Key Takeaways
- We expect China to encourage growth of new consumption-related commercial property REITs, given the broader policy focus on boosting consumption as a driver of GDP.
- However, a slow start is likely for the "commercial property" REIT class due to stringent hurdles for issuers under the current regulatory framework.
- China's commercial-property REIT market could become one of largest worldwide, with potential underlying asset values of up to US$5 trillion.
Shopping malls, department stores, and farmers markets are now eligible assets for REITs in China. Previously qualifying assets were limited to cash flow-generating infrastructure assets, and affordable rental housing. This change in policy will open a path for China to become the world's largest market for commercial property trusts, with up to US$5 trillion in underlying assets.
However, the bar for issuance is set pretty high.
S&P Global Ratings expects only a handful of "consumption-related" REIT issuances over the next year. This is due to stringent regulatory requirements, including restrictions on the use of proceeds in the residential property development and repayment of sponsor's borrowings, as well as requirement on minimum cash flow yield.
At the same time, we see major potential. This market widening fits with China's broader policy goals of boosting consumption. Commercial-property REITs will, over time, offer an important non-debt funding option for issuers. As the market evolves and deepens, established commercial property REITs could scale up through equity placements and increasing leverage, creating space for M&As and growth.
A Major Milestone For China REITs
We believe the inclusion of consumption-related commercial property marks the birth of a more conventionally defined REIT in China--trusts that own or finance income-producing real estate across a range of property sectors. On March 24, 2023, the China Securities Regulatory Commission (CSRC) issued a notice to extend the eligible asset classes for REITs to consumption-related commercial properties.
China's REIT pilot program began in 2015 and expanded in mid-2021, first with traditional infrastructure assets and later included affordable rental properties, industry parks, and logistics assets. The market capitalization of China's REIT market has grown to US$14 billion as of March 31, 2023, but its scale remains relatively small within Asia-Pacific.
The main goal is to support consumption, in our view. China set a firm goal in expanding domestic consumption during the National People's Congress in March 2023. In 2022, retail sales of China was RMB44 trillion (US$6.5 trillion), with consumption contributing 32.8% of GDP. Given the country's targeted GDP growth of around 5% for 2023, accelerating from the 2.2% in 2022, we expect consumption growth will spearhead the target and consumption-related properties can support this policy.
We expect a trickle of commercial property REITs will launch within the next 12 months. Once they are listed, the issuers could expand through capital raising for acquisitions and project developments. The potential balance sheet improvement for REIT issuers will be a by-product.
Table 1
| A summary of key terms based on consumer-related infrastructure REIT guidelines | ||||
|---|---|---|---|---|
| 1. Underlying Assets: | ||||
| (a) Asset location and sectors | Consumer-related commercial property assets, such as department stores, shopping malls and farmers' markets. | |||
| (b) Legality | Completed projects in compliance with all rules and polices. | |||
| (c) Ownership | Full ownership of REITs in underlying assets that held by independent legal entities not being engaged in commercial residential development. | |||
| (d) Operating period | At least three years of consistent and stable cash flow and reasonable returns. Market-based returns, with no reliance on non-recurring income such as third-party subsidies. | |||
| 2. REITs: | ||||
| (a) Distribution | Annual payout ratio of no less than 90%. | |||
| (b) Cash dividend yield | No less than 3.8% for the next three years for non-franchising and operating income rights projects. | |||
| (c) Originator's shareholding | No less than 20%. Mandatory holding period of five years for portion within 20%; and three years for portion beyond 20%. | |||
| (d) Leverage | Total assets cannot exceed 140% of REIT’s net assets, usage of debt limited to operations, maintenance & overhaul, and project acquisitions. Acquisition borrowing cannot exceed 20% of REIT’s net assets. | |||
| (e) Fund/asset management | Managers must have three years of operating track record. Majority of senior managers must have no less than five years’ experience in projects operation. | |||
| 3. Tax break | ||||
| (a) Corporate tax | Corporate tax related to asset transfers will be exempted before the REITs are set up and can be deferred during the set-up process. | |||
| Sources: China Securities Regulatory Commission notice from March 24, 2023, National Development and Reform Commission, State Administration of Taxation of the People's Republic of China, S&P Global Ratings. | ||||
China's commercial property REITs market has the potential to become one of the world's largest. According to market research firm IBISWorld, China's annualized revenue from shopping malls and department stores reached Chinese renminbi (RMB) 2 trillion (US$286 billion) in 2022. Based on the net operating income margin of 60%-70% and capitalization rates of 4%-6% of our rated China property companies, we estimate an asset valuation of RMB20 trillion to RMB35 trillion (US$2.8 trillion-US$5 trillion). The European Public Real Estate Association estimates China commercial property market valued at US$5.5 billion by end of 2022.
