Written & Edited by: Amanda Zhang and Leo Liu (GCS Research)
In August 2022, China launched its first batch of three publicly traded rental property estate investment trusts (REITs). After the launch, they were instantly snapped up by investors in Shanghai and Shenzhen. This batch of REITs is estimated to raise a combined of 3.8 billion yuan and their launch is seen as Beijing’s effort to rescue crumbling the real-estate market which is now reeling amid debt piles, mortgage boycotts, and stagnating sales.
Although REITs are still nascent concepts in China, they have been well-developed and commonly traded financial instruments in the Western economy for almost half a century. In this article, we will explore:
- briefly the history of REITs in the US
- REITs in China
- the implications and opportunities of launching REITs for the Chinese real-estate and financial markets
Introduction
Before we dive into the analysis, we have to first understand some basic concepts.
REIT is a company that owns, operates, or finances income-generating real estates. REITs pool together capital and enable individual investors to earn dividends from real estate investments without having to actually buy or finance any properties themselves. Essentially, REITs allow investors to buy shares in commercial real estate portfolios which can include apartment complexes, office buildings, retail centres, storage facilities, health care facilities, hotels, infrastructures etc.
REITs can generally be categorised into equity REITs, mortgage REITs, and hybrid REITs. Equity REITs own the properties and lease the properties out to distribute the rent it gets as dividends to investors. Whereas, mREITs, short for Mortgage REIT, do not own properties. Instead, mREITs finance the properties in their portfolio and distribute the interest earned on their investments in mortgages or mortgage-backed securities as dividends to investors. Finally, hybrid REITs, exactly like how it’s called, are REITs that employ the investment strategies of both equity and mortgage REITs.
REITs can then be further classified based on how their shares are bought, held, and traded. Publicly Traded REITs are listed REITs that can be bought and sold by individual investors through national securities exchange. For instance, due to its accessibility, in the US, publicly traded REITs are regulated by the Securities and Exchange Commission (SEC). Public non-traded REIts are those that are not traded on national securities exchanges. Hence, they are less liquid than publicly traded REITs and more stable as they are not as susceptible to market fluctuations. On the other hand, private REITs are those that do not trade on national securities exchanges and in the US, they are not registered with the SEC. Normally, individual investors would not be able to access private REITs as they are sold only to institutional investors.
REITs in the United States: Brief History
(1) The initial stage (1960-1968): The Internal Revenue Code of 1960 exempted the REITs from income tax which means that investors do not have to pay income tax when they received dividends from their REITs investment. The Real Estate Investment Trust Act then formalised the establishment of the REITs system in the US.
(2) Rapid expansion stage (1969-1972): Due to the prevailing oil crisis which caused high inflation and that the US had an upper limit on interest on bank deposits, the real estate industry was not able to obtain enough credit from banks. Hence, mortgage REITs emerged as a way to circumvent the problem of banks pulling back on credit commitments. By the end of 1972, the market size of REITs in the United States had rapidly expanded to US$1.881 billion.
(3) The rapid shrinking stage (1973-1979): Due to high inflation and overall recession in the economy, the US real-estate market faced the problem of oversupply, and an increase in the number of mortgage defaults and bankruptcy in real estate developers. Hence, in just two years from 1973 to 1974, the REITs market sharply dropped from US$1.881 billion to US$712 million in size.
(4) Gradual recovery stage (1980-1985): The REITs market learned the lessons of the previous stage and began to pay attention to the level of debt ratio. During this period, the debt ratio of REITs dropped significantly, from 70% in 1973 to 50% in 1985.
(5) The system improvement stage (1986-1991): The introduction Tax Reform Act by the American Congress in 1986 provided many advantages for REITs which stimulated the market to grow rapidly from $9.924 billion in 1986 to $12.968 billion in 1991.
(6) Prosperity and maturity stage (1992-2007): This stage was highlighted by the emergence of the umbrella REITs structure (UPREITs). UPREITs do not directly hold properties, but invest in operating partnerships and the invested operating partnerships hold properties. Compared with the traditional REITs structure, UPREITs can provide the function of tax deferral. At the same time, as regulators relaxed restrictions on institutional investors investing in REITs, the scale of REITs saw another rapid expansion.
