Deutsche Bank to list China Reit in Hong Kong

RREEF China Commercial Trust is seeking to raise up to $335 million from an IPO to pay for the acquisition of the Beijing Gateway Plaza office towers.
Real estate investment trusts (Reits) may not be the most popular asset class in the Hong Kong market, but RREEF China Commercial Trust does have a few things going for it that could make it more palatable to the local investor community.

For one, the latest Reit to line up for a Hong Kong listing will be sourcing its assets from the commercial property market in China, where the potential for capital value appreciation is seen as much greater than in Hong Kong and property yields are also significantly higher. The latter is allowing RREEF CCT to offer an attractive distribution yield without having to resort to financial engineering such as interest rate swaps, rental guarantees from the sponsors or the payment of management fees in units instead of cash.

Hong Kong investors have shown again and again that they do not like such artificial dividend boosting measures (which leave the Reit highly exposed to a drop in yields when the measures come to an end), this should give RREEF CCT an advantage over most of the other Hong Kong-listed Reits.

RREEF CCT, which kicked off the roadshow for its initial public offering earlier this week, is the seventh Reit to list in Hong Kong and only the second to be backed by China assets. It is looking to raise between HK$2.18 billion and HK$2.35 billion ($280 million to $301 million) from the sale of 90% of its total units. The remaining 10% will initially be retained by the vendor of the underlying property, but will also be sold into the market if the greenshoe is exercised, resulting in a potential deal size of up to $335 million.

The trust is offering an annualised dividend yield of 5.9% to 6.4% for 2007, which according to a syndicate research report and sources close to the offering, is more than any other Hong Kong Reit after adjusting for financial engineering measures. It also represents a decent return above the 10-year risk-free rate, which is currently at about 4.25%.

The indicated offering price ranges from HK$5 to HK$5.40.

Another rarity in the Hong Kong market, aside from the clean yield, is the fact that the newcomer will be managed by an independent manager which has no skin in the game. This means that the only way for the manager to make more money is to make sure the Reit grows, both in terms of generating higher net income and in terms of its asset value. As a result, the managerÆs interest is entirely in line with the unitholders.

The current owner of the underlying property, an experienced Chinese developer by the name of Tin Lik, will own 20% of the management company, while the remaining 80% will be owned by RREEF, which is the real estate and infrastructure arm of Deutsche Bank Asset Management.

Aside from The Link Reit, other Hong Kong Reits have been formed through a partial disposal of assets to the Reit by the sponsoring developer, who continues to hold units in the trust even after listing. These Reits are also typically managed by a company owned by the sponsor, meaning the original owner of the properties will continue to exert control over and receive income from the Reit on several levels.

The downside of having an independent manager is that RREEF CCT has no pipeline of acquisition assets, which a Reit linked to a property developer has. Instead, investors will have to rely on the ability of the manager to acquire properties in the market.

RREEF CCT has one property in its portfolio at the moment û a twin tower Grade-A office complex in Beijing called Beijing Gateway Plaza û which will be bought in its entirety (assuming the greenshoe is exercised) from the current owner using the net proceeds from the IPO plus some debt.

The acquisition cost will depend on the amount of proceeds derived from the IPO, but will range from $490 million to $515 million, according to sources. At the bottom of the range, this is equal to a 3.9% discount to the appraised value of the property, which has been estimated at HK$3.98 billion ($510 million) by independent valuer DTZ. The top end represents a premium of just under 1%.

Of the total acquisition cost, 35% will be covered by debt.

The growth strategy will be focused primarily on acquisitions, and while other Hong Kong-listed Reits have so far completed very few acquisitions between them, observers note that RREEF CCT does have an advantage here. The reason, they say, is that its lower yield, compared with Reits that use financial engineering, means the hurdle rate for making yield accretive acquisitions is also lower.

The average 2007 distribution yield (including yield enhancing measures) for the six Reits currently in the market is about 7%, but ranges from 3.7% for The Link Reit to 10.2% for Henderson Land-backed Sunlight Reit. Regal Reit, which is backed by hotel properties and uses the least amount of yield enhancing measures, trades at a 5.5% yield.

According to investors who met with the management during the first couple of days of the roadshow, RREEF CCT has given no acquisition forecasts or targets either with regard to the amount or timing. However, sources say it would be reasonable to expect the addition of at least one more property within the first year.

ôFrankly, RREEF is not in the business of owning single asset Reits. They are pretty clear that to succeed they will have to grow and I think they will be pretty aggressive about it,ö says one source.

Until that happens though, investors will have to take into account that the Reit has only one property in its portfolio, which means it is less diversified than most of its peers in the Hong Kong market. So far, Hong Kong has only one other single-asset Reit in the form of Champion Reit, although this is not an uncommon structure in other markets, including Singapore.

Aside from acquisitions, RREEF CCT is also very much a story of the Beijing office market, which in the medium to longer term is expected to benefit as an increasing number of foreign companies set up offices in the city and domestic enterprises are able to afford better quality office space. According to property agency Knight Frank, Gateway Plaza is one of only nine Premium Grade-A office buildings in Beijing and the only one in the so called Lufthansa district, which is one of the four main commercial districts in the capital.

In the near term however, syndicate research note that there is likely to be downward pressure on office rents due to a spike in supply in 2007 and 2008 caused by an anticipated construction moratorium ahead of the Olympics in August next year.

ôBeyond that, we expect demand to slowly absorb the excess supply and citywide Grade-A office vacancies to drop to 12% in 2010 from 37% in 2007,ö one syndicate analyst argues. ôRental growth could average 5% beyond that,ö he adds.

According to another observer, RREEF CCT is also a capitalisation rate compression story. Cap rates, which measure the rental income in relation to the underlying value of the property, for office properties in China û and Beijing in particular û are still significantly higher than in other markets and are expected to continue to come down. As that happens, the asset value of the property will increase, which in turn should result in a lower cost of equity.

ôThis will have quite a geared effect on the capital value of properties,ö the observer says.

The IPO will have the usual structure for Hong Kong listings with 10% of the offering earmarked for retail investors, subject to standard clawback levels. The base offering will comprise 436 million units plus an additional 48.5 million if the greenshoe is exercised in full. The Government Investment Corporation (GIC) of Singapore has agreed to buy 50 million units as a cornerstone investor, which will give it a 10.3% stake in the Reit post-shoe.

The 3.5-day retail offering will open on June 11 and the final price will be determined on June 15. The trading debut is scheduled for June 22.

According to its Website, RREEF had Ç58.7 billion ($79 billion) of property assets under management as of March 2007 and in September 2006 it was ranked as the largest alternative investment manager globally by a Watson Wyatt survey. It operates several listed and unlisted property funds and has been an active investor in the Asia Pacific real estate market for almost a decade, which should give investors some comfort in its ability to source more properties. The Deutsche Bank unit has little experience in China so far, but the fact that it has teamed up with Tin Lik will undoubtedly give it some extra credence.

The Mainland developer has granted RREEF CCT a right of first refusal to any suitable acquisition opportunities within the prime commercial or Grade-A office building space that he sources or develops over the next five years.

Aside from The Link Reit, which is up 77% since its lising in November 2005, the other five Hong Kong listed Reits are currently either flat or significantly below their respective IPO price. Among the losers, Cheung Kong-backed Prosperity Reit, which focuses on industrial properties, has fallen 24%. Champion Reit, which is backed by Great Eagle Holdings, and Sunlight Reit are both down by about 15%.

GZI Reit, which invests in commercial and retail buildings in Guangzhou, and Regal Reit, which listed as recently as March this year, are both flat.
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