Developing a National Framework for Introducing REITs in China - a Lengthy Process by Roxanne B. Andrieux Shanghai, September 20, 2010 Electronic copy available at: http://ssrn.com/abstract=1680112
3 Abstract This article proposes a process by which a new national framework for listing real estateinvestment trusts (REITs) on the Shanghai stock exchange in China could be developed andimplemented. It makes some assumptions about the actors involved and the action required, andpresents a timeline for the plan. While theoretically, good REIT legislation is a price-stabilizingfactor on the market, there is some reluctance in government circles to permit listing of apublicly tradable REIT vehicle. There are questions to resolve, what structure could a REIT takein Shanghai and, if the REIT is introduced, whether it can be a factor that would contribute tomarket stability in an emerging capital market and have a stabilizing effect on Shanghai’soverheated real estate market and volatile capital market. If this could be proven witheconometric tests, it would make an effective argument for the China Banking RegulatoryCommission (CBRC), China Securities Regulatory Commission (CSRC) and ShanghaiSecurities Exchange (SSE) to permit the listing of REITs. The process outlined in this article would be carried out in three stages, the first resultingin an unlisted pilot product, the restricted institutional REIT; then an interim, slightly expandedversion, the development REIT; and finally a truly liquid, tax-neutral, stable, publicly tradedREIT. The prerequisites for the first, restricted vehicle are discussed extensively in this article.The trust laws, tax regimes and regulatory and professional feature development are benchmarksin the process. The whole process is likely to take three and a half to four years. The Chinesegovernment, rightly so in this author’s opinion, is proceeding in a stepwise fashion by firstdeveloping appropriate tools, standards, guidelines, regulations and laws before fully opening itscapital markets to instruments that may have little meaning and could even threaten its economicstability. It will be some time before we see a full fledged REIT on the market in Shanghai. Electronic copy available at: http://ssrn.com/abstract=1680112
4 Introduction This article proposes a process by which a new national framework for listing real estateinvestment trusts (REITs) on the Shanghai stock exchange in China could be developed andimplemented. It makes some assumptions about the actors involved and the actions required, andpresents the outcomes, future state (two to five years out), milestones, and timeline of the plan.Theoretically, good REIT legislation is a price-stabilizing factor on the market. There are majorquestions to resolve, what a REIT is and what structure a REIT could take in Shanghai; and, ifthe REIT is introduced, whether it can be a factor contributing to market stability in an emergingcapital market in general, and have a stabilizing effect specifically on Shanghai’s overheated realestate market and volatile capital market. If this could be proven with econometric models, itwould make an effective argument for the China Banking Regulatory Commission (CBRC),China Securities Regulatory Commission (CSRC) and Shanghai Securities Exchange (SSE) topermit the listing of REITs. This article focuses specifically on the Shanghai securities market,though the same arguments may be extrapolated to the Shenzhen exchange and other tradingmarkets in China. According to the academic literature, when investors have few alternative investmentvehicles available, speculation on property contributes to the creation of an economic imbalance(Hui, Liu & Shen, 2005). The market drivers are developers that could raise funds on the capitalmarket for property development and acquisition programs, domestic and foreign institutionalinvestors, and individual investors that need a range of investment choices. They act as pushfactors on the demand for REITs. One of the advantages of REITs is that they "allow a propertydeveloper to gain capital from its real estate portfolio by placing it in a trust and listing it on anexchange. This is then tradable, and the capital realized from its sale can be reinvested" (R.,
52009). For the individual retail investor a REIT is quite a convenient structure since the investordoes not actually purchase the physical asset, but purchases trust units that give the investoraccess to the trust’s cash flows from the rental income of a pool of revenue-generatingproperties. The hypothetical problem to investigate is whether—given the current economicenvironment in China—the REIT should be considered a safe vehicle for the risk-averse and forthose who are not onsite to personally manage a real estate portfolio. The emerging capitalmarket needs to be nurtured quickly but carefully. The relevant legal and financial environmentneeds to be developed so that listing new investment vehicles such as the REIT can be donewithout negative impacts on the economy in general and the capital and real estate markets inparticular. In forming new legislation, the Chinese government can influence the REIT structure,circumscribe the investment activities, and restrict shareholders and management functions. Inthe eyes of the government, the ideal outcome is not only that a new publicly listed instrument isavailable to individual investors, but that the SSE be regarded around the world as one that fitsthe definition established by Chin, Dent and Roberts (2006) of an attractive market forinvestment, where the business and financial culture is one of “market openness,professionalism, the presence of property intermediaries, information availability andstandardization, development stability, flexibility, quality of property products, and user andinvestor opportunities” (p. 55). The CBRC drew up “provisional rules” to permit the REIT in 2004; and in 2005, aproposal to introduce REITs was submitted to the central government; however there wereclearly some regulatory shortcomings (Nie & Yu, 2005). The SSE “set up a specialized researchunit in March 2007 [which demonstrated that the] SSE is determined to become one of the REIThubs of Asia” (Ong & Quek, 2007, p. 255). In August 2009, a special team led by the central
