In Rocky III (and probably all the Rocky films – I confess to having watched only two of them) the title character suffers an early setback and comes back successful. China REITs were eagerly expected in the late noughties, but despite several attempts they never gained traction.
As a result, it was no surprise that a joint statement on 30 April 2020 by the China Securities Regulatory Commission (CSRC) and the National Development and Reform Commission (NDRC) about a new pilot for Chinese real estate investment trusts (C-REITs) provoked much interest. However, these new C-REITs are only to finance infrastructure projects which have been in operation for at least three years. Neither the joint statement nor the separate CSRC circular issued on the same day provide details of how the new vehicles will obtain tax neutrality, without which it is hard to see how they will become popular.
REITs have been tried with varying degrees of success in the east Asian markets of Japan, Singapore, Hong Kong and China and a quick review of their progress may help point the way to regulators in making a success of this latest attempt at establishing C-REITs and to see if, Rocky-like, they will get off the floor and land the knock-out blow (with apologies for the plot spoiler of at least two of the Rocky films).
The Investment Proposition behind REITS
Investors have been yield-hungry since interest rates on government bonds have been suppressed by the policy measures taken globally to limit the impact of the global economic crisis. REITs are seen as one way of achieving higher yields. They are trusts that own one or several completed buildings, leased out to multiple tenants, achieving two-layer diversification (compared to owning one building leased to a single tenant). Interests in the trusts are then issued for cash to unit holders, and these units (at least in Asia) are tradable on the relevant stock exchange. This provides investors with a liquid "bond-like" high-yield investment, which is much less volatile than shares in a real estate developer.
To retain bond-like characteristics, several restrictions typically apply to REITs in Asia before they can be listed, including being:
- Required to distribute a high proportion of their profits to unit holders;
- Restricted in the amount they can invest in uncompleted buildings (to minimise development risk); and
- Restricted in the amount of debt (or leverage) they can carry.
REITs are welcomed by real estate private equity funds as a natural purchaser of mature buildings and by pension funds and life insurance companies as an asset that is a good match for their long-term liabilities.
The Early Rounds – REITs in Asia (ex-China)
The Japan REIT market (J-REITs) started in early 2001. Some of its restrictions were relaxed in 2014, allowing a wider scope of investments. As of August 2019, there were 63 listed J-REITs with a market capitalisation of ¥15.7 trillion (US$146 billion).
Singapore also has a successful REIT market, which started in 2002. As of April 2020, there were 43 S-REITs with a market capitalisation of S$91 billion (US$63 billion). Many S-REITS have invested in properties outside Singapore, allowing investors to get exposure to properties around the world, ranging from logistics warehouses in Southeast Asia to commercial buildings in the United States.
Hong Kong started its REIT market in 2005. As of January 2019, the sector comprised only 10 REITs with a total market cap of US$36.5 billion, the bulk of which came from the Link REIT, involving the privatisation of a large number of under-managed community shopping malls. The market has not taken off as it found itself in direct competition with S-REITs and the Singapore regulators generally moved faster than those in Hong Kong in easing restrictions on gearing and development risk, as well as granting greater tax concessions.
However, the easing of investment restrictions on Hong Kong REITs allowed Champion REIT, in May 2020, to accept the issue of about eight million shares allotted from a health care company, which was its tenant, in lieu of rent amounting to HK$33.9m. This has caused some disquiet among investors as it leaves holders of a REIT indirectly owning shares in a health care company which is not the exposure they would have expected.
China – Early Disappointments
A successful REIT market in China could dwarf all of these other Asian markets. According to a 2019 estimate by a Peking University professor, it could be worth up to US$1.7 trillion. Various REIT-like products, or quasi-REITs, have been introduced over the years, but these are more akin to commercial mortgage-backed securities, rather than the holding of an equity interest in real estate. As a result the early rounds went to Singapore and Japan.
The Hero Shakes off the Setbacks?
The joint statement on 30 April 2020 by the NDRC and the CSRC1, announced a pilot programme of publicly-traded infrastructure REITs. The joint statement provided a framework to develop Chinese REITs for infrastructure investment (infrastructure C-REITs) in metropolitan regions of China2.
The CSRC followed up on the same day with a circular on the formation and operation of the infrastructure C-REITs3,requesting public comments by 30 May 2020. The circular clarified the scope of the pilot programme, expressly ruling out the possibility of REITs investing in residential and commercial real estate. Instead, the pilot programme aligns with existing government policy to improve infrastructure such as warehouse and logistics facilities, highway and transportation facilities, utilities facilities and industrial parks.
Infrastructure C-REITs will be different from other Asian REITs. They will not own the assets directly but, instead, will own at least 80% of asset-backed securities that the infrastructure-owning entity issues, giving the REIT the right to income generated by an in-use infrastructure project. Elsewhere in Asia, REITs generally own the underlying assets directly.
Infrastructure C-REITs are restricted to leverage of no more than 20% (a tighter restrictions than those in other markets) and a minimum offering size of at least RMB 200 million (US$28 million).
For infrastructure C-REITs to get off the floor and land the knockout blow to become a significant market they will, however, need legislation to change tax rules to ensure that the structure is tax neutral, i.e. ensuring that creating this new envelope around assets does not create additional tax burdens. That is a challenge this particular Rocky still has to overcome to get back into the game. One hopes that the next step will be to permit them to go beyond the infrastructure arena and on to the undisputed world-title stage of commercial and residential real estate.
1 The full text of the announcement can be assessed at https://www.ndrc.gov.cn/fzggw/jgsj/tzs/sjdt/202004/t20200430_1227465.html (simplified Chinese only).
2 These regions include Beijing-Tianjin-Hebei (JJJ), Yangtze River Economic Belt, Xiong'an New Area, Guangdong-Hong Kong-Macao Greater Bay Area, Hainan and Yangtze River Delta.
3 The full text of the circular can be assessed at http://www.csrc.gov.cn/pub/zjhpublic/zjh/202004/t20200430_374847.htm (simplified Chinese only).
Originally published Mayer Brown, May 2020
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