Electronic copy available at: http://ssrn.com/abstract=1680112

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

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Abstract

This article proposes a process by which a new national framework for listing real estate

investment trusts (REITs) on the Shanghai stock exchange in China could be developed and

implemented. It makes some assumptions about the actors involved and the action required, and

presents a timeline for the plan. While theoretically, good REIT legislation is a price-stabilizing

factor on the market, there is some reluctance in government circles to permit listing of a

publicly tradable REIT vehicle. There are questions to resolve, what structure could a REIT take

in Shanghai and, if the REIT is introduced, whether it can be a factor that would contribute to

market stability in an emerging capital market and have a stabilizing effect on Shanghai’s

overheated real estate market and volatile capital market. If this could be proven with

econometric tests, it would make an effective argument for the China Banking Regulatory

Commission (CBRC), China Securities Regulatory Commission (CSRC) and Shanghai

Securities Exchange (SSE) to permit the listing of REITs.

The process outlined in this article would be carried out in three stages, the first resulting

in an unlisted pilot product, the restricted institutional REIT; then an interim, slightly expanded

version, the development REIT; and finally a truly liquid, tax-neutral, stable, publicly traded

REIT. 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 benchmarks

in the process. The whole process is likely to take three and a half to four years. The Chinese

government, rightly so in this 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 instruments that may have little meaning and could even threaten its economic

stability. It will be some time before we see a full fledged REIT on the market in Shanghai.

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Introduction

This article proposes a process by which a new national framework for listing real estate

investment trusts (REITs) on the Shanghai stock exchange in China could be developed and

implemented. It makes some assumptions about the actors involved and the actions required, and

presents 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 major

questions to resolve, what a REIT is and what structure a REIT could take in Shanghai; and, if

the REIT is introduced, whether it can be a factor contributing to market stability in an emerging

capital market in general, and have a stabilizing effect specifically on Shanghai’s overheated real

estate market and volatile capital market. If this could be proven with econometric models, it

would make an effective argument for the China Banking Regulatory Commission (CBRC),

China Securities Regulatory Commission (CSRC) and Shanghai Securities Exchange (SSE) to

permit 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 trading

markets in China.

According to the academic literature, when investors have few alternative investment

vehicles 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 capital

market for property development and acquisition programs, domestic and foreign institutional

investors, and individual investors that need a range of investment choices. They act as push

factors on the demand for REITs. One of the advantages of REITs is that they "allow a property

developer to gain capital from its real estate portfolio by placing it in a trust and listing it on an

exchange. This is then tradable, and the capital realized from its sale can be reinvested" (R.,

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2009). For the individual retail investor a REIT is quite a convenient structure since the investor

does not actually purchase the physical asset, but purchases trust units that give the investor

access to the trust’s cash flows from the rental income of a pool of revenue-generating

properties. The hypothetical problem to investigate is whether—given the current economic

environment in China—the REIT should be considered a safe vehicle for the risk-averse and for

those who are not onsite to personally manage a real estate portfolio. The emerging capital

market needs to be nurtured quickly but carefully. The relevant legal and financial environment

needs to be developed so that listing new investment vehicles such as the REIT can be done

without negative impacts on the economy in general and the capital and real estate markets in

particular. In forming new legislation, the Chinese government can influence the REIT structure,

circumscribe the investment activities, and restrict shareholders and management functions. In

the eyes of the government, the ideal outcome is not only that a new publicly listed instrument is

available to individual investors, but that the SSE be regarded around the world as one that fits

the definition established by Chin, Dent and Roberts (2006) of an attractive market for

investment, where the business and financial culture is one of “market openness,

professionalism, the presence of property intermediaries, information availability and

standardization, development stability, flexibility, quality of property products, and user and

investor opportunities” (p. 55).

