After years of debate and consolidation, Hong Kong's real estate investment trust (REIT) sector has still to take off. The government has tried to kick start the industry with regulatory changes such as dropping geographic restrictions, but so far no REIT has been successfully launched in Hong Kong. Everyone has been waiting for the listing of the Hong Kong Housing Authority's HK$32 billion Link REIT, but the IPO was aborted in December 2004 after a lawsuit from two public housing estate tenants, who objected to the possibility of sharp rent increases. The listing is not expected to take place before the end of 2005.
What Is Holding Things Back?
Increased property prices have to some extent dampened the enthusiasm for REITs in Hong Kong. The recent sharp increase in property prices has significantly brought down rental yields. The increasing interest rates have further narrowed the property yield spreads. As a result, it has become a lot more difficult to achieve the necessary yield for a REIT to be launched successfully.
As of March 2005, the yield for grade "A" office space in Hong Kong was about 3.5%, while for high-quality shopping centers, it was about 4.9% (see chart). With the 10-year exchange funded bills yielding more than 4%, the thin spreads, currently negative for grade "A" offices and less than 2% for retail spaces, hardly appeal to potential REIT investors.
Cheap capital from banks and the share market have also put a dampener on the attractiveness of REITs as a source of capital release for developers. The overly restrictive regulations imposed by the Securities and Futures Commission (SFC) and a lack of tax incentives are further deterrents. On the investor side, time and education are also needed before Hong Kong investors adjust to investing in REITs. They are used to investments focused on capital appreciation rather than income-producing products.
What Happened in Other Markets?
Hong Kong's REIT market is clearly in its infancy and will take time to develop. However, if the experiences of other countries, such as the US and Australia, are used as a guide, REITs will eventually become an important investment tool in Hong Kong.
The global REIT market has grown swiftly over the past few years, with more countries embracing a tax-efficient property listing structure to encourage private commercial property investment, and providing retail investors with an additional investment option. The largest REIT markets are the US and Australia.
Australia's REIT market took several years to develop, but once established, the industry grew rapidly. Property trust investments increased significantly in Australia throughout the 1990s with the introduction of compulsory superannuation legislation. At the same time, banks started to package their real estate assets into property trusts to reduce their exposure. Currently, more than 50 property trusts are listed in Australia, accounting for about 8.5% of the country's stock exchange market capitalization, and controlling almost half of all institutional commercial real estate in Australia. Standard & Poor's rates nine of them. The total market capitalization of listed property trusts on Australia's stock exchange is more than US$65 billion.
In the US, REITs were first conceived in 1960, although the idea did not gain widespread acceptance until some important tax reforms were instigated in the late 1980s. The real push came in the early 1990s after the Savings and Loans crisis. During this period, property prices collapsed and property funding options dried up. It was at that point that the market turned to REITs as an efficient way to gain access to capital. As of May 2005, about 192 REITs are listed on the New York Stock Exchange. The total market capitalization of REITs increased to about US$297 billion in 2005 from US$13 billion in 1990.
REITs are a fairly new product in Asia, but are quickly gaining popularity. In 2000, legislation was passed in Japan allowing for the establishment of Japan-based REITs. Since then, seven REITs, with an approximate market capitalization of US$5.7 billion, have been established in Japan. In 1999, Singapore enacted its first investment guidelines for the establishment of Singapore-based REITs. In December 2004, Singapore listed the S$722 million (US$436 billion) Suntec REIT on its exchange, its fifth. Malaysia, Korea, and Taiwan have met with success in establishing REITs. The total market capitalization of the REIT sector in Asia was about US$80 billion in 2004.
Market Implications
The establishment of REITs in Hong Kong is expected to improve the liquidity of the commercial property market, create a new channel through which landlords can sell their assets, and offer investors an alternative investment product. Relatively stable returns will be the most important factor in attracting retail investors. From an institutional investor's perspective, not only do REITs provide a good dividend yield, they also provide an effective means to diversify an investment portfolio, and an opportunity to reduce investment volatility in the property market.
Under general listing requirements, overall transparency is expected to improve, because REITs are required to disclose detailed operational data, including their investment objectives, portfolio holdings, and tenancy agreements.
A listed REIT also has to comply with continuing disclosure requirements, such as filing financial reports. Overall, REITs are subject to more public scrutiny and regulatory oversight than most property-related companies listed on a stock exchange. REITs will be easier to understand and will not have corporate activities that make it easier to hide losses and off-balance-sheet obligations.
