Read REITs: Insights into Real Estate Investment Trusts

Financial Distress of China's Long-term Rental Apartments

China’s long-term rental apartments have been frequently hitting the headlines in recent months.

Aug. 20, Hangzhou, Dingjia Apartment bankrupted due to capital flow rupture.
Oct. 18, Shanghai, Xiaomi-backed Yujian Apartment bankrupted.
Oct. 27, Beijing, Haoyuan Hengye Apartment ran short of cash to refund the deposit.

Within one year and a half, over 10 operators had their funding chain ruptured. On Dec.3, Hu Jinghui, the former vice president of B.A. & 5I5J Group, the second largest property agency in Beijing, even put out words that half of the existing long-term rental apartment won’t escape the fate of capital chain break by the coming Spring Festival.

Ever since, Jan. 6, 2015, the release of “Guiding Opinions on Accelerating the Cultivation and Development of the Housing Leasing Market”, Chinese government has been actively promoting Real Estate Investment Trust (REIT), as a measure to stabilize financial market and property market. Long-term rental apartment is one of its substantiations. Popular opinions identify the final materialization of REIT could be the savior to the suffering long-rental market.

So, what is REIT? Could it really save the day? And is it a good choice for the investors?

What’s a REIT?

REITs, as in Real Estate Investment Trusts, are companies that own or finance income-producing real estate in a range of property sectors, whose units are openly traded in exchanges like most of the funds and stocks. Regulations require REITs to offer a high dividend payout, usually over 90%. REITs can be categorized by different standards such as property types, investing methods and legal structure.

To help you better understand how REITs work, here is a little story:

Suppose an investor has small portion of spared money to invest, and he aims at property market. But with his limited capital, he couldn’t fully acquire a property. Similar situation applies to lots of other investors. So, an institution comes in, collects all these investor’s money, buys properties, rents them out or manages in other ways, and finally returns the income to the initial investors by their input proportion.

A Peek at Global REITs

The world’s first REIT was created by the U.S. Congress in 1960. Plenty of countries have followed American practices ever since. 2000s has witness a wider and faster spread of REITs, with 15 mature or new-emerging markets, such as Thailand and Bulgaria, setting up their first REIT. 38 countries have adopted the REIT methods by 2018, many other considering introducing too. Below is an animated map to briefly show the development of REITs.

US Market

Both the bar chart and the scatter chart show that REITs’ return have dropped over the past year given a weaker property market.

Japan Market

J-REITs performed consistently well over the last decade, outperforming benchmarks and most investment market.

J-REITs which operate hotels comprehensively generate higher return.

Hong Kong Market

HK-REITs are mediocre in the long term, and fell sharply this year due to similar reason with the U.S..

Link (823.HK) has the lowest dividend yield with the largest cap, while Huixian has the highest dividend yield with a medium size.

Based on observation of major markets, the U.S., Japan and Hong Kong, REITs rank the second or the third among mainstream investment products in both long term and short term. Despite less fluctuation, REITs’ returns shrink severely during recession period and demonstrate a delay effect from the change of property prices. Primarily, interest rates also influence REIT’s outcome.

C-REITs: Hot Topic or Not?

REITs have been a mature and well-recognized investment choice. Alongside the governments’ pushing, there have been ongoing discussions over Chinese REITs, or C-REITs. However, the development of REITs in China has slowed down this year. It leads to questions of the actual popularity and people’s concern over REITs.

Attention to REITs

The bubble charts on the right shows the topic numbers relating to different investment products on Xueqiu, Chinese leading financial forum. The size reflects the numbers of topics. Stock is undoubtfully the hottest topic, with 2,206,460 topics issued. REITs only have 495 related topics, not a patch on less popular topic like funds or real estate, let alone stocks.

Discussion of REITs

Closer-up, the depth of discussions is also unmatchable between stocks and REITs. As you can see from the word cloud charts, stock-related conversations have already reached to the level of specific indicators like P/E ratio and net profit, and practical transactions. However, conversations about REITs remains on a superficial level, such as its history or how it works.

Offshore C-REITs

Fairly speaking, it’s not exactly appropriate to say that there’s no REITs in mainland China, because there are six major offshore REITs, which are listed in overseas markets, operating mainland property.

The performances vary across the category. New Century Real Estate Investment Trust (1275.HK) suffered an unusual loss compared to its peers. Analysts comment that there’re two main reasons to the poor performance. One is that the REIT’s listing timing happens to crash with the suspected U.S. interest rate hike, affecting the expectation of the said REIT. The other is that its key assets are hotels, whose return relies more keenly on the total economy than any other sectors.

Another one floating around balance point is BHG Retail REIT (BMGU). Its underperformance mainly results from its second lowest dividend yield among other SGS-listed REITs, as well as its property consisting of malls located in tier-3 and tier-4 cities, which could affect the confidence of overseas investors.

Brief of Pre-C-REITs

Development of REITs

For now, there are only pre-REITs or quasi-REITs in mainland China. These securities share similar characteristics with REITs. For example, they are both backed by certain real properties and generates its cash flow from operating said properties. However, unlike REITs’ perpetual units, pre-REITs usually has a certain mature date. The return of these quasi-REITs are fixed ahead. It is not linked to the actual income and no payout requirements are imposed. More importantly, during its time to maturity, no new properties will be acquired or allowed to sell. The portfolio is still.

Since first one set in 2014, now there has been 43 pre-REITs and the speed of new pre-REITs appearing has advanced since 2016. The total amount of capital has exceeded 90 billion yuan. Most pre-REITs operate on commercial property like shopping plaza or retailing shops, taking up nearly 50% of the total market. 11% of these quasi-REITs operate mainly on residential properties, in the form of long-term rental apartment. Real estate of all 43 pre-REITs locates primarily in tier-1 cities like Beijing, Shanghai and Shenzhen.

Policy Environment

From 2007 to 2013 Beijing has been explored appropriate methods to introduce REITs into mainland markets. Several trials have been conducted and two major REITs, Huixian and New Century, have been successfully listed overseas within this period. Afterwards, the government has accelerated its pace. Beijing, Shanghai and other 2 tier-1 cities were requested by Ministry of Housing and Urban-Rural Development to submit their plan of REIT trial.

Hence, it’s not surprising to see many prestigious financial news agencies have predicted that 2018 would be the breakthrough for C-REITs. Reuters even believed that the first ever C-REIT might come into being this year. But with unmatured policy setting and complicated economy situation, they seemed to jump to conclusion too fast.

All factors below will abate the profitability of REITs based on the discovery from other major markets.

Regulation Inadequacy

As for now, the mainstream structures of REITs are SPVs and funds. To be open traded, listed securities requires a 3-year gain and public funds aren’t allowed to hold any specific types of assets accounting for more than 10% of its portfolio. These regulation stops REITs from public funding.

Compared to developed markets adopting tax incentives for REIT, various taxes will be imposed at different stages of REITs transactions under current Chinese taxation system, particularly Land Value Increment Tax charging 30% for the value added for lands. In addition, double taxation will add up tax burdens of REIT operators and investors. REIT companies will be charged for Enterprise Tax, meanwhile the investor end will be charged for Income Tax. These all will pledge the attraction of C-REITs.

Market Difficulties

This year’s economy situation was extra tough, especially for real-estate-related industries. De-leveraging has tightened up the financing pool for all companies. Property market in mainland and Hong Kong has been cooling down for several months, compared to historical data. And with Sino-U.S. trade war continuing and U.S. interest rates hike, the downward pressure is even higher. As a matter of fact, REITs all over the world has performed poorly during the past twelve months.

Nonetheless, the problems prevailing in Chinese property market is what really prevents REITs from fully realization. Chinese have a stronger preference for acquiring one’s own property over renting, which leads to a weaker residential rental market. Commercial property market, boosted by local governments favors, has long been overheated. Over past decade, average retail property area in Shanghai has surged from similar level of Tokyo, to the latter’s thrice. The ratio of commercial area over residential population has reached 3.5, way higher than the common 0.7 to 1.2 ranges. Difficulties in utilizing all these properties and generating promising income will rise in the coming future.

Conclusion

Since its first foundation in 1960 in the U.S., over the past seven decades, REITs have proved itself as a rather stable and high-return-rate investing tool. And it has drawn attentions from regulators and investors in China for its capability to liquidate property and share profit with wider public.

Since 2007, Chinese government has been actively promoting the trial of REITs in mainland and advocates ever harder from 2014 to date. Despite several overseas listed REITs, and 43 pre-REITs, not one single fully qualified REIT has been successfully launched solely within mainland. And many long-term rental apartment, a popular form of pre-REITs, have been running into financing troubles this year.

External factors to this wave of setbacks are the sudden downturn of economy caused by interest rates hike and U.S.- China trade war. But deeper problems lie within the market. Inadequate policy support, and long existing dysfunction in the property market do not only affect current pre-REITs but will also diminish the ability of real REITs.

In brief words:

What are REITs?

REITs is a kind of investing tools which generates income from managing properties using money collecting from selling units or shares, and which is required to pay out most of its profit back to the investors.

Can fully-realized C-REITs save this round of long-term rental apartment setback?

The answer is no. Given the incomplete policy environment and current economy situation, even real REITs couldn’t function well.

Will C-REITs become good choices if finally appears?

Not really. Except from the policy inadequacy, unless the problems caused by investors’ habits and previous action are solved, will the REITs lives up to its peer performances.