6bank of China and comprising 11 ministers was established to speed up the research anddevelopment of REITs in China. In December 2009 the State Council of the government inBeijing had approved plans for a REIT framework, but another REIT plan was submitted to theState Council for approval in June 2010. Nevertheless as of late 2010, it still had not beenadopted in Shanghai or on any other exchange in China. The process proposed in this articlewould be carried out gradually, in three stages, the first resulting in an unlisted pilot product,then an interim, slightly expanded version and finally a publicly traded REIT. The REIT Regulatory Framework: a Review of the Academic Literature Other capital markets, both mature and emerging, with publicly listed, securitized REITs,serve as models from which the CBRC and CSRC draw lessons. Analysis of the impact ofintroducing the instrument on capital markets, at the moment of and following its introduction,would shed light on its merit. In order to assess the safety of the REIT investment vehicle, long-term observations and econometric tests need to be made to measure REIT performance behaviorand establish its integrity during periods of financial crisis, specifically in the U.S. during the2007-08 financial crises and in Asia during the 1997-98 crises. Next, the precise structures of aREIT vehicle as spelled out in law need to be compared. Aspects of mature economies should beexamined closely for features that are conducive to successful implementation of REITs on theirsecurities exchanges. To further investigate whether the Chinese government’s reluctance to introduce theREIT heretofore is justified, this author examined the econometric studies in the works of K.H.Liow, that evaluate the relationships between performance of securitized and real property. Liowhighlighted advantages of the former, and emphasized the fact that securitization enablesinvestors to hold property indirectly without the responsibility of managing the physical assets
7(Liow, 2001). Another early study tested the relationship between the volatility of physicalproperty returns and volatility of stock market returns, concluding that “it is very likely thatproperty stock return and volatility characteristics are different from those of stock markets(especially) in the long term” (Chen, Lee, & Rui, 2001, p. 533). Within China, the English-language literature is scarce. Tsinghua University’s School ofEconomics in Beijing published a summary of the legislative and regulatory environment as of2008, the first paper ever to appear on the topic (Chen, Sun, & Wang, 2009). The majority ofacademic literature focuses on the REIT story in the U.S, Canada and Australia; many of theprofessional journals are U.S. or Canada-based with relatively little attention paid todevelopments overseas. Regarding the general structure of REITs, the foremost authorities areBlock, Campbell, Ghosh, Newell, and Sirmans who, according to a 2002 survey of journals, haveproduced a vast body of literature (Acheampong, Juchau, Newell, Webb & Wing, 2002). Theliterature is sorely lacking in regards to the exact impact of introducing the REIT vehicle in thecapital market—particularly in an emerging capital market where the real property market isoverheated, as is the case in Shanghai. The REIT has existed on the financial markets in the U.S. since the 1960s. In Japan, J-REITs, as the Japanese vehicle is called, have existed since 1970 and have been introducedelsewhere within Asia more recently, with the Philippines being the latest entrant in June 2010.REITs received a significant boost to their reputation as reliable investment vehicles in 2001when Standard & Poor’s indices included them for the first time, stating that such inclusionfurthers its goal of reflecting “the U.S. equity markets and through the equity market, the U.S.economy” (National Association of Real Estate Investment Trusts, 2003, p. 3). Furthermore,Jorion (2003) established that the introduction of international equities had a stabilizing effect on
8an overall portfolio through diversification. Hoesli, Lekander, and Witkiewicz (2004) argued thatadding international real estate is an excellent and necessary way of diversifying a portfolio. During the 1990s large institutional investors became significant REIT players, and itwas shown that “the increase in institutional participation in the REIT market in the 1990s haveresulted in REIT stocks behaving more like other equities in the stock market” thereby possiblyreducing the diversification benefit of adding REITs to an investment portfolio (Chan, Leung &Wang, 2005, p. 100). Following the 1990s in the U.S., the REIT structure and investmentstrategy gradually changed and it became less of a pass-through vehicle simply collecting anddistributing rental income and more actively managed for high growth (Ooi, Webb & Zhou,2007). Many studies show that a portfolio still benefits from the introduction of REITs, fromdiversification, as well as from internationalization (Camilo & Hoesli, 2007; Cauchie & Hoesli,2006; Cheong, Wilson, & Zurbruegg, 2008; Huang, Ibrahim, & Liow, 2006; Liow, 2006). Thebenefit of holding widely distributed international real estate instruments would have been trueparticularly in the case of the addition of assets in Australia which had relatively stable economicconditions while the rest of the Western world suffered a downturn in 2007-08 (Chee, Wilson, &Zurbruegg, 2008). In addition to internationalization of real estate investment and REITs inparticular, the first decade of the 21st century was characterized by the trends of privatization andprivate equity investment. At a REIT Conference in Shanghai in 2006, an entire working sessionwas dedicated to the subject of private equity where the prevailing sentiment was that the worldwas “awash with private equity”. Between 2006 and 2009 at least some REITs were takenprivate and de-listed. From 2006 to 2010, the trend pertinent to real estate holdings and real
