Real Estate Investment Trust in China
CHAPTER 1: INTRODUCTION
Background of the study
To conduct a proper research about Real Estate Investment Trust (REITs) in China, some background data and information about the Chinese real estate market as well as the REIT is necessary. In this section, the following subjects will be discussed.
Chinese real estate market
China’s economy has been growing tremendously since it opened its market in 1979 and this growth has led to an increased demand of retail, commercial, office spaces and housing facilities (Cao, 2008). The owner of this land in which these properties stands is the Government of China which is responsible for leasing out the land to people and this is done for a period of 70 years. China has a large potential for real estate investments and this has led to an increased interest from investors across the world. (Han, 1998 and Cao, 2009). Investors in real estates are always looking for differentiation and interesting returns. Wang, Sun and Chen (2008) states that most of the high quality real estates are owned by the Chinese government, commercial banks and also some developers with banks being the biggest financiers of reals estates projects.
The real estate is considered as one of the key drivers of the rapid growth of China’s economy for the past decade. Investments in real estate in China grew from a GDP of 4 percent in the year 1997 to a percentage of 15 of the total GDP in 2014. China has been famous in residential investment which has been high when compared to other countries. As at today, residential investment on its own stands for more than 15 percent of the total fixed asset investment and also 15 percent of the total urban employment in the economy. Bank lending for residential investment only accounts for 20 percent of the total loans that are given by banks towards the development of the real estate market. The real estate industry is also linked to other upstream and downstream industries whereby sales become the main source of public finance. In this case, property is used as the security for corporate borrowing. (Liang, Gao, and He, 2006)
For the last decades, real estate companies have been growing together with the general Chinese economy. China has a huge market for its real estate but the problem comes in due to the fact that it does not have similar indirect real estate investment possibilities like in other economies such as the emerging Asian economies, the Europe and the U.S. For more potential to be created in the real estate market as well we in the entire Chinese economy, these indirect investment possibilities can have something to offer to the investors. There is a big potential for the Chinese real estate, but the lack of well-established vehicles of investment such as the real estate investment trust (REIT) due to the many challenges as researched later in the dissertation, makes this topic worth being researched on. This study will seek to develop a deeper understanding of REITs in China, the challenges that face the implementation of REITs and how to overcome the same challenges through sourcing alternative funds by the developers and investors. It is interesting to research on the challenges and obstacles that face REITs in the Chinese market and why the Chinese government has been adamant in introducing and managing REOTs within its economy. Some real estate investors may be willing to invest in the Chinese real estate market through the REITs but due to the many challenges that face them, they tend to hesitate. Other investors completely believe that it is not yet secure to invest in the Chinese REITs. What these investors would love to see is the introduction of other possibilities of capital financing aimed at improving the liquidity of the real estate market.
Research indicates clearly that there is a huge local demand for REITs in China by investors and this calls for further research to examine the major challenges that face REITs in China and also recommends the best ways of overcoming these challenges or even sourcing other alternative sources of funds by the developers and investors
Real Estate Investment Trust
Real Estate Investment Trust is an investment trust company that operates in the field of investing and managing property mainly real estates. The Real Estate Investment Trust (REIT) is a special vehicle of investment that was first created in 1960 by the U.S. Congress with the purpose of increasing the liquidity of assets and also encouraging small and novice investors to benefit from the growth of real estate. Geltner &Miller (2007) confirms that REIT in the U.S. are a type of passive vehicle of investment which offers investors with a more liquid way of investing in a diversified and a comprehensive portfolio of real estate properties and be in a position to achieve the profits and revenues associated with the development of real estate.
A REIT can either be held privately or publicly with publicly held REITs being listed on the stock exchange. REITs combines capital from various investors and use this capital to reinvest in real estate. They obtain their cash flow from renting the real estate as well trading with the investors paid out in the form of dividends. REITs hold a special tax status since the investments bare made using combined capital from various investors under a special legislation. The person who invests in REITs pays only income tax since the REIT has to pay more than 90 percent of its income (Wang, Sun and Chen, 2008). REITs gives investors the chance to invest indirectly into property and also provides capital to developers. In addition, investors are given the chance to have an access to markets that would instead stay out of reach in direct real estate.
The main advantage of REITs over other vehicles of investments is the issue of tax deduction and this gives REITs a comparative advantage. The concept of tax deduction is regulated by the law whereby REITs are allowed to deduct dividends that are paid to its shareholders form the taxable income. This means that most REITs remit a minimum of 100 percent of their taxable income to the shareholders and this means that no corporate tax is owed. Shareholders thus pay taxes on the dividends that are received as well as any capital gains.
Types of REITs
There are three major types of REITs namely: Equity REITs, mortgage REITs and hybrid REITs.
Equity REITs are real estate companies that acquire or own commercial real estate properties including office buildings, apartments or shopping centers and lease the space to tenants who are supposed to pay rent for the spaces they have rented. After all the expenses related to operating the properties are payed, then Equity REITs pay out the bulk of the remaining income to their shareholders in the form of dividends. Equity REITs also comprise of capital appreciation obtained from the sale of properties in the dividends paid out. For instance, in the case of Timber REITs, the dividends paid out include gains that accrue from selling the timber. In essence, what it means to own REITs is that dividend distribution should be designed in such a way that it approximates the investment returns that would be received by the investors if they owned these properties privately. In other words, equity REITs mostly own and operate income generating real estate such as shopping malls, warehouses, and other forms of offices. Income is not only generated in the form of rent but also from the increasing value that accrue to the properties owned. A wide range of real estate activities are contained in the equity REITs and these include leasing, maintenance and development of the property owned among other tenant services offered. One major difference between REITs and other reals estate companies is that REITs acquire and develop property mainly to have them as part of their own portfolio instead of reselling them once they develop.
Mortgage REITs offer financing for real estate whereby they offer mortgage to investors who invest in real estate and the REITs earn income form the interest on these investment. Mortgage REITs specializes in holding mortgages which offer financing to real estate investors, owners and operators in the form of lending. Mortgage REITs also offer credit indirectly through the process of acquiring loans and other mortgage-backed securities. In most cases, mortgage credit is only offered on already existing properties. Most of the mortgage REITs are believed to manage their interest rate and risks of credit by the use of securitized mortgage investments, hedging technique among their generally accepted financial derivatives.
A Hybrid REIT owns properties for the purposes of renting to and also extend loans to real estate owners, investors and operators (NAREIT, 2009). Hybrid REITs have the qualities of both equity and mortgage REITs and that is why they are referred to as hybrid REITs.
REITs in other parts of the world
RITs were first introduce into the market in the U.S. and Asia and the experiences seen in these countries offered an insight for China to introduce the same into their economy. REITs were first introduced in Asia in 2001 with the first introduction being in Japan and Singapore and then later in 2005, the introduction of REITs was extended to South Korea, Hong Kong, Taiwan, Malaysia and Thailand. Ooi, Newell, and Sing (2006) asserts that real estate market has been interesting simply because REITs can get a good diversification in Asia as a result of international real estate securities funds. It has also been proved by Quek and Ong (2008) that if a REIT investment in Chinese assets is well structured and done effectively, it can perform well. However, the performance of such an investment depends on the diversification, the story of growth as well as the originator of the reputation. The key to REITs success in Japan, Singapore, Taiwan, South Korea, Malaysia, Hong Kong and Thailand has been due to god legislation. China’s legislations were different some years ago, however, after it adjusted its market environment, China introduced REITs into the economy. As at 2015, China had not developed any strong REITs and thus needed a strong legal and regulatory infrastructure so as to be able to undertake anything to do with REITs. As seen in the areas where REITs have developed such as in the U.S. and in Asia, the REIT market is mostly improved by an influence on institutional investors as this makes the market more transparent and also creates a certain level of cultivation (Newell et al., 2009).
Governments are believed to play a key a key role in the performance of REITs as they create sound infrastructure for the development of financial and real estate markets. This means that governments are responsible for setting free the growth potential for REITs (Newell et al., 2009). After the U.S. and the above mentioned Asian countries introduced REITs into the market, the efficiency and the liquidity of their real estate markets increased and this was also accompanied by the growth of corporate governance and the distribution of information. REITs also brought about legal and regulatory changes into these markets and also increased the trust form investors. Ooi, Newell, and Sing (2006) indicated that REITs brought various positive effects into the Asian states economy and this encouraged China to think of introducing REITs into the economy.
REITs in China
China began trials on REIT s back in 2002 after the Chinese government found out that REITs and real estate debt had a strong growth potential in the market as a result of the huge market capitalization of commercial properties and commercial mortgages in China at that moment (Minye and Yongheng, 2008). For long periods of time, commercial banks, the Chinese government as well as some investors have owned almost all the quality reals estates in China (Wang, Sun and Chen, 2008). The Chinese government understood that REITs are more advantageous in that they do not need all the financing form banks and that investors can unite and contribute capital and be able to own a real estate and hence participate in the growth of the Chinese economy. However, legal and procedural difficulties have prevented the commencement of REITs in China.
Characteristics of REITs
The Real Estate Investment Trust (REIT) in China has been in existed for quite some time and has various characteristics that differentiate it from other REITs in other parts of the world such as in the U.S. and in the Asian countries. First, REITs in China are not exempted from taxation (Cao, 2006). This concept has been termed as a barrier and holds back the growth of REITs especially in a country like China, which is an emerging powerhouse in this field For REITs in chine, the policy and the regime of tax remains a critical issue since it determines the rate of growth of the real estate industry. The second characteristic of REITs in China is that they are used to provide finance to investors, land owners and property developers (Dai, 2007). This means that owners and developers of property can own property such as commercial buildings form whose spaces can be rented and this brings income in the form of rent.
In addition, mortgage REITs offer financing for real estate whereby they offer mortgage to investors who invest in real estate and the REITs earn income form the interest on these investment. The third characteristic is that most REITs raise their capital and funds under initiatives that are run and conducted privately. The transactions that take place in the business of real estate need not be publicized provided that the parties involved are satisfied (Ding, 2007). Fourth, REITs are not allowed to be traded in the stock market simply because they are too sensitive and can affect the liquidity of the economy (Ding, 2006). The fifth characteristic of REITs is that they act as a pool of funds from where investors and new people who wish to invest in real estate can access loans such as mortgage (Fei, 2005). Mortgage REITs are a kind of REITs that specialize in holding mortgages which offer financing to real estate investors, owners and operators in the form of lending and they offer credit indirectly through the process of acquiring loans and other mortgage-backed securities to real estate investors.
The sixth characteristic is that REITs in China are mostly concentrated in the owning residential property unlike in other countries where REITs extend to commercial and office property (Kai, 2006). China entered the REITs industry just recently and thus decided to focus much on offering REITs related to owning and renting houses for the purposes of renting space to residents. The seventh characteristic and purpose of REITs is that they earn profits from interests as a result of mortgage loans as well as benefiting from rents collected from tenants and also capital gains (Li, 2007). Finally, REITs in China can be seized for even more than a year, in this case, the period is given as 1.85 years, and this is something that has been missing in other countries (Luo, 2009). The purpose of this paper is to conduct a study that evaluates the challenges that face REITs in China and also recommends effective ways on how to overcome these challenges and also source alternative funds for investors and developers.
It is believed that REITs in China face various fundamental and operational challenges that need to be addressed so as to unveil new sources of funds for investors and developers in the real estate industry. Legal challenges are a major aspect of the challenges that affect the implementation of REITs in China. (Quek & Ong, 2008). REITs in China are regulated by the Trust Law of the People’s Republic of China. Despite this, it has still been very difficult for the Chinese government to implement the effective REITs unlike in countries like Hong Kong where a law for unit trust has been formed for effective implementation of REITs. The main problem associated with the REIT law in China relates to liquidity which is connected to specified trust certificates. This means that REIT firms are not permitted by law to publicly trade their business so as to raise funds simply because they hold the certificates for private investors and developers (Scherrer, 2004). However, there are still certain cases whereby investors and developers can authorize the transfer of funds after signing the certificates with the buyer. As a result, REITs in China suffer from lack of liquidity as a result of operational and procedural measures secured by the law (Luo, 2009).
The other critical legal problem that affects REITs in China is that REITs cannot be traded in the stock exchange markets and this is not the case in other countries such as in the U.S and other Asian countries (Teng, 2006). In China, the law is very rigid and strict when it comes to the stock market despite the fact that it recognizes other bonds and stock as securities and fails to recognize REITs. However, the findings are found to be ambiguous since REITs cannot be traded as securities for bonds in the exchange market (Luo, 2006).
Another major legal problem that is associated with REITs in China relates to industrial funding. In China, the Securities Investment Fund Act only allows stocks to be traded in the form of liquid investments, for instance in the form of fixed interest incomes and stocks but it forbids anything to do with venturing in real estate (Wang, Sun & Chen, 2009). Despite the existence of an Industry Fund Act whose work is to enable mutual funds invest in real estates, the Chinese government still has total control over when funds can be released and this is often more than a year, usually 1.85 years (Yang, 2007). For long periods of time, the Chinese government has been trying to justify their stand pertaining this law on the basis that it would ensure that REITs are protected from unscrupulous investors who enter into the market and exit at any time that they wish and this creates serious problems related to liquidity (Luo, 2009).
The other major area that creates problems for REITs in China is the tax regimes and weights. Unlike other nations where the concept of REITs originated from such as the U.S., China has never been a favorite for REITs because its tax regime does not favor the concept of REITs. It has been specifically stated that REITs in china are subjected to double taxation despite the fact that more than 90 percent of the dividends accrue to the investors. As a matter of fact, analysts term REIT tax laws in China as particularly complex (Wang, et al. 2009). This is due to the idea that investors and developers are subjected to tax both at the company level as incomes and also at the individual level from the dividends that are paid out to them. In addition to this, REIT developers are also expected to pay taxes from any rent that they collect from tenants in the aspect of enterprise income tax (Zhu, Sim & Zhang, 2006). The existing Chinese tax code stands at a rate of 25 percent and this has double levies, initially as enterprise tax and later as a real estate building tax. The impacts of such kind of multiple tax regime REITs in China is that funds that could be invested in additional properties are locked down and this becomes a challenge especially for a country like China where the population is growing at an alarming rate and needs more housing units (Luo 2009).
The other major category of challenges that face REITs in China is the moral risks that are associated with the real estate industry. Various debates have raised concerning issues that come out of claims that some people, firms and governmental institutions have been involved in sabotaging the free flow of information to REIT developers and investors (Robert & Sirmans, 2002). Such cases creates a disjointed REIT sector whose top management are not in a good position to make timely and informed decisions for their client companies. There are claims and complains that REITs asset managers are well equipped with relevant information but they rarely share it with the rest of the stakeholders on the real estate fraternity and the entire Chinese market as whole despite the law stating that such kinds of information need to be shared evenly across the market (Ding, 2007). It has also been claimed that these asset managers tend to compromise the interest of investors and engage in corruption and scandals for their personal benefits and this puts the rest of the management team into jeopardy (Ding, 2006). For instance, if internal systems and processes are not airtight, then unscrupulous asset managers can include the introduction of unauthorized projects into an organization’s REIT system and earn themselves commissions which are not remitted to the original investors or developers (Luo, 2009). There have been fresh cases of moral risks involving real estate managers who are unable account for their assets and other associated funds and this is termed as an indication of the state of the moral risks in the Chinese economy. In more other countries where REITs are well developed, the law allows the use of independent assets accountants and auditors who are tasked with the responsibility of detecting such moral risks (Fei, 2005). Nevertheless, in China, there are big gaps in accountability and the supervision of real estate assets and this calls for an urgent need of strong policies so as to deal with most of these REITs problems (Kai, 2006).
The last category of the problems that face REITs in China regards to land tenure. Theoretically, land in China belongs to the Chinese government and that its sale and distribution must be subjected to the existing political exemption. In addition, there are two kinds of land adjudication that exist in China namely: allocated land use rights and granted land use rights (Ding, 2007). Under the granted land use rights, the Chinese government is responsible for setting the time period for the lease before it can be transferred for the purposes of REIT. Normally, granted lands in China have a lease period of 70 years for residential purposes, a 40 year period for commercial purposes and 50 years period for industrial, office and other related purposes. Under the allocated land use rights, the land is owned by the state government and that the state can decide the mode of use and this limits investments in REITs in China (Wang, et al. 2009). The land allocated to the investors and developers is prohibited from being sold to the public. The problem with this situation is that REITs in China may call for relatively longer and total ownership of land since some of the constructed and established assets can be too expensive and may require longer periods for return on investments to be realized (Kai, 2006). However, some REITs in China could end up suffering problems associated with liquidity as time elapses and this is due to the limited systems of land tenure. Similarly, China has laws that limit the possibility of land transfers at the public level and this controls the type of REIT investment options (Quek & Ong, 2008). Also, lands that have been allocated to investors by the state do not deserve to be used for purposes of REITs transfers and this prevents the transfer of funds in China (Luo, 2009).
Objectives of the study
To study and evaluate the funding challenges that face REITs in China and to propose and recommend alternative channels aimed at solving these problems.
Specific objectives for the study are:
- To discover how legal challenges affect the funding of REITs in China
- To exploit the effects of the current Chinese tax regimes and how they hinder the funding of REITs in China.
- To explore the possible impact of moral risks on the funding of REITs in China
- To evaluate how various policies and systems that are related to the tenure of land and how this affects the funding of REITs in China.
- To come up with other sources of obtaining funds to be used for the purposes of REITs in China.
Hypotheses and research questions
For the sake of this study, the following relevant hypotheses were proposed for each of the research questions, since we agree with Luo (2009) that China needs to try new and alternative funding methods of REITs so as to help improve on the effectiveness of REITs in China.
Research Question 1: How do the current Chinese laws and regulations support the funding of REIT initiatives for both developers and investors in China?
Hi (Null hypothesis): The current laws and regulations applied on REITs in China tend to limit options of fund raising whether on stock markets or by individual investments.
Ho (Alternative hypothesis): The current laws and regulations applied on REITs in China tend to delimit options of fund raising whether on stock markets or by individual investments.
Research question 2: Do tax system applied on Chinese projects by the government affect the funding of REITs?
Hi (Null hypothesis): The multiple system of taxation of REITs in China increases the access of funds by investors and developers.
Ho (Alternative hypothesis): The multiple system of taxation of REITs in China reduces the access of funds by investors and developers.
Research question 3: What kinds of moral risks prevent the growing of funds for REITs in China?
Hi (Null hypothesis): The regulations applied by the Chinese government on REITs are adequate to alleviate the moral risks that are believed to slow down the funding growth.
Ho (Alternative hypothesis): The regulations applied by the Chinese government on REITs are not adequate to alleviate the moral risks that are believed to slow down the funding growth.
Research question 4: How Do the policies related to land tenure affect the funding of REITs in China?
Hi (Null hypothesis): The centralized policy of land ownership applied by the Chinese government denies REITs in China from getting access to enough funds.
Ho (Alternative hypothesis): The centralized policy of land ownership applied by the Chinese government does not deny REITs in China from getting access to enough funds
Bookstaber, M. (2006). Global REITs Development. WB/IFC Housing Finance Conference. Washington. March.
Bryman, A. and Bell, E. (2007), Business Research Method, 2nd ed. Oxford: Oxford University Press.
Cao, Y. (2006). Shanghai Finance. No.1: 44-46.
Chinese Statistic Year Book (2008). National Bureau of Statistic of China. Available: http://www.stats.gov.cn/tjsj/ndsj/2008/indexch.htm [Accessed on April 30, 2015].
Dai, X. (2007). Researches on C-REITs. Economy & Management. No. 3: 56
Ding, C. (2007). Policy and Praxis of Land Acquisition in China. Land use policy. No. 24: 1-13
Ding, K. (2006). The Effect of REITs against Chinese Real Estate Development. Shanghai Business. No. 3: 56-58.
Fei, R. (2005). Chinese Real Estate Investment trust—from international experience. Real Estate Finance. 298(10): 55-57.
Financial Times (2013). ‘Beijing land prices soar amid criticism,’ January 2.
Financial Times (2012). ‘China Property – Falling Margins,’ December 20.
Fisher, C. (2004). Researching and Writing a Dissertation for Business. Students. Harlow:
FT Prentice Hall – Pearson Education Limited.
Geltner, D. M. & Miller, N. G. (2007). Commercial Real Estate: analysis and investment. The Second Edition. Thomson South-Western.
Guba, E. & Lincoln, Y.S. (2005), Paradigmatic Controversies, Contradictions, and Emerging Confluences. In: Denzin, N.K. and Lincoln, Y.S. eds. Handbook of qualitative research. 3rd ed. Thousand Oaks: Sage. pp. 191-215.
Han, S.S., (1998), “Real estate development in China”, Journal of Real Estate Literature, Vol. 6 pp.121-33.
Ho, R. (2013). China’s Real Estate Investment Handbook: The Details that Make a Difference. China Real Estate Industry. Deloitte. Available at http://www2.deloitte.com/content/dam/Deloitte/cn/Documents/real-estate/deloitte-cn-re-realestate-investment-handbook-2013-en-250713.pdf [Accessed on April 29, 2015].
Jankowicz, A. (2005). Business Research Projects. 4th edition. London: Thomson Learning.
Kai, Y. (2006). Development model of Chinese real estate investment trusts. Finance Economy. No. 31: 48-51
Leedy, P. & Ormrod, J. (2005). Practical Research: Planning and Design. 8th edition, New Jersey: Prentice‐Hall Inc.
Li, Z. (2007). The Future Development of C-REITs. Financial Fujian. No 6: 14
Luo, Y. (2009). Implementation of Chinese Real Estate Investment. Master of Science Thesis No. 481. Stockholm. Available at https://www.kth.se/polopoly_fs/1.159647!/Menu/general/column-content/attachment/481.pdf [Accessed on April 29, 2015].
Luo, Z. (2006). Chinese REITs development strategy. Construction Economy. 288; 10: 31-33.
Mason, J. (2002), Qualitative Researching, 2nd ed. London: SAGE Publications.
Moody’s Investor Service (2012). ‘Moody’s Revises Outlook on China’s Property Sector to Stable,’ Global Credit Research, November 29.
Moss, A. (2007). Global REITs Report. AEM Capital. Feb, 2007
National Bureau of Statistics of China (2013). Statistical Data.
Quek, M. C.H. & Ong, S. (2008). Securitizing China real estate: a tale of two China-centric REITs. Journal of Property Investment & Finance. 26(3): 247-274.
Scherrer, P. S. (2004). Financing and investing considerations for REITs. Corporate Governance. 4(4): 78-82.
Saunders, M., Lewis, P. & Thornhill, A. (2012). Research Methods for Business Students, 6th Edition Pearson Education Limited Harlow, Essex, England, Available at http://wps.pearsoned.co.uk/ema_uk_he_saunders_resmethbus_6/
Saunders, M., Lewis, P. & Thornhill, A. (2007), Research Methods for Business Students. 4th ed. London: Prentice Hall.
Schacht, U. & Wimschulte, J. (2008). German property investment vehicles and the introduction of G-REITs: an analysis. Journal of Property Investment & Finance. 26; 3: 232-246.
Teng, Y.(2006). The Development of Chinese REITs. Group Economy. 193(3): 140
Thomas, A.B. (2004), Research Skills for Management Studies. U.S: Routledge.
Wang, H., Sun, Y. & Chen, Y. (2009). Special considerations for designing pilot REITs in China. Journal of Property Investment & Finance. 27 (2); 140-161.
Xinhua News (2012). ‘Housing Sales May Rebound in 2013,’ December 29.
Yang, G. (2007). Research in Development of Real Estate Investment Trust Financing in China. Value Engineering. No 2: 143-145.
Yin, R.K. (2003), Applications of Case Study Research, 2nd ed. Applied Social Research Methods Series, Volume 43, Sage Publication. USA.
Zhang, B. (2009). Financial creation for Chinese real estate industry. Contemporary Economy and Management. 31 (3), 34-36.
Zhu, J., Sim, L-L., & Zhang, X-Q. (2006). Global Real Estate Investments and Local Cultural Capital in the Making of Shanghai’s New Office Locations. Habitat International. No, 30: 462–481
Zhu, Q. & Luo, Z. (2006). Some consideration of developing Chinese REITs. Social Science of Jiangxi. No. 10; 249-252.