire repair and maintenance obligation to the tenant, de facto creating a bond-like investment for the landlord. This shift in responsibility is eventually in the interest of both parties because the tenant has owned and operated the property for a number of years and is, therefore, in a much better position to make CAPEX estimates than the buyer as the future landlord, resulting in a higher sales price. Furthermore, many tenants also see their real estate as a core strategic asset, which they need to be able to adjust to changing market demands and trends. A good example of this are certain schools for hotel management operated in the French-speaking part of Switzerland, where it is business-critical that the tenant remains in control of the look and feel of the leased objects.
With the abovementioned exceptions, sale and lease back lease agreements often have a very long term of 15 to 20 years with several extension options. On the one hand, these long terms provide the tenant with sufficient predictability in terms of its location and time to write off investments. On the other hand, long terms generate very high sales prices because they take uncertainty out of the discounted cash flow model underlying the real estate valuations of the buyers.
Optimisation of real estate capital gains tax
The Swiss tax system consists of three different levels: taxes are levied at federal, cantonal and communal level. At federal level, gains resulting from the sale of properties belonging to a person's business assets are subject to income tax or corporate income tax. At cantonal/communal level, gains from all kinds of properties are subject to taxes. In cantons which apply the so-called 'monistic system,' the value increase of a property is taxed at the time of a sale with real estate capital gains tax. This is the case in both asset deals and share deals. The value increase of a property is the difference between the market value of such property (typically the sales price) and the investment costs, whereby the investment costs include the original purchase price plus any value-enhancing investments made by the owner since the acquisition. Cantons which apply the monistic system include Zurich, Berne and Basel – ie, important cantons, which are often the focus of investors when they look for investments in Switzerland.
There is a twist in the system outlined above: if a seller has owned a property for more than 20 years, in most monistic cantons, an owner may choose in a sales transaction whether, for purposes of real estate capital gains tax, the value increase of a property is calculated as the difference between (i) the market value of the property and the original purchase price plus any value-enhancing investments made by the owner since the acquisition, or (ii) the market value of the property and the property's market value 20 years ago plus any value-enhancing investments made by the owner in the last 20 years. Thus, if the property's market value 20 years ago plus any value-enhancing investments made by the owner in the last 20 years is higher than the original purchase price plus any value-enhancing investments made by the owner since the acquisition, there would be a gap between the higher market value of the property 20 years ago (plus investments) and the lower original purchase price (plus investments). This gap is tax free – ie, it is not subject to real estate capital gains tax or any other tax.
This mechanism can be very attractive in future sales transaction: after the Swiss real estate market reached a peak in 1990, there was a steep and constant decline in real estate prices until about 1998/1999. As a result, in the past ten years, it was seldom attractive for a seller to base real estate capital gains tax on the market value of the property 20 years before a sales transaction as such market value was often lower than the original acquisition costs. As a result, sellers most often paid real estate capital gains tax on the 'real' value increase of a property – ie, the difference between the market value of the property and the original purchase price plus any value-enhancing investments. This is now about to change: since about 1999, real estate prices in Switzerland have been on a constant rise until today (with the exception of a temporary drop around 2002/2003); regarding the development of Swiss real estate prices see, for instance, Immobilienmarkt Schweiz: Experten von IAZI rechnen 2021 mit einer Trendwende. As a result, in a future transaction, the market value of a property 20 years before a transaction (plus investments) will often be higher than the original purchase price (plus investments). This is particularly true if a property was acquired in the declining market between 1991 and 1998. Thus, there is an opportunity to create a gap for the purposes of calculating real estate capital gains tax. As this gap is tax free, there is an opportunity for sellers to avail of significant tax savings in future transactions.
Set-off of gains and losses in real estate transactions
The Swiss tax system not only consists of three different levels – federal, cantonal and communal – but the 26 cantons also have different tax systems. As a result, it is rather complex to successfully navigate through this jungle. A topic which is often overlooked in real estate sales transactions is the possibility to (i) set off gains from the sale of one property against losses from the sale of another property, and to (ii) set off gains from the sale of real estate against losses accrued in the non-real estate business of a seller. These options may become more relevant in the future as there is a common understanding that the Swiss market is at a peak concerning real estate prices rather than at a low, as a result of which losses in real estate transactions in Switzerland may become a reality again after 20 years of increasing prices.
As an example, for the purposes of real estate capital gains tax, the Canton of Zurich allows relevant gains and losses from the sale of different properties to be set off if these properties are sold to the same buyer (§ 223 Zurich Tax Act). A set-off is, however, not possible if the properties are sold to different buyers. Thus, in a situation where several properties are sold and where a seller will avail of a gain on some properties but suffer a loss on others, the seller should always check whether the properties can be sold to one buyer. As real estate capital gains taxes sometimes account for up to a third of the value of a real estate transaction, the sale of profit and loss-making properties to one buyer can be more attractive than a sale of these properties to several buyers even if the one buyer offers a lower total purchase price than the price that could be achieved if the properties were sold to several buyers. Many cantons have similar rules, as in the Canton of Zurich. There is one caveat: the set-off of gains that are subject to real estate capital gains tax against losses is only possible if the properties are located in the same canton. A set-off across cantons is not possible.
The rules are different when it comes to the potential set-off of property gains that are subject to real estate capital gains tax against losses of the non-real estate business of a seller. The Swiss Federal Court decided that such property gains can be set off against losses from the non-real estate business of a seller if such real estate gains and non-real estate losses are based in in different cantons. However, until recently, the Canton of Zurich did not allow such a set-off of real estate gains against non-real estate losses if both gains and losses are based in the Canton of Zurich. In June 2018, the Canton of Zurich adopted a new provision in its Tax Act (§224a) which now explicitly allows the set-off of real estate gains against non-real estate losses even if both gains and losses are based in the Canton of Zurich. Other cantons may have different rules.
While the rules regarding the set-off of real estate and non-real estate gains and losses within and across cantons are rather complicated, a seller of real estate who either has accumulated a loss in the selling entity or who will suffer a loss upon sale of the property itself should always check these rules; they may provide opportunities for significant tax savings.
The Federal Act on the Acquisition of Real Estate by Foreigners, commonly referred to as 'Lex Koller,' restricts the acquisition of non-commercial properties in Switzerland by foreigners. Prior to acquiring a property, a foreigner must ensure that the acquisition of such property is not prohibited. Restrictions apply to individuals who are neither Swiss nor EU or EFTA citizens domiciled in Switzerland nor foreigners with a permanent residence permit. Furthermore, restrictions apply to foreign legal entities and partnerships or foreign-controlled legal entities and partnerships domiciled in Switzerland.
Foreigners are entitled to acquire commercial properties, main residences if they are acquired in an asset deal and not in a share deal, shares in listed real estate companies and units in regularly traded real estate funds. Lex Koller's remaining key restriction is the prohibition of acquisition of residential properties by foreigners for investment purposes.
In the last couple of years, there have been numerous political discussions, initially about liberalising the Act, and, more recently, about tightening it. For the time being, the Act remains unchanged. However, due to the political trend of applying the Act rigorously, it can be observed in real estate transactions that the cantonal authorities have become quite anxious about making no mistake, and even clear-cut cases are put under scrutiny. More often than in the past (and sometimes more than is reasonably required), a formal Lex Koller ruling must be obtained, and this has a significant impact on the timing of the closing of a transaction because the procedure can easily take up to three to five months, depending on the complexity of the acquisition structure and the canton. The consequences of a violation are severe: the transaction is null and void, it must be undone, and there may even be penal consequences. Thus, it is highly recommended to get a formal approval whenever a case is doubtful. This is usually the case when foreign investors are involved and the underlying real estate asset does not clearly qualify as commercial property. As an example, this is the case with mixed-use properties, properties with vast land reserves or properties used similar to a hotel but not as a hotel (such as boarding houses, student residences, retirement homes, etc).
Other regulatory trends and developments
Switzerland has long been politically very stable with respect to real estate related laws. In recent times, however, a number of legislative proposals and initiatives have been lodged with effect on real estate investments.
For example, there has been a recent initiative by a young socialist party intended to freeze the size of the building zone to that of today's, prohibiting any future transfers of agricultural land into building zones. In February 2019, however, Swiss voters clearly voted against that initiative. At the same time, there is a government process under way which requires cantons to downsize their building zones to their envisaged usage for the next 15 years. For many cantons this means having to 'down-zone' land from the building zone into an agricultural zone or other non-building zones. Individuals affected by such downgrading may have a claim for indemnification.
For upgrades, in zoning law there is currently a process under way to introduce an extra tax on the value increase resulting from 'up-zonings.' Swiss federal law only requires the introduction of a tax on the value increase created by up-zoning a real estate property from the agricultural zone into a building zone. Many cantons, however, are contemplating applying this tax also for up-zoning within the building zone (eg, from a zone allowing one-storey buildings to a zone allowing three-storey buildings). This development is of particular importance to real estate development companies since they traditionally buy underdeveloped land with a view of up-zoning and development.
Another important regulatory development is the limitation of second homes (eg, holiday homes). In essence, this new body of law prohibits building permits for the creation of second homes in communities with a second home ratio of more than 20%, which basically covers the entire mountain area of Switzerland. An exception to this prohibition is available if the new second home is operated for tourism purposes. To fall under this category, the second home would have to be permanently offered on the market at current conditions for short-term usage. Second homes may also be constructed in connection with hotel projects provided that, among others, the usable floor space of the second home does not exceed 20% of the overall usable floor space of the hotel project. Loss-making hotels that have been running for at least 25 years may also be converted into second homes as a last resort. Similar exceptions are available for second homes in protected buildings. Homes which were rightfully constructed or bindingly approved before 12 March 2012 are exempt from these limitations regarding second homes and may, therefore, be discretionarily converted from first homes into second homes and vice versa.
Despite certain regulatory uncertainties, real estate investments in Switzerland continue to be attractive. In particular, in larger transactions, the buyers' market is currently dominated by Swiss pension funds, life insurers and foreign institutional investors; Swiss pension funds and life insurers are forced to invest in Swiss real estate to secure stable returns to satisfy the claims of their beneficiaries. Although real estate prices in Switzerland are high and consequently returns are rather low for a Swiss pension fund and a life insurer, a Swiss real estate investment is still more attractive than depositing cash with the Swiss National Bank at negative interest rates. For many foreign investors, Switzerland's stable political and economic environment as well as the strong Swiss franc provide a hedge against many uncertainties in their home countries.
The increased presence of foreign investors in the Swiss real estate arena has fostered more sophisticated and more complex transaction and real estate holding structures: while foreign investors appreciate the stability of Switzerland, they are typically looking for higher returns than the rather conservative Swiss investors. As it is now hardly possible to buy Swiss real estate at modest prices, higher returns can primarily be achieved by more sophisticated legal and tax structuring of transactions. As foreign investors are often used to more complex transactions from their home countries, they apply the same strategy in Switzerland as well. This is one important reason that explains the increased complexity and sophistication of real estate transactions in Switzerland in recent years. There is little doubt that this development will continue.