Updating China’s REITs

Sunday, August 2, 2009 11:50
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– Guest Writer Zhou Ji Ming

While attending a recent industry event, the conversation again turned to the probability of China introducing REITS this year as an alternative fund raising vehicle for real estate companies. The general consensus was that, at the moment at least, a number of competing factors are making introducing a REIT class in China a difficult decision to take.

While there are currently no REITs listed in China, several REITs do own assets here which have been injected into HK-listed REITs, which has given rise to hope among developers and investors that new investment options will emerge, there are currently no clear indications of when the first REIT will appear in the market.

Regionally, REITs have been badly hurt in the 2nd quarter, as values of Hong Kong-listed REITS alone show that almost everyone down as much as 29% and many down 20% or more by mid-June. The one shining star – GZI – fell only 9%.

In China, the government’s economic stimulus measures and increased lending over the past 3-6 months have helped drive sentiment – and buying of property – so that developers are feeling less financial pain than they were one year ago, while consolidation of smaller developers that was also expected at that time has failed to occur. Taken as a whole, one might conclude that industry players remain strong and have no dire need for additional sources of financing, and that enough has been done by the government to support this key pillar of the national economy.

That being said, it is worth looking beyond the industry to get an indication of why REITs are the next show to drop. Consider what REITs could mean for the equity markets.

In late 2008, the discussion of allowing insurance companies to invest in real estate was raised during a revision of China’s insurance law followed by January 2009’s announcement by the State Council Information office revealed government plans to launch REITs.

The announcement did not, however, indicate a specific timetable for listing the first public real estate trust in China. What matters though is that a new class of REITs would provide additional avenues through which large insurance companies could invest huge amounts of premium capital to invest, the same capital which is pushing the Shanghai index up and up in recent months.

But what does this mean for the small investors?

Culturally, Chinese individual investors tend to purchase their own real estate rather than a fund expecting to use the property and possibly to provide strong longer-term equity returns. But they do not necessarily seek strong short-term yields, so attributing buying behavior to the yield argument would be a mistake. Therefore, I do not believe that the individual Chinese investor will necessarily be drawn more heavily to a REIT product than to a well-known and established Chinese property company such as Vanke (00002). Why buy the REIT, they ask?

In terms of what REITs would mean for the broader equity market, it is reasonable to assume that a portion of the liquidity propping up the Shanghai index at the moment will shift to a REIT but predicting how much new liquidity will be attracted

The most meaningful metric to watch, I think, will be the impact that an entire category of REITs could have on bank lending in China. Presumably, a high quality portfolio would be able to attract cheaper capital and provide higher credit quality debt to their bankers in return. Over time, if investors are able to migrate toward a higher credit quality class of REITs issuing equity calls then banks will be left to compete only for less well established borrowers, reducing the credit quality of their portfolios.

In reality, however, the amount of REIT equity available to investors is unlikely to significantly impact bank lending. Operationally, the possibility of listing a portfolio on the equity market will provide the motivation for property owners to set and achieve higher operating standards across their property management, if not already doing so.

The great thing about REITs is that it does not take a genius or number cruncher to evaluate the portfolio of one. With a little ingenuity, anyone can quickly build a stacking plan, a tenant profile and forecast reasonably – sometimes very accurately – the security of the rental income or cash flow of the portfolio.

It is only likely that a bubble would form around a REIT product is if the Trust can demonstrate the potential of strong rent increases and very stable occupancy over 12-24 months. Assuming the portfolio of the REIT includes Shanghai or Beijing comer properties, the current environment of declining commercial rents is not likely to support a strong yield once a REIT is introduced on the market. I cannot see investors large or small of getting overly excited beyond the initial interest a REIT listing would draw.

The short-term upside a listed REIT provides the market will be limited and will probably have little impact on small operators of virtually all property classes. I anticipate that a new REIT listed portfolio will be comprised mainly of quality office or industrial properties as they tend to provide the most predictable, stable and credit-worthy cash flows. Until multiple REIT products in each property class (industrial, commercial office and residential) emerge, smaller players will be at a disadvantage.

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