A real estate investment trust (REIT) is a collective investment scheme that invests primarily in income-generating real estate with a view to providing unit holders with returns derived from the rental income and any capital appreciation of the relevant real estate holdings.
The Hong Kong Code on Unit Trusts and Mutual Funds currently prohibits authorised funds from investing in any type of real estate (including buildings) or interests in real estate. Only authorised funds can be marketed to retail investors in Hong Kong.
However, in March 2003 the Securities and Futures Commission (the SFC), given the success of REITs in various other major financial markets (including the US, Australia and Singapore), released a consultation paper and draft code on its proposals for the structure, authorisation and regulation of REITs in Hong Kong.
This paper examines the key features of REITs as proposed in the consultation paper and the draft code, and highlights some of the important considerations which may determine the success or otherwise of REITs in Hong Kong.
Key features of the proposed Hong Kong REITs
The consultation paper contemplates that all REITs are to be structured in the form of a trust, with an independent trustee and a management company.
It is proposed that REITs authorised by the SFC would be exempt from profits tax – thus rental income received by the REIT on the relevant property would not be subject to profits tax.
Stamp duty will, however, be payable (at a maximum rate of 3.75 per cent), in relation to the transfer of the relevant property to the REIT. It is likely this would be funded through the investment made by the initial unit holders, such that they would suffer an immediate dilution in their investment.
In addition, the REIT will be subject to property tax (at the rate of 15.5 per cent for the tax year 2003-4 and 16 per cent thereafter) with respect to the properties owned by it.
Each REIT will have a trustee; the trustee will be required, among other things, to exercise all due diligence to ensure that the rights and interests of the unit holders are protected, the assets of the REIT are properly managed and segregated for the benefit of the unit holders, and that the real estate is independently valued in accordance with the requirements of the code.
The draft code proposes that the trustee shall:
- be a licensed bank, a subsidiary of a licensed bank, or an overseas banking corporation that is acceptable to the SFC;
- possess at least three years of experience in holding real estate under a scheme that operates in a similar manner to a REIT (this requirement suggests it is likely that the trustee will need to be an offshore Hong Kong entity);
- ensure adequate insurance coverage is arranged for the properties of the REIT; and
- be independently audited and have a minimum issued and paid-up capital and non-distributable capital reserves of HK$10m or its equivalent in foreign currency.
The consultation paper proposes that while the management company is to be responsible for the overall functions of a REIT, it can delegate the property management function, namely those relating to the day-to-day maintenance of the real estate owned by the REIT, to a professionally qualified property manager. However, the management company must carry out proper diligence in the selection and ongoing monitoring of its delegate.
Under the draft code, the management company shall:
- be licensed by the SFC for the management of collective investment schemes;
- be engaged primarily in the business of fund management and have a track record of at least five years in managing public funds;
- have at least two personnel, each with at least five years of experience in analysing the property market in Hong Kong or advising on property investment in Hong Kong, including two years of experience with respect to the type of properties proposed for the REIT;
- demonstrate that it has sufficient financial resources and have a minimum paid-up capital and capital reserves of HK$1m or its equivalent in foreign currency;
- not lend to a material extent; and
- at all times maintain a positive net asset position.
The management company shall, at the outset and upon any vacancy arising, appoint an auditor of the REIT that is independent of the management company and the trustee.
All REITs seeking authorisation by the SFC must appoint an independent property valuer. Under the draft code, the property valuer shall:
- be a company that carries on the business of valuing properties in Hong Kong;
- have key personnel who are fellow or associate members of the Hong Kong Institute of Surveyors;
- have a minimum HK$5m paid-up capital and sufficient financial resources to carry out its duties;
- have adequate professional insurance coverage; and
- be independent of the REIT, its trustee and its management company.
The draft code requires the property valuer to retire after it has conducted valuations for the real estate of a REIT for two consecutive years, and not to be eligible for reappointment until two years after such retirement.
