Is a China REIT imminent?

The creation of China’s first REIT has been in the offing for some time. But investors might have to wait some time yet, writes Helen Roxburgh

Across Asia, real estate investment trusts (REITs) are still a new asset class. With countries from Japan to Singapore launching REIT regulations, investors have long been anticipating the emergence of one in China. But despite wide-ranging discussions, including proposals put to the central bank in 2010, no official REIT market has emerged.

“It hasn’t been top of the government’s policy to pursue that area of investment,” says Tim Daly, managing director at Kensington Realty Partners. “Because essentially, and as we’ve seen over the last month, when the green light is given, things can happen very quickly.”

With legal and procedural hurdles preventing REITs from taking off, alternative forms of real estate investment are emerging. Properties in China were packaged into REITs listed elsewhere, and private investors poured as much as $15bn (€13.3bn) into property assets abroad last year.

But after years of procrastination, China might finally be getting its own REITs. This year, a coalition of Shenzhen-based property group China Vanke and Penghua Fund Management launched what was dubbed China’s first REIT. In reality, it was a closed-end fund that raised ¥3bn on the initial listing, with an investment life of 10 years. But while the involvement of a development giant like Vanke gave the investment vehicle credibility, but not everyone is convinced.

Experts have pointed out that only one property is listed in the REIT – a single office complex in Qianhai, a special economic zone in Shenzhen. This is a significant point of difference with traditional REITs, which diversify risk across a pool of stable assets.

“One property is not diversified enough; the risk is just with that property,” says James Lee, head of ICAEW China. “If that property fails, the REIT fails.”

In a traditional REIT, a trustee holds underlying assets on behalf of investors. The REIT proposed by China Vanke and Penghua would not give ownership of the underlying assets to the trustee. 

While the Penghua-Vanke REIT differs from conventional REITs, it is still a positive step as it “seems to offer some innovative mechanisms”, according to Alvin Wong, an analyst at Barclays Research.

The Penghua-Vanke REIT will “provide an alternative way for small investors to invest in the real estate market and lower barriers to entry for investors,” Penghua said, sentiments popular among China’s investing public. 

And in other ways, the vehicle is more REIT-like, being open to all retail investors, with dividends paid at least once a year. At least half of the proceeds will be invested into other financial products, such as stocks.

But that investment in stocks could cause concern. In August, the Chinese stock market crashed, causing panic across global markets and vaporising $8trn in wealth. The government moved to roll out China’s biggest economic stimulus since the 2008 financial crisis – interest rates were cut to record lows, banks were encouraged to lend and new infrastructure spending was rolled out.

One expected outcome of the market turbulence is a more tempered approach to investment and a flight to stability for investors seeking a more reliable return.

“Chinese investors have a lack of investment channels and variety of choices,” says Frank Chen, executive director and head of research at CBRE China. “The stock market is perceived to be volatile, so REITs should have merits for investors over the long term as they should provide more steady income.”

Daly adds: “You need a place for people to have reliable yields that are reasonably insulated by the quality of the operator and the quality of the underlying assets.”

And for developers it could also be an opportune time for REITs. A property market slump has driven builders to look for alternative ways to make money from commercial property, after aggressive overbuilding squeezed profit margins. International bond markets have also been difficult places to raise finance after troubled Chinese property developer Kaisa Group Holdings defaulted on interest payments on its offshore bonds this year. In one example of alternative financing, Dalian Wanda raised ¥5bn this year from its crowdfunding app and online-payments website, after it launched a product offering a 6% annual yield.

But while most investors agree that REITs would be a successful investment structure for China, the tax system does not make them particularly attractive.

In mature REIT markets such as the US, Australia and Singapore, tax benefits are one of the most attractive features. But heavy rates of tax on rental income in China place further pressure on returns. The government charges both 12.5% property tax and 5.5% for business tax on a recurring revenue stream such as rental income, both of which are non-recoverable.

“The first REIT has only the right to claim the rental income generated from the asset but not the direct ownership of the underlying assets, which is the general format of REITs internationally,” say Chen. “Besides the lack of regulations, another key challenge for China’s REIT market to develop is whether there is a sufficient pool of quality assets that can be pooled into REITs while at the same time offering attractive returns for investors.”

The lack of investment-grade stock looks set to remain a fundamental problem, largely due to market mentality. Most mixed-use developments have been built with the primary aim of sales, and this build-and-sell approach is a considerable hurdle given that almost all of a REITs’ income comes from rents. And even for developers who want to develop an investment-grade property, they still need to see some immediate return to not only recover high land costs, but to repay very high financing costs. Banks in China treat residential development and commercial development the same in terms of lending requirements.

“I don’t see a pipeline for more REITs listed in China,” says Chen. “At the moment, landlords who hold assets under an offshore structure can choose to list such assets in Hong Kong and Singapore as REITs. These offshore markets have a more comprehensive regulatory framework and better market liquidity and depth for REITs.”

Most experts agree that a future REIT regime could offer much-needed alternative fund-raising and investment in China. But given the obstacles, it looks unlikely to be substantial in the immediate future.

As Daly says: “You have to ask whether it makes sense for these big players to wait for a REIT regime in China, when they can just list in Hong Kong or Singapore – and it’s an easy and established path.”