China REIT excitement is still premature

Regulators have set the draft guidance of a pilot program. But those hopeful a first batch of REITs can be rolled out in the third quarter should curb their enthusiasm.

The Chinese government has finally approved a pilot program for its long-awaited real estate investment trusts. Approved on April 30, the program is open for public consultation until the end of next week.

It is aimed at investments in income-generating real estate and infrastructure projects in operation for at least three years. Examples in the draft guidance include: warehouses, toll roads, airports, ports, public utility facilities and industrial parks, according to regulators. With a minimum offering size of at least 200 million yuan ($28 million; €26 million), the assets of these REITs should sit in either the Beijing-Tianjin-Hebei region, the Yangtze River Delta and the economic zone along the river, the Xiongan economic zone, the Hong Kong-Zhuhai-Macao area and Hainan province.

Once implemented, China will see its first ‘real’ REIT – a publicly traded investment trust backed by property income instead of debt. Just like in neighboring India, the creation of a REIT regime has been a long and slow journey in China, with countless debating and launches of experimental products along the way. The closet products introduced are privately traded ‘quasi-REITs’ that resemble commercial mortgage-backed securities more than property income vehicles.

But while private real estate managers and developers are excited about the opening of a new channel of capital in the country, institutional investors still have three significant concerns.

First, it remains unclear from the draft guidance whether there will be tax exemption. That will greatly affect distributed income. A developer transferring a property to a REIT will be subject to enterprise income tax, land appreciation tax, business tax and stamp duty, while the REIT would be subject to deed tax. Singapore, one of the most developed REIT markets in Asia with 43 listed S-REITs and property trusts, offers attractive tax incentives for investors. For example, an S-REIT’s income is not taxed for trustees.

Second, the leverage levels currently stated in the draft document seem too low, especially when compared with other regimes. The draft guidance only allows borrowing up to 20 percent of gross asset value of the REIT, significantly lower than 45 percent for Hong Kong REITs and 50 percent for Singapore REITs. In China, leverage for development projects is often around 50 percent.

Third, obtaining a public REIT manager license in China is not easy. Investors will have to work with local securities houses as China REITs currently are set up as domestic funds that invest in an asset-backed securities scheme, which in turn indirectly owns the underlying assets, according to a note from law firm Baker Mckenzie. Currently, the ABS manager and the REIT manager must be from the same organization. Most of the logistics managers in China, for instance, do not have this license. It is different to Singapore where the sponsor can easily be the REIT manager at the same time.

Market sources tell PERE the Chinese government is looking for “market leaders” and state-owned enterprises to forerun the program. Some are hopeful the first REITs will be rolled out as early as in the third quarter this year. Real estate executives from India can account for not depending on such optimistic timescales at this stage of a REIT regime’s evolution. It took 11 years from idea to inception there before the first REIT, Embassy Office Parks REIT, was launched last year. Regulators spent five years in just finetuning the framework after initially opening their doors to the product in 2014.

Although the establishment of a REIT regime in China is only a matter of time, the country with a GDP more than four times that of India will need to address these issues, possibly others, before it launches successfully. For now, private real estate managers remain left to figure out the best way to position themselves for that time – while the rules are still being drafted.

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