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China’s New REIT Structure: What Are The Pros And Cons?

China’s New REIT Structure: What Are The Pros And Cons?

The announced structure differs in many ways from established regimes in other countries, and all eyes will be on the first batch of C-REITs to be launched in the second half of this year.

By Matthew Schmidt, Senior Analyst at B&I Capital Ltd.

China published the structure for a pilot REIT programme and its corresponding draft guidance on April 30, 2020.

In this new programme, C-REITs will be equity REITs managed by mutual funds. The structure will afford investors returns through both dividends and capital gains while providing greater trading liquidity than is currently available with the existing on-shore “pre-REIT” structures. C-REITs will be required to pay out 90% of core earnings to investors in the form of dividends. 

The new programme only includes industrial-type asset classes (warehouse, data centres and business parks) along with government infrastructure assets such as toll roads, seaports, airports, and public-private partnerships. There was specific mention that residential and commercial properties would not be part of the initial program. All assets injected into a C-REIT will need to be fully owned by the REIT. The inclusion and focus on infrastructure in the C-REIT programme is principally provided to allow Chinese municipal governments to deleverage. Surprisingly, multi-family, which had been long rumoured to be the first asset class, was not included. Therefore this latest development of the Chinese REIT market should be seen as laying the groundwork for other asset classes to be added in the future after the C-REIT structure proves its worth and regulatory issues are worked out. 

Low leverage limit, vague tax treatment

There were several disappointments for the market. For example, the 20% loan-to-value limit (versus on-shore pre-REITs at 50-70% and 50% for S-REITs and HK-REITs), the restriction that debt can only be used to finance “renovations,” and that all asset purchases need to be fully equity financed. However, this is similar to the initial Thai trust debt limits, which were changed to a REIT structure to allow for higher loan-to-value limit after several years as market participants became comfortable with the new instruments. Therefore, while acknowledging the shortfalls, our view is that we should give the new programme the benefit of the doubt and look for improvements to the regime as the market accepts and gets used to it. 

The C-REIT programme is also still vague on tax transparency, implying that there will not be standardised tax treatment across asset classes and tax waivers will be on a “case by case” basis. This will cause confusion for any listing. But if C-REITs have a similar “equity + shareholder loan” structure as the on-shore, pre-REITs, the taxable scrape will be lower than the off-shore REITs listed in Singapore and Hong Kong which pay both corporate and withholding taxes. 

The first batch of C-REITs is expected to launch in the second half of 2020 with the Chinese media reporting there are 64 C-REITs with RMB 134 billion (US$19 billion) in assets under management (AUM) in the pipeline. However, it is unlikely all 64 will IPO.

Unlike Hong Kong and Singapore REITs, where a sponsor externally manages the REIT (The Link REIT being the noticeable exception), in the proposed structure C-REIT will be managed by a mutual fund manager outside the sponsor (for a presumable fee of 50-60 basis points of AUM). The sponsor will be required to have a 20% holding in the REIT and appears can still manage the underlying assets. 

However, this structure has raised concerns for the sponsor that they could potentially lose control of the underlying assets which they inject into the C-REIT. 

Acquisition-based growth 

The leverage levels will likely limit the yields and growth potential of C-REITs. C-REITs are expected to generate yields at or below 5% (c.200bps above 10-year government paper). If only stabilised, core assets are injected; growth will predominantly be based on acquisition potential through the sponsor. As debt cannot be used, placements will be needed on any subsequent asset purchase; the length of the bookbuild process is unsure but appears that any acquisition from the sponsor will require an EGM; which could lengthen the process.

Overall, what is essential for the long-term success of on-shore China REITs will be corporate governance and, though the sponsor will not control the REIT manager, it appears to have significant influence over the assets. This should be viewed positively.

Low leverage at the beginning is not all negative, given that Thailand Trusts and Singapore REITs originally had low gearing limits, and both had successful total return and asset growth. But it will limit the overall yield and clarity on placements, which would be beneficial in light of needing further equity to grow assets. Despite low leverage, we would still look for high single-digit total returns to make the investment look attractive, preferably with the asset of choice being logistics in Tier-1 cities. Most importantly, we would like to see from the beginning that C-REITs are strongly supported by domestic investors—both institutional and retail —like REITs in other markets. 

About the author: Matthew Schmidt is a Senior Analyst at B&I Capital Ltd based in Singapore. He has been with B&I Capital since 2010 covering Asia x Japan REIT markets and in Asia since 1999.