The CBRC drew up “provisional rules” to permit the REIT in 2004; and in 2005, a

proposal to introduce REITs was submitted to the central government; however there were

clearly some regulatory shortcomings (Nie & Yu, 2005). The SSE “set up a specialized research

unit in March 2007 [which demonstrated that the] SSE is determined to become one of the REIT

hubs of Asia” (Ong & Quek, 2007, p. 255). In August 2009, a special team led by the central

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bank of China and comprising 11 ministers was established to speed up the research and

development of REITs in China. In December 2009 the State Council of the government in

Beijing had approved plans for a REIT framework, but another REIT plan was submitted to the

State Council for approval in June 2010. Nevertheless as of late 2010, it still had not been

adopted in Shanghai or on any other exchange in China. The process proposed in this article

would 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 of

introducing 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 behavior

and establish its integrity during periods of financial crisis, specifically in the U.S. during the

2007-08 financial crises and in Asia during the 1997-98 crises. Next, the precise structures of a

REIT vehicle as spelled out in law need to be compared. Aspects of mature economies should be

examined closely for features that are conducive to successful implementation of REITs on their

securities exchanges.

To further investigate whether the Chinese government’s reluctance to introduce the

REIT 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. Liow

highlighted advantages of the former, and emphasized the fact that securitization enables

investors to hold property indirectly without the responsibility of managing the physical assets

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(Liow, 2001). Another early study tested the relationship between the volatility of physical

property returns and volatility of stock market returns, concluding that “it is very likely that

property 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 of

Economics in Beijing published a summary of the legislative and regulatory environment as of

2008, the first paper ever to appear on the topic (Chen, Sun, & Wang, 2009). The majority of

academic literature focuses on the REIT story in the U.S, Canada and Australia; many of the

professional journals are U.S. or Canada-based with relatively little attention paid to

developments overseas. Regarding the general structure of REITs, the foremost authorities are

Block, Campbell, Ghosh, Newell, and Sirmans who, according to a 2002 survey of journals, have

produced a vast body of literature (Acheampong, Juchau, Newell, Webb & Wing, 2002). The

literature is sorely lacking in regards to the exact impact of introducing the REIT vehicle in the

capital market—particularly in an emerging capital market where the real property market is

overheated, 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 introduced

elsewhere 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 2001

when Standard & Poor’s indices included them for the first time, stating that such inclusion

furthers 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

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an overall portfolio through diversification. Hoesli, Lekander, and Witkiewicz (2004) argued that

adding international real estate is an excellent and necessary way of diversifying a portfolio.

During the 1990s large institutional investors became significant REIT players, and it

was shown that “the increase in institutional participation in the REIT market in the 1990s have

resulted in REIT stocks behaving more like other equities in the stock market” thereby possibly

reducing 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 investment

strategy gradually changed and it became less of a pass-through vehicle simply collecting and

distributing 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, from

diversification, as well as from internationalization (Camilo & Hoesli, 2007; Cauchie & Hoesli,

2006; Cheong, Wilson, & Zurbruegg, 2008; Huang, Ibrahim, & Liow, 2006; Liow, 2006). The

benefit of holding widely distributed international real estate instruments would have been true

particularly in the case of the addition of assets in Australia which had relatively stable economic

conditions 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 in

particular, the first decade of the 21st century was characterized by the trends of privatization and

private equity investment. At a REIT Conference in Shanghai in 2006, an entire working session

was dedicated to the subject of private equity where the prevailing sentiment was that the world

was “awash with private equity”. Between 2006 and 2009 at least some REITs were taken

private and de-listed. From 2006 to 2010, the trend pertinent to real estate holdings and real

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estate development continued to be internationalization and in late 2010, REIT listing was in

vogue once again.

In spite of certain drawbacks, the U.S. serves as the base reference for the structure of the

REIT vehicle itself as well as for the regulatory environment in which it exists on a financial

market. In contrast to publicly listed equities, the unique features of a U.S. REIT are that it must

distribute at least 90% of annual taxable income, have at least 75% of assets invested in real

estate, and derive at least 75% of income from rents (Block, 2006). After Japan adopted the

REIT 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 in

Singapore in 2002 (Pua, 2005). Hong Kong adopted the REIT within the last decade and the

U.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 scheduled

for July (Business Times, June, 2010). In the case of China, the first REIT containing mainland

property was actually listed in Hong Kong in 2005 (Li & Lam, 2006). The second REIT with

100% 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 across

REITs in 31 countries. General tendencies are clear. Operationally, most REITs have 75% of

their equity invested in real estate, at least 80% (and sometimes as much as 100%) of their

income distributed as dividends, their debt levels and leverage are constrained, and minimum

initial 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’s

particular requirements. A key finding of Hoesli and Serrano’s (2009) analysis highlights the

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different nature of property activities from region to region within the REIT structure. In contrast

to the U.S. and Europe they write, “In Asia… property markets are mainly dominated by

property developers and by investors in search of potential capital gains rather than rental

income. This makes both securitized and private property companies in Asia more volatile than

in the other continents” (p. 16).

Several key factors found in countries’ macroeconomic environments appear to be

conducive to the successful implementation of REITs on securities exchanges. These include: a

mature economy and capital market, clear property law, tax legislation, company law, and

securities regulations pertaining to listing, delisting, takeover and merger. Without an adequate

regulatory environment, concern arises over the premature formation and listing of new

investment vehicles negatively impacting the economy and the real estate market. The

aforementioned summary of extant Chinese legislative and regulatory framework by Chen, Sun

and 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 to

Malaysia’s abortive attempt to introduce REITs in 1989 (Acheampong, Ting & Newell, 2002).

A comparison between the regulatory environments of Hong Kong, Singapore and Australia by

Flinn & Sullivan in 2006 showed that Singapore law did not have takeover provisions and that

the Hong Kong REIT formation regulation was inordinately lengthy. These are aspects that the

SSE would be well advised to avoid.

The Issues in China

The real estate business in China started with the expansion of the residential market

following the 1998 reform of housing. This jump slightly predates the 1999 reform of the

financial sector and opening of the banking sector to foreign banks. As a result of the booming

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residential housing market, the residential mortgage market also took off. In 2007 foreign banks

were permitted to offer RMB services to retail clients, including housing mortgages. Up to this

point, the “big four,” as the largest Chinese state-controlled banks are commonly called, were the

main sources of funds for private borrowers. Deng (2005) explains the history, “The first

residential 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 outstanding

mortgage balance in China was only around RMB Yuan 22 billion. By August 2002, the total

outstanding 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 the

five years between 2002 and 2006, the total investment in China’s real estate sector had reached

USD657.6 billion (RMB5.3 trillion). National real estate investment in the first three quarters of

2006 reached USD165 billion (RMB1.3 trillion).

One of the issues that the Chinese government has been grappling with since 2004 is that

in large cities such as Shanghai and Beijing property prices are much higher than the average

citizen there can afford—a situation referred to as an overheated market. The government seems

to suspect that speculation by wealthy domestic and foreign investors seeking the advantages of

international diversification are factors in pushing up prices. While legal restrictions limit the

acquisition 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 the

rapidly growing China market. Foreign investment firms are permitted to develop real estate but

are not permitted to list their companies on the China markets. Among the restrictions placed on

foreign property developers is that foreign currency cannot be imported and bank loans can only

be used to finance up to 60% of the purchase cost of land plots. Therefore some foreign

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developers and equity investors form local business entities and rely on Chinese Yuan generated

from its operations and domestic bank loans to expand and acquire further pieces of land for

development. In July 2006, the Chinese government issued “Circular 171” prohibiting foreign

individuals from purchasing property in China (Chen, 2007). One primary residential unit for

foreigners was permitted later. In June 2007, a brand new regulation on property rights took

effect. So, while property rights were clarified, foreigners were, and still are as of this writing in

2010, discouraged from investing. The ostensible reason is to cool an overheated property

market, but another could be protectionism. As a developing country, the government would

want not only to protect its prime, real property from being bought up by foreigners while

domestic 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 accounting

standards and real estate and REIT valuation methods differ from one region to another and

comparisons may be misleading (Ooi, Webb & Zhou, 2007). The fact that international real

estate performance indices are not standard must be taken into consideration (Hoesli & Serrano,

2009). Investors and professionals typically compare performance of securities and other

investment vehicles within the industry, across time, across countries and occasionally across

industries. Once China has harmonized its accounting principles and implemented International

Financial 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 the

different parts of Greater China (including the mainland, Hong Kong, Macau and Taiwan) while

at the same time comparing its extant standards to the (increasingly less favored) GAAP and the

IFRS. Each of the Greater China countries has different historical, legislative and educational

backgrounds and practices that differ from one country to another (Lin, 2007). For example, Lin

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(2007) revisits Taiwan’s 2001 Appraisal Techniques, the 2002 Financial Asset Securitization

Statute, the 2003 Real Estate Securitization Statute, and the 2006 Ordinance of Real Estate

Appraisal Techniques in Taiwan. He describes the overlap of seemingly straightforward real

estate valuation with the creation of financial instruments and the evolution of these two areas of

expertise into one of global relevance. The comparison of the Taiwan regulatory environment to

those in the U.S., the U.K. and Canada shows that the lack of a solid regulatory environment

could lead to “disorder” in the markets (p. 298).

One of the most complex issues is that of taxation. Historically, China has not had

property tax, that is, a tax on the capital gain realized upon sale of real estate until 2006. The

purchase 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. The

owner of the asset obtains a renewable right to use the land for a given period of time. The land

can appreciate in value, and this is taxed very highly through the LAT, up to 60%. Set against

this background of China property law, most REITs throughout the world follow the regime set

out in the USA and Australia and do not pay income tax. They are exempt from corporate

income tax since they pay between 80% and 100% of their income, usually derived from

commercial rents, as dividends to their shareholders. China’s economists and tax specialists are

undoubtedly working this out among other thorny issues.

In addition to its lack of fully formed regulatory environment, the Chinese government

appears to fear the unforeseen effects of new investment vehicles and this may be one of the

reasons for its apparent hesitation to permit REITs. Throughout 2009 and 2010, the subject of the

overheated real estate market appeared in Chinese newspapers on a daily basis. This situation

prevailed for a variety of reasons, not least of which was the memory of the implications of real

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estate on the economic crises of 1997-98 in Asia and of 2008 in America, but also the possibility

that bubble-like prices in the luxury property sector could cause social unrest domestically. In

China during this period, developers persisted in building luxury properties for quick capital

return. Developers were not incentivized to produce affordable housing but at the same time

rapid urbanization occurred and incomes rose across labor market segments but not yet nearly

enough to afford the available luxury properties. In fact there is a shortage of affordable housing

for the 15.4 million low-income urban households; in Beijing, the average housing price per

square 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 from

introducing any new investment vehicle, it is essential that the regulatory framework and the

instruments introduced on the stock market be properly constructed from the beginning. The

government, in particular the Central Bank, CBRC, CSRC and the SSE clearly have a mighty

task ahead. Since caution is advised, a stepwise approach to introducing such a new investment

product in China has been proposed. Examples of Taiwan and Malaysia both having introduced

REITs 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 real

estate and financial markets. Thereafter, the Taiwanese government has been very cautious in

regulating 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

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response to evolving market requirements. This was necessary because companies exploiting real

estate in the mainland—that adhere to REIT characteristics—may list as REITs on the Hong

Kong exchange. The regulations in question pertained to securities with mainland real estate

products. 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 the

state; property developers have a licensed right (renewable) to use the land. The business culture

and legal heritage of Hong Kong is essentially British common law, and mainland China land

use 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 a

framework for implementation of REITs evolves, barriers such as the lack of proper

documentation (which may prevail for historical reasons) need to be overcome. Clearly, the

development of a REIT regime with sound legal and regulatory infrastructure is a process that

needs to be tailored to China’s particular domestic circumstances. The government also needs to

instill 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 various

market participants’ requirements, and to support eventual positioning and internationalization of

its financial activities and the stock markets (Newell, Ooi & Sing, 2006).