Investment limitation and dividend policy
The draft code proposes that a REIT shall:
- only invest in real estate in Hong Kong which is income generating;
- have a clear statement regarding its investment policy and its investment objectives;
- distribute 100 per cent of its net after tax income as a dividend to unit holders;
- not hold any non-income generating real estate in excess of 10 per cent of the total net asset value of the REIT;
- not invest in vacant land or property development with the exception of refurbishment and renovation;
- hold its real estate for a period of no less than two years unless otherwise approved by its unit holders;
- not engage in investment in hotels or recreation parks that do not generate recurrent rental income;
- not borrow more than 35 per cent of the total net asset value of the REIT;
- only hold cash or cash equivalent, up to 10 per cent of the REIT's total net asset value;
- not lend, assume, guarantee, endorse or otherwise become directly or contingently liable for, or in connection with, any obligation or indebtedness of any person nor shall it use any assets of the REIT to secure the indebtedness of any person;
- not acquire any asset which involves the assumption of any liability that is unlimited; and
- invest at least 70 per cent of its non-cash assets in a particular type of real estate if the name of the REIT indicates such type of real estate.
In relation to the corporate governance of REITs, the consultation paper focuses on the requirements to raise the transparency of connected party transactions, to provide if necessary for the replacement of the management company, and to ensure fair and independent valuation of the scheme assets. More specifically, the draft code requires that:
- all transactions carried out by or on behalf of the REIT must be carried out at arm's length and must be independently valued and consistent with the investment objectives and strategy of the REIT, and in the best interests of the unit holders;
- unless the total consideration or value of the transaction in question is less than the lower of either HK$10m or 5 per cent of the latest net asset value of the REIT, all connected party transactions (being transactions involving the management company, the property valuer, the trustee or any associate entities or key officers of any such entities, although not, it seems, delegates of the management company such as the property manager) must be subject to prior approval by the unit holders by way of a special resolution passed at an extraordinary general meeting;
- the management company may be dismissed by means of an executive order from the trustee acting in the interests of the unit holders, or upon approval by holders of 75 per cent of the outstanding value of the units (provided that connected persons interested in the relevant transaction are required to abstain from such voting); and
- a valuation certificate must be produced on a quarterly basis for a REIT listed on the Hong Kong Stock Exchange (HKSE), and on a semi-annual basis for an unlisted REIT and a full valuation report shall be prepared on an annual basis.
The draft code requires at least two financial reports to be published in each financial year: the annual report, which must be distributed to unit holders within four months of the end of the REIT's financial year; and the semi-annual report, which must be distributed to unit holders no later than two months after the end of the relevant half-year. All such financial reports must also be filed with the SFC.
The SFC is currently working with the HKSE on means of streamlining the HKSE listing procedure for a REIT authorised under the proposed code.
For an unlisted REIT, the draft code requires the provision of an annual redemption facility, which allows redemption of up to 10 per cent of the outstanding units of a REIT.
Such redemption facility is not required to be retained for a REIT listed on the HKSE as holders of units can redeem their investment by selling their units on the HKSE.
Some important considerations
The following proposals contained in the draft code may influence the success of any offering of a REIT issued under the proposed guidelines.
The offering document in respect of a REIT may disclose the rental yield actually achieved by the relevant property at the time the relevant valuation report was made. However, no forecast of anticipated rental yield is permitted.
This may be contrasted with the position with respect to IPOs in Hong Kong where, subject to certain conditions being fulfilled, a profit forecast may normally be included in the offering document. Also, by way of comparison, profit forecasts can be included in offering material for Singapore REITs if a waiver from the Singapore Stock Exchange is obtained.
It is not, however, clear whether pro forma accounts (based on historic data, but modelled as if the REIT had been established in previous periods) will be acceptable.
There are relatively extensive ongoing obligations and responsibilities imposed on the trustee, which may require a more active role than in traditional debt issues.
It is contemplated that the management company appointed with respect to a REIT will be an experienced fund manager. The management company may delegate the property management functions, and would be expected in many cases to delegate such role to the originator of the REIT – but the management company remains fully liable to the relevant unit holders and trustee for the proper performance of any such roles delegated thereunder.
A REIT is required to distribute to unit holders 100 per cent of its net after tax income. This may give rise to some cash management issues for the REIT, as the REIT will be unable to maintain a reserve to meet unexpected expenditure requirements that arise.
A REIT may not borrow more than 35 per cent of the total net asset value of the REIT.
The limitation on gearing has been a significant impediment to the success of REITs in some jurisdictions. Accordingly, an important element in the success of Hong Kong REITs will be whether this borrowing limitation set by the SFC satisfies the investment objectives, risk profile and the required liquidity of the relevant parties.
It will be interesting to see what changes the SFC makes to its proposals in light of the comments received by it. We will be producing a separate note on the SFC's final proposals as and when they are published.
We are currently working on a number of proposed Hong Kong REITs. If you have any questions on Hong Kong REITs generally or on the SFC consultation paper, please contact: