It is no secret that many of China’s real estate firms are in need of cash. Urban property prices fell by a record amount in February as developers cut their rates in an attempt to lure buyers. Although transaction volumes were up, there is still not enough demand to cope with the supply glut. Credit ratings analysts are asking whether these firms will be able to pay off their debts.
Not for the first time, terms like "industry consolidation" and "government bailout" are being bandied about. So too is another blast from the past: real estate investment trusts (REITs).
REITs are created by parcelling up property assets into exchange-tradable securities, which offer investors a share of rental income or mortgage repayments, as well as capital appreciation. After years of much talk but no action regarding the launch of a mainland REIT, last December the State Council endorsed a pilot program. Reports say it will be based in Tianjin or Shanghai.
According to Vivian Lam, a partner at law firm Paul Hastings in Hong Kong, sponsors are working on REIT structures and the bureaucratic wheels are turning. "Government departments have been meeting to discuss roles and regulations, and the structure will be ready for launch in the second or third quarter," she said.
Experts exhibit differences of opinion over China’s state of readiness. This can in part be put down to uncertainty as to how the system will work. According to Ernst & Young’s global REIT report 2008, China’s REIT structure will be "fundamentally different from its international counterparts – totally tailored to fit the Chinese environment."
The report concluded that, although a pilot project is likely to launch in 2009, a fully operational REIT market is still a few years away. It cited tax issues and new legislation as the major obstacles.
The principal tax concern is that investors could be levied twice, one charge on the property assets themselves and another on the dividend payments made by the REIT. As for legislation, the pilot REIT may be issued under China’s Trust Law and only trade on the interbank market. Widening the scheme and allowing REITs to list on the stock market would almost certainly require a more detailed legal framework.
There is little doubt that REITs are, in theory, a good thing. Not only do these products bring liquidity to real estate developers, allowing companies to take liabilities off their balance sheets and simultaneously raise new funds for investment, they also benefit the individual investor.
"The concept of a REIT makes a lot of sense in China. It gives small investors who can earn only 2.25% on their bank deposits the chance to earn 5% per year on high quality, fully leased buildings," said Jack Rodman, Beijing-based senior advisor to Westport Capital Partners, a private equity firm focused on real estate.
At the same time, Rodman is cautious about the prospects for REITs, pointing to what he sees as irresponsible behavior in other markets. Rather than use REITs as stable, long-term investments, people have used them for speculative purposes, creating volatility. The rate of return on Asian REITs fell by 60% in 2008 as the boom of recent years collapsed.
In this sense, the controls that Beijing places on REIT activities will be very important. There is no international-standard model to follow, but experts believe the Chinese regulators are looking closely at Hong Kong. The GZI REIT, the first to offer mainland China exposure, debuted on the Hong Kong Stock Exchange in 2005. Rules in the territory are strict, with REIT managers required to keep 90% of their funds in completed, income-generating assets.
"The scope of investment for REITs in Hong Kong is much more restrictive," said Angela Lee, partner at law firm Baker & Mackenzie in Hong Kong. "If they adopt the same framework for the China REIT, it will be easier to regulate."
Of course, the more effectively REITs are regulated, the less likely they are to offer a quick fix for the property market.
"This could be a new funding channel, but it’s more for the long term," said Kaven Tsang, property analyst at Moody’s in Hong Kong.