The value of properties included in REITs will be closely monitored. This could have implications for the way property companies value their assets. In Hong Kong, the market for commercial properties is very thin and a true market price is sometimes difficult to obtain. Given the absence of direct comparables, most estimates are derived by capitalizing market rents. REITs do not use this method of valuation; instead, their net asset values are calculated using the discounted cash flow method, which can result in different valuations.
Easing Regulatory Requirements
The SFC regulates REITs in Hong Kong. It initially applied fairly restrictive regulations to the industry, but has started to relax the rules. Recent changes have included the dropping of geographic restrictions, increasing the maximum gearing limit, and changing the management fee payment mechanism. These changes are making it more attractive to list REITs in Hong Kong. The key regulations that apply to REITs in the territory are:
· All REITs need to be listed, which should provide a convenient exit mechanism for investors.
· REITs are not subject to property tax, but instead to corporate profit tax. Tax deductions for this are more generous than for property tax. This is more restrictive than overseas REIT markets, but Hong Kong is a relatively low-tax jurisdiction.
· The government has recently increased the maximum gearing limit to 45% from 35% of the gross value of the assets. This compares with 35% in Singapore. In Japan, Australia, and the US there are no gearing limits.
· REITs must distribute no less than 90% of after-tax profits as dividends. This allows the REIT to offer a relatively high yield.
· REITs are not permitted to engage in property development. While this means they are not exposed to development risks, it may restrict earnings potential.
· Initially, REITs in Hong Kong were not allowed to invest in overseas properties. This restriction has recently been dropped, and now property trusts have no limitations on geographical coverage. Given Hong Kong's proximity to mainland China, the relaxation of investment rules may lead to the establishment of REITs that invest in a combination of properties in Hong Kong, Shanghai, and Beijing.
· There are stringent disclosure requirements. REITs are required to disclose operational data, including occupancy rates, tenant profiles, lease renewal structures, and financial policies.
· REITs must appoint an independent property valuer. Valuations on REIT properties are performed once a year.
· REITs must be structured as a trust with an independent trustee and a management company. The trustee should be a licensed bank or a trust company that is a subsidiary of a licensed bank.
· The management company needs to be licensed by the SFC to manage investment funds and have a strong track record in managing Hong Kong properties.
Analyzing REITs
Credit ratings have been used extensively in other markets to provide transparency to property trusts in their public offerings and debt issuances. Standard & Poor's has rated 69 REITs in the US and 18 in the Asia–Pacific region. These property trusts generally display investment-grade characteristics. For example, CapitaMall Trust, which was launched in Singapore, is rated 'A-'. Relatively conservative regulations and high-quality property assets should mean that property trusts in Hong Kong would obtain good investment-grade ratings.
When Standard & Poor's analyzes the creditworthiness of REITs, it looks carefully at asset quality and cash flow predictability. The quality and diversity of assets held provide key insights into the stability and reliability of cash flow. The many factors assessed include building age, rental terms, occupancy levels, tenant quality, and lease maturity profile.
The different asset type is one of the main factors that will determine the rating outcome for REITs in Hong Kong. Each has different income and capital value characteristics through a property cycle. In general, retail assets, in particular large-scale neighborhood shopping centers, have the strongest operating profiles. Top-tier malls in good locations have survived the latest economic downturn almost unscathed. Office buildings provide less income stability, but some high-quality assets still remain. The weakest asset class is likely to be residential assets, which have minimal lease protection and are exposed to a high degree of rental volatility. In this respect, management ability to renew leases and maintain a good tenant mix, as well as the location of property, are important considerations.
The evaluation of investment strategies and property management skills is also an important rating consideration because it has a bearing on future performance. Standard & Poor's conducts due diligence meetings with investment management companies, and related property companies. Issues discussed include investment strategy, asset selection process, administrative framework, and management incentives. A company that adopts cautious growth strategies and is financially disciplined is in a better position to receive a higher credit rating.
Having evaluated the quality of the asset portfolio, Standard & Poor's analyzes the trust's financial risk profile. REITs must maintain strong liquidity because of their low level of cash retention. The main financial issues that Standard & Poor's focuses on include cash flow strength, capital structure, liquidity, and financial flexibility to raise capital, given property trusts' inability to retain meaningful earnings. Standard & Poor's pays particular attention to debt maturities, exposure to interest rate volatility, capital spending plans, access to committed bank facilities, and debt covenants. The main ratios used by Standard & Poor's to assess the degree of financial risk include loan-to-value, interest coverage, debt service coverage, and cash flow to total debt.
[The article is an abstract from RatingsDirect, Standard & Poor's Web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]
