Thursday, November 20, 2014

Mainland China Property REITs to Multiply

Boundary between Hong Kong, on left, and Shenzhen, China, on right, photographed from Ramada Hotel
I’ve just returned from a recent trip to China, where financial deregulation continues onward. The week I arrived, the Chinese government approved a figurative “Through Train” that links the Shanghai and Hong Kong stock exchanges. And the first two days saw a massive transfer of capital from Hong Kong to Shanghai, with little capital flowing in the reverse direction. Part of the reason is because Mainland China is still perceived as the place where the growth opportunities are, and the Chinese Yuan currency has steadily appreciated relative to the Hong Kong Dollar, which is statutorily fixed to the U.S. dollar. The continuing trade imbalance between China and the U.S. continues to propel the Chinese Yuan slowly higher relative to the Dollar.

In this continuing Chinese financial deregulation, international real estate investors should take note of the proposal to organize mainland Chinese properties into REITs to be traded starting next year on the Shanghai exchange, with assets of these REITs estimated to top $6 trillion by 2020. This is an effort to support “the ailing Chinese property industry”. The Chinese government is also admitting a slowing of the economy as they announce reductions in taxes in order to stimulate business.

But if what ails the Chinese property industry is overbuilding, attracting more investors does not solve the fundamental problems of the industry, which is in need of more tenants, not more investors. More investors just pushes asset prices upward without improving net operating income, thus driving yields down, such as in Shanghai, where current yields were once over 7% but are now less than 5%.

Such compression of yields gives the appearance of improving real estate markets even when fundamentals are not keeping pace. For instance, I blogged last year about a portfolio of southern California industrial and retail properties I monitored over 11 years and found an average decline of 17% in net operating income but and average value appreciation of 28% in the same time period.

It remains to be seen how today’s investors will react to the new possibilities of investing in Chinese REITs. Such REITs often offer the prospects of instant dividends by the use of earn-out arrangements funded in IPOs, which serve as a return of capital rather than as a return on capital. Perennial China Retail Trust is an example, initially stumbling badly in the Shenyang market before finishing more successful projects in Chengdu and Foshan. Initial investors who bought at the 70-cent IPO price saw the stock price plummet to 40 cents before recovering to today’s 54 cents per share. Those buyers at 40 cents, including some insiders, still received dividends from the earn-outs funded in the IPO and profited enormously with the earn-out dividends and partial recovery in the stock price. Buyers will need to scrutinize prospectuses for actual net operating income sufficient to fund the advertised dividends.

Meanwhile, a recent Cushman & Wakefield report shed light on where Mainland real estate capital is headed -- out of the country, to "mature markets", with the U.S. being the favorite destination and United Kingdom in second place, and Hong Kong and Singapore as the preferred destinations for real estate investments in Asia.