9estate development continued to be internationalization and in late 2010, REIT listing was invogue once again. In spite of certain drawbacks, the U.S. serves as the base reference for the structure of theREIT vehicle itself as well as for the regulatory environment in which it exists on a financialmarket. In contrast to publicly listed equities, the unique features of a U.S. REIT are that it mustdistribute at least 90% of annual taxable income, have at least 75% of assets invested in realestate, and derive at least 75% of income from rents (Block, 2006). After Japan adopted theREIT in the 1970s, Malaysia introduced a REIT-like vehicle in 1989 (Acheampong, Ting, &Newell, 2002). The next Asian real estate funds were introduced in Korea in 2001 and inSingapore in 2002 (Pua, 2005). Hong Kong adopted the REIT within the last decade and theU.K. and Germany also started using it in 2007. Though Malaysia had an abortive start in 1989,the market is undergoing a reprise in 2010 with the announcement of two new REITs scheduledfor July (Business Times, June, 2010). In the case of China, the first REIT containing mainlandproperty was actually listed in Hong Kong in 2005 (Li & Lam, 2006). The second REIT with100% Mainland property assets was securitized in Singapore in 2006 (Ong & Quek, 2007). In order to identify structural commonalities among REIT vehicles around the world,Hoesli and Serrano (2009) identified operational, financial and shareholder requirements acrossREITs in 31 countries. General tendencies are clear. Operationally, most REITs have 75% oftheir equity invested in real estate, at least 80% (and sometimes as much as 100%) of theirincome distributed as dividends, their debt levels and leverage are constrained, and minimuminitial capital requirements are generally imposed on the shareholders (Hoesli & Serrano, 2009).The fine details of each aspect need to be evaluated to find the right balance for China’sparticular requirements. A key finding of Hoesli and Serrano’s (2009) analysis highlights the
10different nature of property activities from region to region within the REIT structure. In contrastto the U.S. and Europe they write, “In Asia… property markets are mainly dominated byproperty developers and by investors in search of potential capital gains rather than rentalincome. This makes both securitized and private property companies in Asia more volatile thanin the other continents” (p. 16). Several key factors found in countries’ macroeconomic environments appear to beconducive to the successful implementation of REITs on securities exchanges. These include: amature economy and capital market, clear property law, tax legislation, company law, andsecurities regulations pertaining to listing, delisting, takeover and merger. Without an adequateregulatory environment, concern arises over the premature formation and listing of newinvestment vehicles negatively impacting the economy and the real estate market. Theaforementioned summary of extant Chinese legislative and regulatory framework by Chen, Sunand Wang (2009) may be compared to that in Taiwan (Lin, 2007) and South Africa(Acheampong, Du Plessis & Newell, 2002)—both mature and successful cases—and toMalaysia’s abortive attempt to introduce REITs in 1989 (Acheampong, Ting & Newell, 2002).A comparison between the regulatory environments of Hong Kong, Singapore and Australia byFlinn & Sullivan in 2006 showed that Singapore law did not have takeover provisions and thatthe Hong Kong REIT formation regulation was inordinately lengthy. These are aspects that theSSE would be well advised to avoid. The Issues in China The real estate business in China started with the expansion of the residential marketfollowing the 1998 reform of housing. This jump slightly predates the 1999 reform of thefinancial sector and opening of the banking sector to foreign banks. As a result of the booming
11residential housing market, the residential mortgage market also took off. In 2007 foreign bankswere permitted to offer RMB services to retail clients, including housing mortgages. Up to thispoint, the “big four,” as the largest Chinese state-controlled banks are commonly called, were themain sources of funds for private borrowers. Deng (2005) explains the history, “The firstresidential mortgage loan in China was actually issued by the China Construction Bank in 1986[but the market grew very slowly until 1999-2000]; by the end of 1997, total outstandingmortgage balance in China was only around RMB Yuan 22 billion. By August 2002, the totaloutstanding balance of the residential mortgages reached RMB Yuan 763 billion” (p. 118).According to the People’s Bank of China third-quarter 2007 monetary policy report, over thefive years between 2002 and 2006, the total investment in China’s real estate sector had reachedUSD657.6 billion (RMB5.3 trillion). National real estate investment in the first three quarters of2006 reached USD165 billion (RMB1.3 trillion). One of the issues that the Chinese government has been grappling with since 2004 is thatin large cities such as Shanghai and Beijing property prices are much higher than the averagecitizen there can afford—a situation referred to as an overheated market. The government seemsto suspect that speculation by wealthy domestic and foreign investors seeking the advantages ofinternational diversification are factors in pushing up prices. While legal restrictions limit theacquisition by foreigners of real estate and securities, foreign funds do not stay away from China.Instead, they seek loopholes and alternate mechanisms that enable them to participate in therapidly growing China market. Foreign investment firms are permitted to develop real estate butare not permitted to list their companies on the China markets. Among the restrictions placed onforeign property developers is that foreign currency cannot be imported and bank loans can onlybe used to finance up to 60% of the purchase cost of land plots. Therefore some foreign
