Hong Kong REITs – Why the FSDC proposals are important

29 January 2014   Category: News, Asia, Global, Hong Kong   By Peter Mitchell*

The Financial Services Development Council (FSDC) has recently issued a research paper on the topic of Developing Hong Kong as a Capital Formation Centre for REITs. It is one of four papers that have been issued as part of its charter to provide a high-level, cross-sectoral platform to advise the government on ways to further develop Hong Kong’s financial services industry.

The paper identifies four key areas which the FSDC believes are important to address if Hong Kong is to secure a position as an international asset management centre and capital formation centre for REIT listings.

Why is this important? REITs have become an important financial instrument globally. Many pension funds and other institutional investors in Europe and North America, recognising the performance and diversification benefits of REITs, have fixed and separate allocations to REITs on a global basis.

Since the launch of the first REIT in Asia (Japan, September 2001) the REIT market has grown enormously. Market capitalisation is around US$146 billion and rising. With more investment grade real estate continually being developed, and with the prospect of new REIT markets in India, the Philippines and elsewhere, it is quite conceivable that this could exceed $500 billion in the near future. The success of this product has been driven by the success of the REIT markets in Japan and Singapore, which together account for around 78% of Asian REIT market capitalisation.

The market capitalisation of Singapore’s REIT market is approaching $50 billion, and given the fixed REIT investment mandates that many global institutional investors have, it is strongly arguable that much of this capital would not be in the Singapore economy but for its successful REIT market.

According to recent research commissioned by Asia Pacific Real Estate Association (APREA), China currently accounts for 7% of the global investable real estate market, with this share forecast to increase to almost 30% of the global market by 2031. With no REIT legislation yet in place in China, the likelihood of more and more listings of Chinese property in offshore REITs should be obvious.

Hong Kong should stand to benefit most from this, and thereby attracting significant additional capital into the economy. However, currently the “go to” jurisdiction for cross-border listings is Singapore. Hong Kong has missed a significant amount of this business and the market has not grown anywhere like Japan and Singapore.

Why is this? It is because of the issues raised in the FSDC paper. This is clear from a recent industry survey conducted for APREA as part of a forthcoming research report on the impact that REITs have had on Asian economies. Of particular importance are the FSDC proposals related to development and tax.

At the moment Hong Kong REITs cannot participate in property development activities, and this concept is defined very broadly such that they can’t even develop their own aging assets. So, currently REITs can only acquire investment properties in the market and are forbidden from building their own assets. A capacity to invest early in the project cycle would create pricing advantages and would also give a REIT some input and control over the final product. The current inability to redevelop ageing assets is also suboptimal for investors. Buildings have lifecycles, and not being able to undertake significant upgrading works will compel a REIT to sell the asset, at a price which would not reflect the full potential of the asset.

These restrictions do not apply in the US, Australia, Singapore or even Malaysia.

The FSDC is proposing quite a relatively modest and conservative change, in keeping with the situation in Singapore – it would allow REITs to engage in development activities but only up to 10% of the total asset value of the REIT. No such limit applies in the US and Australia – in those countries it is left to the market to decide. In addition, the FSDC proposes a minimum holding period following completion. In Singapore the same 10% restriction applies and, coupled with the legal limit on borrowing (similar to Hong Kong), it has given REIT managers additional capital management flexibility and flow-on benefits to investors, which are currently not available in Hong Kong. REIT investors make their investment decisions taking into account the REIT’s development risks and other merits, such as asset quality, management profile, growth potential, and capital structure.

Permitting a degree of development activity of itself will not make REITs more risky or lead to volatile distributions. The Singapore experience bears this out. Furthermore, in keeping with the conservative nature of its proposal, the FSDC has proposed a number of investor protection measures. Those REITs that undertake some development activity will have their valuations adjusted by the market.

US REITs may develop property for their own account that, once developed, they hold for investment. In the US context, the relevant inquiry is whether the property is held as investment (for the long term) or as inventory as a dealer (for the short term).This rule provides the flexibility for those REITs that have property development expertise to benefit their shareholders by undertaking development for their own account, thereby achieving cost efficiency and savings. This rule also helps spur development by REITs with particular development and redevelopment expertise. Unlike the US where there is no statutory restriction, the FSDC proposes a 10% limit on development activities and also imposes the same requirement to hold the asset following completion.

The FSDC paper also proposes giving Hong Kong REITs the same tax transparency treatment that applies in other jurisdictions. “Tax transparency” means that as long as a REIT satisfies the requirement to distribute most of its income to unitholders, it will not be subject to income tax at the trust level. Tax is payable by unitholders at their marginal rate.

This tax advantage is a fundamental characteristic for REITs as an investment product and a key factor that contributes to REITs’ popularity among investors, particularly pension funds. It is also a key element to the value proposition of REITs – with their high levels of distribution, tax transparency and liquidity benefit, they are a proxy for investing directly in real estate, enabling investors of all descriptions and sizes to invest in quality income-earning real estate through the stock market. If the tax transparency component is not there, the value proposition for investors is substantially diluted.

Hong Kong stands alone amongst mature REIT markets in not providing for tax transparency, and the results of the APREA-commissioned research report in the impact that REITs have had on Asian economies confirm that this is a major reason for the Hong Kong REIT market not having kept up and not realising its potential.

*Peter Mitchell is CEO of the Asia Pacific Real Estate Association (APREA)