Hong Kong to allow cross border Reits

The Securities and Futures Commission of Hong Kong offers a carrot and stick for Hong Kong''s Reit market by allowing cross border Reits to be listed, while intensifying the regulation of the Reit managers.

In a move designed to put some impetus back into the Hong Kong Reit market, the SFC yesterday announced that it was allowing cross border Reits to be listed in Hong Kong. Under the terms of the Reit regime that came into practice 18 months ago, only Reits with properties physically in Hong Kong could be listed. Now any property anywhere in the world will be able to be listed in a Hong Kong Reit.

According to Alexa Lam, executive director of the SFC, the change will be completed in June after completion of a consultation period, "but interested parties can start talking to us now," she says.

At the same time as the geographical restrictions are being relaxed, Lam says that the SFC will be bolstering its powers of regulation and authorization of Reit managers to ensure that investors receive adequate protection.

To this end, the SFC will be offering licenses to managers on the basis of one license per Reit. To get a license the managers will have to demonstrate that they have the international experience, competence and resources to run international Reits. In particular the SFC will be looking at the property portfolio management expertise of the managers when handing out licenses.

The SFC will thus be able to regulate the managers of the Reits in a way that it cannot even regulate the boards of directors of listed companies. This will give investors in the Reits additional comfort. If the managers are found wanting, they can expect their licenses to be revoked along with reprimands and fines.

In terms of the product itself, the SFC is focusing on making the manager of the Reit do extensive work on risk management and due diligence. "The stress is on the manager doing the proper work on risk management for the investors," says Lam. "This is the focal point of the whole regime. The buck stops with the manager."

The SFC is also considering changing the Reit regime's code on gearing. At present Hong Kong Reits are limited to a gearing level of 35%. Lam says that this may go up slightly to allow for the extra costs of currency hedging in cross border Reits to be taken into account. However, given that most young Reits tend to maintain a relatively low level of gearing in the early years of their existence, this point may be moot. Lam says a decision will be codified by mid May.

The SFC is also willing to entertain special changes to the regime and allow such practices as paying the managers in units of the Reit, as is common practice in the US and Australia.

Hong Kong's Reit market has had a troubled infancy. Since the regime came in 18 months ago, only one Reit, the Link Reit has attempted a listing. While garnering $80 billion of global demand, it nevertheless failed to list due to political interference.

Furthermore, the owners of Hong Kong property - concentrated in the hands of the big family developers - have had no incentive to put any of their assets into a Reit. They also do not need the cash.

Thus the move to allow international assets to list in Hong Kong seems aimed at creating a new market of cross border Reits, rather than upgrading the existing market of Hong Kong Reits (which isn't really there anyway).

Still, bankers and the SFC have taken note of the huge demand generated for the Link Reit and seen that an demand for this product definitely exists in Hong Kong. "There is a large appetite for quality investment products in Hong Kong," says Nick Ridgewell, division director of the banking and property group at Macquarie Bank in Hong Kong. "There is a lot of money here chasing good returns... [this move] opens the globe up for investment opportunities. There is a passion for real estate investing here in Hong Kong and investors will lap this up."

Ridgewell says that Macquarie - as both a Reit manager and a bank able to do the listing of potential Reits - "is very interested" in the changes and is "very, very keen on expanding in this region." He predicts that the first cross border Reit will be listed by the end of 2005.

According to other real estate investment bankers canvassed over the last week, getting a good sponsor and good manager to list quality China investment properties in a Hong Kong Reit would be "the holy grail" of the business. If such a listing were to be successful, it would open up a floodgate of other potential deals.

However, the spectre of such a transaction going wrong clearly haunts the regulators. One dodgy deal, with bad properties and fake tenants could scupper the whole exercise. Hence the SFC's insistence of close scrutiny of the managers and licensing of each Reit.

"Hong Kong is very well placed to do deals from North Asia and especially China," says Lam. "Real estate in China is getting better, especially retail and office space. But institutional money has been worried due to the lack of protection [in China], but this move [to allow cross border Reits] will help to mitigate those fears."

Leading Reit managers in the region will definitely be taking notice of this change. In particular, the Singaporean managers such as ARA Asset Management and Capitaland will see this as a good way to expand into China without paying the discount for listing China deals in Singapore.

Hong Kong developers as well, might now see the benefit of setting up in-house Reit management teams and then seeing if the market will offer them better valuations for the China properties in a Reit than they represent on their balance sheet. If so, then this would not only be an easy way of raising capital, but would also increase the value of the developers' shares as the China properties get stripped off their balance sheets.

The key reason why these developers claim they have not set up Hong Kong Reits so far is the lack of any economic incentive - tax or otherwise - to do so. But this new ruling might persuade them to take a fresh look at their global assets and see whether or not the Hong Kong investing public would afford them a higher valuation if they were presented in a transparent and well managed Reit.

The tax treatment of Hong Kong cross border Reits will also be attractive, in contrast to the lack of tax transparency for Hong Kong based Reits. In effect, tax will be paid at the home country level and then all income will flow through the Reit to the end investors as dividends in Hong Kong, where there is no dividend nor capital gains tax.

"The government has removed the estate duty and stated clearly that offshore funds will not be taxed," says Lam, adding that this shows the revenue department is willing to think about future tax measures for the Reit market. "Hong Kong is a low tax regime and if we are talking about cross border Reits then tax is not an issue as there is no dividend tax here."

The move will generally be applauded, in particular as it shows the SFC proactively working to develop a new way for Hong Kong's markets to improve. The contrast between the SFC in this exercise and other arms of the government in the Link Reit fiasco could not be starker. Hong Kong Reits will also be attractive.