(7) In the post-financial crisis stage (from 2008 to the present): Due to the subprime mortgage of 2008, the market size of REITs contracted by 38.57%. However, following efforts from the US government such as REITs Investment and Diversification Act aiming to stablise the market, REITs began to expand their investment in non-traditional fields to infrastructure, warehousing, data centres, healthcare and other fields. In particular, infrastructure REITs have developed rapidly, quickly becoming the largest type of REITs in the US market.
The launch of REITs in China
China’s new infrastructure REITs are structured like public funds that invest in asset-backed securities, which indirectly owns the underlying asset.
According to the Head of Capital Markets at JLL, the REITs are uniquely structured to suit China’s needs. It is not only aimed to provide liquid income-producing real asset investments to the market, but also to direct investment capital towards infrastructure projects which will further enhance China’s economic development. This means, the funds raised by REITs could help the Chinese government fund infrastructure projects off their balance sheets.
The REITs launched by China are limited to exclude for-sale residential building and include only infrastructure and certain types of real estate, such as logistics and business parks. This is a sharp contrast to the international REITs market where shopping centres, offices, hotels, and residential apartments typically tend to form part of REIT portfolio.
Implications and opportunities for the Chinese real-estate and financial markets
In the past decades, China’s rapid economic growth relied heavily on the infrastructure and real-estate sectors. However, with the increase in the scale of infrastructure construction and real estate investment, the potential incremental space left for growth continues to shrink. Under this context, the development of the real estate sector and infrastructure investment have come to a turning point from scale expansion to sector upgradation.
Traditional financing model for the sector mainly included debt financing including bank loans and bonds, which inevitably led to a high level of indebtedness of for real estate companies and local governments. In this case, firms have to adopt high turnover rate between projects for them to maintain a healthy cash flow and balance sheet. As a result, the high turnover rate makes entities unable to benefit from the long-term holding of assets, including consistent cash inflows and the appreciation of assets over time.
In the early stage of market development, this model can indeed quickly expand the scale of real-estate companies. However, as the market has less incremental space for growth, real estate companies need to transform to a long-term model and aim for asset upgradation.
As REITs provide fund to enterprises in the form of equity, they provide an alternative financing tool for real-estate firms apart from the traditional, commonly used debt financing method, which have significantly raised the leverage ratios of these firms in the past. Therefore, REITs can serve as a supplement that lower the financing costs of real-estate companies from high interest payments and reduce their corresponding leverage ratios. In addition, lower leverage could also stimulates enterprises’ transformation into a holding & management model as they no longer have to maintain an exceedingly high turnover rate. As a result, it may help to improve firms’ operation levels and prompts enterprises to no longer pay attention to short-term ambitions, which would be critical for domestic companies to enhance their international competitiveness in developed regions.
Furthermore, REITs provide a channel for real estate assets to be traded publicly and offer a more systemic pricing mechanism under market forces of public trades. This reduces the risk to the banking system under the old context where local governments and real-estate companies relied on highly-leveraged financing of their projects. Thus, REITs, in a sense, would provide more stability to the market as it offers promising financing to the real-estate companies.
Besides, the high-leverage behaviour of local governments and real estate companies has exacerbated the accumulation of debt risks, which could transmit risks to the banking system and affect the stability of the financial markets. Under this context, REITs as an equity financing tool to gain funds from the public can help to lower the high leverage ratio of real estate companies and diversify risks to the wider economic system.
Finally, REITs also lowers the threshold for real estate investment and provides a channel for ordinary investors to participate in property investing. Without REITs, the real estate market would hardly be accessible as an investment tool to the average salary earners in China due to their high price as well as the liquid nature of property investing. Thus, REITs enables the investors in China to access the lucrative property market, it could also serve as a preferable investment for investors who prefers stable returns.
Disclaimer: None of the content in this article should be construed as legal, investment, financial, or other advice or recommendation.
GLOBAL CHINA STUDY 