12developers and equity investors form local business entities and rely on Chinese Yuan generatedfrom its operations and domestic bank loans to expand and acquire further pieces of land fordevelopment. In July 2006, the Chinese government issued “Circular 171” prohibiting foreignindividuals from purchasing property in China (Chen, 2007). One primary residential unit forforeigners was permitted later. In June 2007, a brand new regulation on property rights tookeffect. So, while property rights were clarified, foreigners were, and still are as of this writing in2010, discouraged from investing. The ostensible reason is to cool an overheated propertymarket, but another could be protectionism. As a developing country, the government wouldwant not only to protect its prime, real property from being bought up by foreigners whiledomestic buyers could not afford it, but also to protect its emerging capital markets (Tan, 2004). Another of the issues which the Chinese government is sorting out is that accountingstandards and real estate and REIT valuation methods differ from one region to another andcomparisons may be misleading (Ooi, Webb & Zhou, 2007). The fact that international realestate performance indices are not standard must be taken into consideration (Hoesli & Serrano,2009). Investors and professionals typically compare performance of securities and otherinvestment vehicles within the industry, across time, across countries and occasionally acrossindustries. Once China has harmonized its accounting principles and implemented InternationalFinancial Reporting Standards (IFRS), realistic comparability will be achieved (Andrew &Zhang, 2010). The case of China is exacerbated since it needs to harmonize standards used in thedifferent parts of Greater China (including the mainland, Hong Kong, Macau and Taiwan) whileat the same time comparing its extant standards to the (increasingly less favored) GAAP and theIFRS. Each of the Greater China countries has different historical, legislative and educationalbackgrounds and practices that differ from one country to another (Lin, 2007). For example, Lin
13(2007) revisits Taiwan’s 2001 Appraisal Techniques, the 2002 Financial Asset SecuritizationStatute, the 2003 Real Estate Securitization Statute, and the 2006 Ordinance of Real EstateAppraisal Techniques in Taiwan. He describes the overlap of seemingly straightforward realestate valuation with the creation of financial instruments and the evolution of these two areas ofexpertise into one of global relevance. The comparison of the Taiwan regulatory environment tothose in the U.S., the U.K. and Canada shows that the lack of a solid regulatory environmentcould lead to “disorder” in the markets (p. 298). One of the most complex issues is that of taxation. Historically, China has not hadproperty tax, that is, a tax on the capital gain realized upon sale of real estate until 2006. Thepurchase and sale of physical property involves stamp duty and land appreciation tax (LAT).Real property can be bought and sold, however the land remains the property of the state. Theowner of the asset obtains a renewable right to use the land for a given period of time. The landcan appreciate in value, and this is taxed very highly through the LAT, up to 60%. Set againstthis background of China property law, most REITs throughout the world follow the regime setout in the USA and Australia and do not pay income tax. They are exempt from corporateincome tax since they pay between 80% and 100% of their income, usually derived fromcommercial rents, as dividends to their shareholders. China’s economists and tax specialists areundoubtedly working this out among other thorny issues. In addition to its lack of fully formed regulatory environment, the Chinese governmentappears to fear the unforeseen effects of new investment vehicles and this may be one of thereasons for its apparent hesitation to permit REITs. Throughout 2009 and 2010, the subject of theoverheated real estate market appeared in Chinese newspapers on a daily basis. This situationprevailed for a variety of reasons, not least of which was the memory of the implications of real
14estate on the economic crises of 1997-98 in Asia and of 2008 in America, but also the possibilitythat bubble-like prices in the luxury property sector could cause social unrest domestically. InChina during this period, developers persisted in building luxury properties for quick capitalreturn. Developers were not incentivized to produce affordable housing but at the same timerapid urbanization occurred and incomes rose across labor market segments but not yet nearlyenough to afford the available luxury properties. In fact there is a shortage of affordable housingfor the 15.4 million low-income urban households; in Beijing, the average housing price persquare meter is equivalent to seven months’ salary on average. The Process Involved in Creating a New Framework In order to ensure a smooth process with little or no ripples in the economy fromintroducing any new investment vehicle, it is essential that the regulatory framework and theinstruments introduced on the stock market be properly constructed from the beginning. Thegovernment, in particular the Central Bank, CBRC, CSRC and the SSE clearly have a mightytask ahead. Since caution is advised, a stepwise approach to introducing such a new investmentproduct in China has been proposed. Examples of Taiwan and Malaysia both having introducedREITs in abortive attempts in the 1980s, show that “imperfect regulation” (Lin, 2007, p. 298)and “local structural and regulatory factors” led to failure (Acheampong, Ting & Newell, 2002,p. 110). “Turmoil arising among investors, issuers, and governments led to disorder in the realestate and financial markets. Thereafter, the Taiwanese government has been very cautious inregulating the mechanism for investor protection” (Lin, 2007, p. 298). In the case of Malaysia,the government “liberalized its REIT framework in early 2005” (Newell, Ooi & Sing, 2006, p.207). This new regulatory framework greatly facilitated success of REITs in Malaysia. The Hong Kong securities exchange regulator also modified its regulations in 2010 in
15response to evolving market requirements. This was necessary because companies exploiting realestate in the mainland—that adhere to REIT characteristics—may list as REITs on the HongKong exchange. The regulations in question pertained to securities with mainland real estateproducts. The special features of mainland land ownership certificates, land use rights, etc.required modification of trust takeover and delisting regulations. Land in China belongs to thestate; property developers have a licensed right (renewable) to use the land. The business cultureand legal heritage of Hong Kong is essentially British common law, and mainland China landuse certificates may not be readily available. According to the new regulations in Hong Kong,this fact may be mentioned as a risk factor in the listing prospectus. As the process of creating aframework for implementation of REITs evolves, barriers such as the lack of properdocumentation (which may prevail for historical reasons) need to be overcome. Clearly, thedevelopment of a REIT regime with sound legal and regulatory infrastructure is a process thatneeds to be tailored to China’s particular domestic circumstances. The government also needs toinstill proven best practices, transparency and ethics in the market. International best practices,eventually set down in the regulations will be driven by the need to accommodate the variousmarket participants’ requirements, and to support eventual positioning and internationalization ofits financial activities and the stock markets (Newell, Ooi & Sing, 2006). The legal and regulatory infrastructure includes financial legal frameworks (such asbankruptcy codes and conflict resolutions mechanisms between creditors and debtors),supervision, accounting, auditing, and the rules, practices and professions that go with them, aswell as financial corporate governance institutions (Renaud, 2003 and Deng & Zhang, 2008). Inthe process of developing its emerging economy, China is fostering and pro-activelyimplementing these and other aspects such as information availability, flexibility, property
16intermediaries and professions. Legal issues are concerned with the creation and evolution of ahost of institutions, laws, regulations, rules and interested parties within the government. “Invery simple terms, the institutional structure of any market might be viewed as the set of rulesgoverning the operation of that market” (D’Arcy, 2008, p. 2). Establishing such a structure is acomplex and wide-ranging yet delicate task and the structure must also be sustainable as theactors in the market change and the institution becomes internationalized. Until standardized information and the tools to convey it and evaluate it are fullyavailable, and the full legal and regulatory infrastructure is in place, the government mayintroduce the REIT in stages. As a first step, a REIT-like instrument might only be madeavailable to institutional investors, according to an article in the 2009 International FinancialLaw Review. Rather than being publicly listed right from the start, a trust vehicle may compriseSpecial Economic Zone (SEZ) properties and be traded on the inter-bank market. Based uponcasual observation in China, the government typically examines and analyzes overseas practicesin detail, debates prospective actions internally, then issues plans and proclamations and receivescomment before promulgating law. Initially, trial balloons and test cases are permitted whereonly certain qualified actors may participate in specified geographical areas. New institutions areimplemented in a relatively confined geographical and economic context, such as in a SEZ orSpecial Administrative Region (SAR) for a period of observation before going nationwide.Domestic market acceptance is essential well before inviting foreign actors into the market. Theentire stepwise process may take years. Often times Shanghai, the securities exchange of whichlies within an SEZ, and Hong Kong which is an SAR, are the trial platforms. Costs of Implementing a New REIT Regime In analyzing the costs involved, it is important to realize that real estate is an important