The legal and regulatory infrastructure includes financial legal frameworks (such as

bankruptcy codes and conflict resolutions mechanisms between creditors and debtors),

supervision, accounting, auditing, and the rules, practices and professions that go with them, as

well as financial corporate governance institutions (Renaud, 2003 and Deng & Zhang, 2008). In

the process of developing its emerging economy, China is fostering and pro-actively

implementing these and other aspects such as information availability, flexibility, property

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intermediaries and professions. Legal issues are concerned with the creation and evolution of a

host of institutions, laws, regulations, rules and interested parties within the government. “In

very simple terms, the institutional structure of any market might be viewed as the set of rules

governing the operation of that market” (D’Arcy, 2008, p. 2). Establishing such a structure is a

complex and wide-ranging yet delicate task and the structure must also be sustainable as the

actors in the market change and the institution becomes internationalized.

Until standardized information and the tools to convey it and evaluate it are fully

available, and the full legal and regulatory infrastructure is in place, the government may

introduce the REIT in stages. As a first step, a REIT-like instrument might only be made

available to institutional investors, according to an article in the 2009 International Financial

Law Review. Rather than being publicly listed right from the start, a trust vehicle may comprise

Special Economic Zone (SEZ) properties and be traded on the inter-bank market. Based upon

casual observation in China, the government typically examines and analyzes overseas practices

in detail, debates prospective actions internally, then issues plans and proclamations and receives

comment before promulgating law. Initially, trial balloons and test cases are permitted where

only certain qualified actors may participate in specified geographical areas. New institutions are

implemented in a relatively confined geographical and economic context, such as in a SEZ or

Special Administrative Region (SAR) for a period of observation before going nationwide.

Domestic market acceptance is essential well before inviting foreign actors into the market. The

entire stepwise process may take years. Often times Shanghai, the securities exchange of which

lies 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

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asset 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 to

communicate” and the lack of it may have important consequences on valuation and hence on

the economy as a whole (Ambrose & Lee, 2009, p. 484). Designing solutions to standardize

practices and developing the regulatory framework invariably generates compliance costs,

including for example, expertise accreditation of market participants. Costs also include the

standardization of accounting treatment and valuation techniques, auditing and financial

corporate governance, as well as the technical tools, rules, practices and professions for these

(Deng & Zhang, 2008; Ooi, Webb & Zhou, 2007; Renaud, 2003). “Foreign ownership of

companies, limits on the scope of services … barriers to hiring non-national personnel, and

controls on flows of both information and capital and also the repatriation of profits” are other

costly barriers to overcome (D’Arcy, 2008, p. 7). In addition to formal barriers are informal ones

including “traditions of real estate practice and culture… ingrained attitudes towards the status of

the specific activities, and language” (p.7). Such business and cultural barriers have been reduced

in Europe, and will also need to be addressed in China and harmonized throughout Greater

China. 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 and

for comparisons. In the U.S., relevant indices are NCREIF, National Council of Real Estate

Investment Fiduciary’s Property Index (NPI) and National Association of Real Estate Investment

Trust’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, the

Chinese REITs will necessarily be compliant with the FTSE EPRA/NAREIT global index of

over 300 public real estate companies.

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A stepwise process for developing the regulatory environment and the REIT instrument

could proceed through: analysis of domestic actors’ characteristics and requirements; analysis of

overseas institutions; issue preliminary plans; internal debate; digest feedback; issue

proclamations; observation and coordination; and finally promulgate regulations. The actors

involved in this lengthy process range from academic institutions and professional associations

providing expertise, through local administrative bodies all the way to the central bank and the

State Council of the government itself. The cost is large in terms of time as well as manpower

and intellectual capacity. The parties concerned, in particular the Central Bank, the CSRC and

the SSE can modify existing institutions using examples of other countries and take into account

the peculiar circumstances in the Chinese environment. Even the failures of some cases are

especially useful because they show pitfalls to avoid. With these advantages, as well as the

tremendous intellectual power that is available and focused at the key parties involved, the costs

may not be as great as those borne by a country simply starting from scratch and making abortive

attempts at creating the right framework for public REITs.

While critics may argue that development stability, quality property products, and market

openness are prerequisites to a successful REIT regime; this author would argue that waiting for

such 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 other

aspects, 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.

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All of these are associated with aspects of the process of implementing REITs in China, as

shown in the table below.

Table 1

Costs Associated with Implementing a New REIT Regime

Problem Solution Cost Factors Element Involved in the Solution

Observe and test REIT regimes in other countries

Draw conclusions from lessons learned, extrapolating to China

- Long span of time conducting studies - Academics feedback to policy makers is lengthy

Academics Management

Legal, financial, tax and regulatory framework need to be changed

Create new systems to support future investment vehicles on the market

- Long span of time - Manpower of numerous government departments and banks

Legal Finance

Non standardized accounting practices and lack of performance indices

Harmonize existing standards with international standards and create new indices

Intellectual capacity of professional bodies and exchange regulators

Accounting

Best practices absent or inconsistently applied

New reporting standards, governance and transparency rules

Costs of compliance by businesses

Standards Bodies Professional Associations

Formal and informal barriers

Create harmonious policies

Costs for market participants

Leadership Policy-makers

Nature of property investment activities for short-term capital gain

Influence investor behavior through tax and other incentives

Potential cost to general smooth operation of economy

Securities exchanges

Long span of time Apparent inaction while vehicle is unavailable to individual investors

Opportunity costs --

Market acceptance Trial projects in SEZ and SAR

Contingency costs Marketing

Staged Implementation Plan

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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 have

long term goals, less speculative money, “more understanding of the product and better risk

management than the average domestic retail investor” and supposedly better than foreign

speculators (Lee & Leung, 2010). An unlisted vehicle would be made available for purchase in

large, en bloc transactions on either the non-stock OTC electronic market or the inter-bank

market, or both. The process of implementation entails extensive modification of existing

regulations. The Central Bank and the CBRC need to approve any securitisaton. The CSRC

controls 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 possibly

serve as platforms for REITs, respectively the specific asset management plan (SAMP), and real

estate trust investment schemes (RETIS). A security fund is a third type of investment vehicle

that may possibly serve as a better platform for evolving a REIT. This is a mutual fund the shares

of which already trade on the open market. It is an instrument managed by a licensed fund

management company, currently restricted to high net worth individuals. These are also

governed by the CBRC. The current form of securities fund holdings could eventually be

expanded 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 to

permit insurance companies and pension funds to invest a limited portion of their holdings into

private equity and real estate. China Life Insurance and China Pacific Insurance, and Ping An

Insurance already seek investment opportunities in commercial property, as well as debt and

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shares of non-listed companies as they plan to diversify their investments. These institutions are

banned from developing properties directly (Colins, 2010).

New entities, funds or trusts, comprised only of rental revenue-producing real estate need

to be created. The physical properties need to be identified, valued and examined for compliance

to traditional REIT parameters. Next, proposals to amend the rules for SAMP, RETIS, and

securities funds as well as their respective trading platforms need to be drafted and submitted by

their regulators for review by higher authorities, namely the People’s Bank of China, relevant

ministries and the central government. Tax neutral policies, which are not yet available on

securitized products in China, also need to be created and approved by the Ministry of Finance

and the State Administration of Taxation. Currently, SAMPS (and fixed-income securities) are

traded for short-term, while RETIS raise project based financing and bridge capital (raising debt

is 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 to

engage in property development, rather than paying most of it to investors as returns. Cities in

the interior of China need infrastructure and other development, and these are often overlooked

by property developers which seek high profits in wealthy costal and capital cities. A

development REIT would be permitted to re-invest a portion of its proceeds in new development

projects, not only pay out rental income as dividends. Furthermore, traditional REIT

characteristics include numerous shareholders that own units or shares of the trust. Hence, the

interim vehicle needs to be created in such as way that its revenue use, ownership and capital

structure are clearly defined. This stage is estimated to require eight to ten months.

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Regardless of the asset type, professional asset management and management of the

trust’s physical assets and finances are needed. A corresponding monitoring system including

licensing and periodic re-certification are also needed. As of 2010, there is no licensing system

for asset management in China. These standards can be readily borrowed from more developed

countries and international bodies. Although admittedly the time to hone such skills and develop

experienced fund managers will require much longer. As a start, imitating international

certifications 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 be

profitably revenue-producing continuous for at least three years. There are few such properties in

second-tier cities, and these could emerge during the third and final stage. “The ideal asset types

would be large-scale rent-generating properties such as offices, shopping malls and serviced

apartments” as well as industrial properties (Chen et al., 2009, p. 154). For the last and final

stage, the steps leading to public listing have been summarized by Bedford (2010) of KPMG the

following table:

Table 2

The 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

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Steps Key Issues

2. Structuring the portfolio from acquisition, holding and exit

Operating and running costs of each 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 and obtaining regulatory approval

Determining time and place of 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 acquisitions

Source: Bedford, “China’s Trust Sector: The Next Chapter”, 2010.

A staged introduction conforms to the traditional pattern of the Chinese government. It

enables simultaneous development of regulations and policies while testing the vehicle at the

same time. If this policy were to be implemented, it will address the pent-up demand for insurers

to invest in real estate, albeit indirectly and through a less volatile vehicle. Currently, in China

and in Shanghai especially, real property is far too volatile for large investors. Subsequently, the

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second stage would open up REITs and could help draw retail investors away from property

speculation and towards a longer term, steady return typically provided by REITs.

The process of implementation comprises not only the legal, financial and economic

actors, but some pure political actors as well. The English language national newspaper, the

China Daily, reported on April 26, 2010, that the unlisted REIT vehicle may be made available

in either Shanghai or Beijing (Lee & Leung, 2010). There is rivalry between the two cities and

both are eager to pave the way. Actively operating, government-backed properties in free trade

zones, 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, the

retail investor and property developer endure opportunity costs to spend their savings and raise

financing 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 instructing

banks 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. This

can be caused by lack of affordable housing for the masses. This is yet another reason that the

government policy must quickly provide investment vehicles to address pent up demand of

investors. Throughout 2009 and 2010, the Vice Premier and Minister for Housing and Urban

Development are featured in the news calling for more affordable housing to be built. For

example, on August 22, 2010, Vice Premier Le Keqiang “called on local government to bear

major responsibility for affordable housing construction, diversify fund raising channels to

25

obtain more investment, arrange for sufficient land supplies, and ensure transparency and

fairness 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 is

absolutely essential that the regulatory framework and the instruments introduced on the stock

market be properly constructed from the beginning. The macroeconomic policy objectives of

long-term growth and stability could be severely affected by errors and omissions in the

implementation. Three major steps along this process can be demarcated as the presence in the

market of: a pilot vehicle—the restricted institutional REIT; the development REIT; and the

publicly traded REIT. The prerequisites for the first, restricted vehicle have been discussed

extensively in this article. The trust laws, tax regimes and regulatory and professional feature

development 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 to

take 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 the

rest of the world in terms of its housing policy and investment markets, it aims to rival many

established financial markets.

Due to recent volatility of real estate prices and related securities in the U.S., it is useful

to compare the performance of REITs to the overall stock market in a volatile economy in order

to assess the value and stability of the REIT instrument. Clearly, the organizational form, tax

status, regulatory framework and investment performance of real property and securitized

property are quite sensitive to economic conditions. Evidence shows that the REIT is an

investment vehicle satisfactorily lending itself to the demands of investors primarily in

26

developed economies with mature capital markets. In developing countries, such as Malaysia, it

met with limited success until pertinent regulations were liberalized. Hong Kong and Taiwan

have also refined and streamlined their regulations.

China has resisted the introduction of the REIT vehicle for several reasons related to the

maturity level of the economy and, specifically, to the presence of pertinent legislation and

regulatory mechanisms. Only in October 2007 did China abandon the traditional Dian Quan

system and introduce a code of property law that conforms to a (German- and Swiss-style) civil

law system. Furthermore, accounting standards, technical tools for securitization and valuation

(upon which securitization naturally depends) and capital market mechanisms are not yet

sufficiently standardized globally, let alone within China. The Chinese government, rightly so in

this 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 instruments

that may have little meaning and could even threaten its economic stability. As a result of all

these factors, it will be some time yet before we see the REIT in China.

27

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