17asset class in the economy, even leading the business cycle (Green, 1997). Given its importance,actors in the marketplace need “area-specific information that is by nature subtle and hard tocommunicate” and the lack of it may have important consequences on valuation and hence onthe economy as a whole (Ambrose & Lee, 2009, p. 484). Designing solutions to standardizepractices and developing the regulatory framework invariably generates compliance costs,including for example, expertise accreditation of market participants. Costs also include thestandardization of accounting treatment and valuation techniques, auditing and financialcorporate governance, as well as the technical tools, rules, practices and professions for these(Deng & Zhang, 2008; Ooi, Webb & Zhou, 2007; Renaud, 2003). “Foreign ownership ofcompanies, limits on the scope of services … barriers to hiring non-national personnel, andcontrols on flows of both information and capital and also the repatriation of profits” are othercostly barriers to overcome (D’Arcy, 2008, p. 7). In addition to formal barriers are informal onesincluding “traditions of real estate practice and culture… ingrained attitudes towards the status ofthe specific activities, and language” (p.7). Such business and cultural barriers have been reducedin Europe, and will also need to be addressed in China and harmonized throughout GreaterChina. These ethical or cultural issues also result in costs to be borne by the market participants.Another costly barrier to overcome is the development of indices for recording performance andfor comparisons. In the U.S., relevant indices are NCREIF, National Council of Real EstateInvestment Fiduciary’s Property Index (NPI) and National Association of Real Estate InvestmentTrust’s equity index (NAREITEI) which is the counterpart of NPI for U.S. public real estate(Chen & Mills, 2006). Equivalents will have to be established in China. Furthermore, theChinese REITs will necessarily be compliant with the FTSE EPRA/NAREIT global index ofover 300 public real estate companies.
18 A stepwise process for developing the regulatory environment and the REIT instrumentcould proceed through: analysis of domestic actors’ characteristics and requirements; analysis ofoverseas institutions; issue preliminary plans; internal debate; digest feedback; issueproclamations; observation and coordination; and finally promulgate regulations. The actorsinvolved in this lengthy process range from academic institutions and professional associationsproviding expertise, through local administrative bodies all the way to the central bank and theState Council of the government itself. The cost is large in terms of time as well as manpowerand intellectual capacity. The parties concerned, in particular the Central Bank, the CSRC andthe SSE can modify existing institutions using examples of other countries and take into accountthe peculiar circumstances in the Chinese environment. Even the failures of some cases areespecially useful because they show pitfalls to avoid. With these advantages, as well as thetremendous intellectual power that is available and focused at the key parties involved, the costsmay not be as great as those borne by a country simply starting from scratch and making abortiveattempts at creating the right framework for public REITs. While critics may argue that development stability, quality property products, and marketopenness are prerequisites to a successful REIT regime; this author would argue that waiting forsuch prerequisites to emerge is the most costly option. These are elements of a mature economy,and in the process of emerging, China is fostering and proactively implementing these and otheraspects, such as information availability, flexibility, property intermediaries and professions.They all must be engendered together with user and investor opportunities (Chin, Dent &Roberts, 2006). The categories of actors and fields of endeavor include marketing, finance,accounting, tax, management, leadership, legal issues, ethics, global dimensions, and policies.
19All of these are associated with aspects of the process of implementing REITs in China, asshown in the table below.Table 1Costs Associated with Implementing a New REIT RegimeProblem Solution Cost Factors Element Involved in the SolutionObserve and test Draw conclusions - Long span of time AcademicsREIT regimes in from lessons learned, conducting studies Managementother countries extrapolating to China - Academics feedback to policy makers is lengthyLegal, financial, tax Create new systems to - Long span of time Legaland regulatory support future - Manpower of numerous Financeframework need to investment vehicles government departmentsbe changed on the market and banksNon standardized Harmonize existing Intellectual capacity of Accountingaccounting standards with professional bodies andpractices and lack international standards exchange regulatorsof performance and create new indicesindicesBest practices New reporting Costs of compliance by Standards Bodiesabsent or standards, governance businesses Professionalinconsistently and transparency rules AssociationsappliedFormal and Create harmonious Costs for market Leadershipinformal barriers policies participants Policy-makersNature of property Influence investor Potential cost to general Securities exchangesinvestment behavior through tax smooth operation ofactivities for short- and other incentives economyterm capital gainLong span of time Apparent inaction Opportunity costs -- while vehicle is unavailable to individual investorsMarket acceptance Trial projects in SEZ Contingency costs Marketing and SAR Staged Implementation Plan
20 First Stage – The Pilot REIT The first stage would limit investors to institutions such as insurance companies, banks,pension funds, and wealthy corporations (Chen, Sun & Wang, 2009). These institutions havelong term goals, less speculative money, “more understanding of the product and better riskmanagement than the average domestic retail investor” and supposedly better than foreignspeculators (Lee & Leung, 2010). An unlisted vehicle would be made available for purchase inlarge, en bloc transactions on either the non-stock OTC electronic market or the inter-bankmarket, or both. The process of implementation entails extensive modification of existingregulations. The Central Bank and the CBRC need to approve any securitisaton. The CSRCcontrols the OTC non-stock electronic market and the CBRC regulates the inter-bank market.Furthermore, both the CSRC and the CBRC regulate existing forms of trusts that could possiblyserve as platforms for REITs, respectively the specific asset management plan (SAMP), and realestate trust investment schemes (RETIS). A security fund is a third type of investment vehiclethat may possibly serve as a better platform for evolving a REIT. This is a mutual fund the sharesof which already trade on the open market. It is an instrument managed by a licensed fundmanagement company, currently restricted to high net worth individuals. These are alsogoverned by the CBRC. The current form of securities fund holdings could eventually beexpanded to include real estate; the fund could then be listed and traded publicly. Another key player in the transformation is the China Insurance Regulatory Commission(CIRC), which governs insurance companies. CIRC modified its rules in early August 2010 topermit insurance companies and pension funds to invest a limited portion of their holdings intoprivate equity and real estate. China Life Insurance and China Pacific Insurance, and Ping AnInsurance already seek investment opportunities in commercial property, as well as debt and
21shares of non-listed companies as they plan to diversify their investments. These institutions arebanned from developing properties directly (Colins, 2010). New entities, funds or trusts, comprised only of rental revenue-producing real estate needto be created. The physical properties need to be identified, valued and examined for complianceto traditional REIT parameters. Next, proposals to amend the rules for SAMP, RETIS, andsecurities funds as well as their respective trading platforms need to be drafted and submitted bytheir regulators for review by higher authorities, namely the People’s Bank of China, relevantministries and the central government. Tax neutral policies, which are not yet available onsecuritized products in China, also need to be created and approved by the Ministry of Financeand the State Administration of Taxation. Currently, SAMPS (and fixed-income securities) aretraded for short-term, while RETIS raise project based financing and bridge capital (raising debtis not permitted) as interim financing for property developers. If either of these vehicles is used,this stage is estimated to require 18 months, including the difficult modification of tax codes. Interim Stage – The Development REIT In the second stage, the trust could be permitted to use a small portion of its revenue toengage in property development, rather than paying most of it to investors as returns. Cities inthe interior of China need infrastructure and other development, and these are often overlookedby property developers which seek high profits in wealthy costal and capital cities. Adevelopment REIT would be permitted to re-invest a portion of its proceeds in new developmentprojects, not only pay out rental income as dividends. Furthermore, traditional REITcharacteristics include numerous shareholders that own units or shares of the trust. Hence, theinterim vehicle needs to be created in such as way that its revenue use, ownership and capitalstructure are clearly defined. This stage is estimated to require eight to ten months.
22 Regardless of the asset type, professional asset management and management of thetrust’s physical assets and finances are needed. A corresponding monitoring system includinglicensing and periodic re-certification are also needed. As of 2010, there is no licensing systemfor asset management in China. These standards can be readily borrowed from more developedcountries and international bodies. Although admittedly the time to hone such skills and developexperienced fund managers will require much longer. As a start, imitating internationalcertifications bodies is estimated to require approximately six months. Final Step – The True REIT A pre-requisite according to traditional RIET structure is that the property must beprofitably revenue-producing continuous for at least three years. There are few such properties insecond-tier cities, and these could emerge during the third and final stage. “The ideal asset typeswould be large-scale rent-generating properties such as offices, shopping malls and servicedapartments” as well as industrial properties (Chen et al., 2009, p. 154). For the last and finalstage, the steps leading to public listing have been summarized by Bedford (2010) of KPMG thefollowing table:Table 2The Path to REIT Listing with Key Steps to Consider Steps Key Issues 1. Identifying the portfolio Asset valuation Financial analysis on future income stream projection Financial, legal and tax due diligence
23 Steps Key Issues 2. Structuring the portfolio from Operating and running costs of each acquisition, holding and exit structure Cash flow assessment Income support arrangements Repatriation of income Tax planning to minimize tax leakage 3. Preparing the portfolio for REITs Controlling interest in REITS Tax efficient management fee structure Financial modeling and determination of optimal financing structure Fair value assessment 4. Submitting the listing application Determining time and place of and obtaining regulatory approval listing Preparation of the listing documents Resolving comments raised by the regulators Accountants report, comfort letters 5. Roadshow Investor relations Yield forecasts Future funding Post-listing strategy 6. Listing Compliance with the Code, Listing Rules and trust deed Risk management and operational control Corporate governance Ongoing audit and tax compliance Subsequent acquisitionsSource: Bedford, “China’s Trust Sector: The Next Chapter”, 2010. A staged introduction conforms to the traditional pattern of the Chinese government. Itenables simultaneous development of regulations and policies while testing the vehicle at thesame time. If this policy were to be implemented, it will address the pent-up demand for insurersto invest in real estate, albeit indirectly and through a less volatile vehicle. Currently, in Chinaand in Shanghai especially, real property is far too volatile for large investors. Subsequently, the
24second stage would open up REITs and could help draw retail investors away from propertyspeculation and towards a longer term, steady return typically provided by REITs. The process of implementation comprises not only the legal, financial and economicactors, but some pure political actors as well. The English language national newspaper, theChina Daily, reported on April 26, 2010, that the unlisted REIT vehicle may be made availablein either Shanghai or Beijing (Lee & Leung, 2010). There is rivalry between the two cities andboth are eager to pave the way. Actively operating, government-backed properties in free tradezones, such as ports facilities, logistics centers and warehouses, could be put into the first pure-China REIT be they in Beijing’s or Shanghai’s nearby port cities (Lee & Leung, 2010). While the solutions for REITs and other investment vehicles are being formulated, theretail investor and property developer endure opportunity costs to spend their savings and raisefinancing respectively. This situation is in part responsible for the rising prices of real property.During 2010, the government has been trying to cool the rise of real estate prices by instructingbanks to curb credit to speculative buyers. This places a high onus on retail banks which,nevertheless, may exercise subjective judgment and make selective decisions. The final policy implication to mention here is the issue of potential social unrest. Thiscan be caused by lack of affordable housing for the masses. This is yet another reason that thegovernment policy must quickly provide investment vehicles to address pent up demand ofinvestors. Throughout 2009 and 2010, the Vice Premier and Minister for Housing and UrbanDevelopment are featured in the news calling for more affordable housing to be built. Forexample, on August 22, 2010, Vice Premier Le Keqiang “called on local government to bearmajor responsibility for affordable housing construction, diversify fund raising channels to
25obtain more investment, arrange for sufficient land supplies, and ensure transparency andfairness in the distribution of affordable housing” (Xinhua, 2010). Conclusions In order to ensure a smooth process with little or no ripples in the economy, it isabsolutely essential that the regulatory framework and the instruments introduced on the stockmarket be properly constructed from the beginning. The macroeconomic policy objectives oflong-term growth and stability could be severely affected by errors and omissions in theimplementation. Three major steps along this process can be demarcated as the presence in themarket of: a pilot vehicle—the restricted institutional REIT; the development REIT; and thepublicly traded REIT. The prerequisites for the first, restricted vehicle have been discussedextensively in this article. The trust laws, tax regimes and regulatory and professional featuredevelopment are benchmarks in the process. The final objective is to create a truly liquid, tax-neutral, stable and publicly traded real estate securities instrument. The whole process is likely totake three and a half to four years. The Chinese government itself, in particular the CBRC,CSRC and the SSE, have far-reaching objectives. China aims not merely to be on par with therest of the world in terms of its housing policy and investment markets, it aims to rival manyestablished financial markets. Due to recent volatility of real estate prices and related securities in the U.S., it is usefulto compare the performance of REITs to the overall stock market in a volatile economy in orderto assess the value and stability of the REIT instrument. Clearly, the organizational form, taxstatus, regulatory framework and investment performance of real property and securitizedproperty are quite sensitive to economic conditions. Evidence shows that the REIT is aninvestment vehicle satisfactorily lending itself to the demands of investors primarily in
26developed economies with mature capital markets. In developing countries, such as Malaysia, itmet with limited success until pertinent regulations were liberalized. Hong Kong and Taiwanhave also refined and streamlined their regulations. China has resisted the introduction of the REIT vehicle for several reasons related to thematurity level of the economy and, specifically, to the presence of pertinent legislation andregulatory mechanisms. Only in October 2007 did China abandon the traditional Dian Quansystem and introduce a code of property law that conforms to a (German- and Swiss-style) civillaw system. Furthermore, accounting standards, technical tools for securitization and valuation(upon which securitization naturally depends) and capital market mechanisms are not yetsufficiently standardized globally, let alone within China. The Chinese government, rightly so inthis author’s opinion, is proceeding in a stepwise fashion by first developing appropriate tools,standards, guidelines, regulations and laws before fully opening its capital markets to instrumentsthat may have little meaning and could even threaten its economic stability. As a result of allthese factors, it will be some time yet before we see the REIT in China.
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