It would only take a fraction of such assets to be listed to transform China's REIT market into a sizable one. For instance, the U.S. has the largest property REIT market worldwide in terms of capitalization at US$460 billion by 2022 including residential, retail, office and hospitality REITs.
Return requirements could provide an alternative for investors seeking stable income. Under China's REIT guidelines, the underlying REIT assets have to be performing and require not less than 3.8% annual cash yield for the next three years. This investment protection is unique across regions where 90%-100% of income is required to be distributed, but not a required minimum yield to investors.
Table 2
| Overview of Property REIT Requirements Across Asia-Pacific And U.S. | ||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| China | Hong Kong | Singapore | Australia | Japan | U.S. | Taiwan | ||||||||||
| Minimum initial capital | No minimum initial capital required | No formal minimum capital requirements | S$300 mil. (about US$225 mil.) | No minimum initial capital required | ¥100 mil. (about US$0.75 mil.) | No minimum initial capital required | Ranging from NT$300 mil. to NT$2 bil. (about US$ 9.83 mil. to US$ 65.56 mil.) depending on the scope of business engaged by the trustee | |||||||||
| Listing | Required | Required | Not required | Not required | Not required | Not required | Not required | |||||||||
| Requirement on issuing entity | Engaged only in commercial property development and operation | No requirement | No requirement | No requirement | No requirement | No requirement | No requirement | |||||||||
| Requirement on use of funds | Prohibited to fund non-commercial property development including offices. Prohibited from using for debt repayment | No requirement | No requirement | No requirement | No requirement | No requirement | No requirement | |||||||||
| Asset rule | 100% in consumption-related commercial properties | 75% of the GAV of the REIT is required to be invested in real estate that generates recurring rental income at all times | At least 75% of the property fund's deposited property should be invested in income-producing real estate | Can establish corporate structure and staple to the trust so that trading businesses such as developing land for sale can be undertaken | Min 70% of total assets under management in real estate. Min 95% of total assets under management in real estate, real estate-related assets, and liquid assets; net assets and total assets must exceed ¥1 bil. and ¥ 5 bil., respectively | Min 95% of earnings and min 75% of assets must be in real estate activities and passive sources such as dividends and interest | Min 75% invested in real estate assets or other assets permitted by the Real Estate Securitization Act | |||||||||
| Distribution requirement | At least 90% of its consolidated distributable income (annually); for non-franchising and operating income rights projects, the annual net cash flow distribution rate for the next three years is expected to be no less than 3.8% | Min 90% of net income after tax (annually) | Min 90% of taxable income (annually) | No requirement. (Typical distribution of 100% at least annually).However, trustee of trust is taxable if unitholders are not presently entitled to 100% of the income of the trust at year-end. | Min 90% of distributable profits to qualify for the dividend payment deduction | Min 90% of taxable income(annually) | Pursuant to the REIT contract (within six months after the closing of the fiscal year) | |||||||||
| Property developments | Prohibited to conduct commercial residential development | Property development activities cannot represent more than 10% of GAV | Up to 25% of its deposited property; only if:(a) the REIT obtains specific unitholders’ approval for the higher development limit of 25%; and (b) the additional 15% allowance (over and above the current 10% limit) is used solely for the redevelopment of an existing property that has been held by the REIT for at least three years and which the REIT will continue to hold for at least three years after the redevelopment. | No restriction | Not permitted to conduct ground-up developments | No restriction | Public REITs limited to urban renewal or public infrastructure projects only, capped at 15% NAV. Private REITs may invest in public and private projects, capped at 40% NAV. | |||||||||
| Gearing limit | Assets to equity capped at 140%; acquisition borrowings cannot exceed 20% of net assets | Max 50% of GAV | Max 45% of GAV; may increase this limit to 50% only if it has a minimum adjusted interest coverage ratio of 2.5 after taking into account the interest payment obligations arising from the new borrowing | Unlimited; but the extent to which interest is deductible is limited by the general thin capitalization rules | Unlimited, but any borrowings by a J-REIT must be from a qualified financial institution | Unlimited, but tax authorities may impose limits on amount of related party leverage | 50% for rating of 'twAA' or above by two credit rating agencies; 35% for rating of 'twA' or above; 25% if lower than 'twA'; 15% if otherwise | |||||||||
| GAV--Gross asset value. NAV--Net asset value. NT$--New Taiwan dollar. S$--Singapore dollar. Sources: National Development and Reform Commission, China Securities Regulatory Commission, Hong Kong Securities and Futures Commission, Hong Kong Financial Services Development Council, Monetary Authority of Singapore, European Public Real Estate Association, FTSE Group, PwC, Bloomberg, Wind, S&P Global Ratings. | ||||||||||||||||
Multiple Hurdles Will Make For A Slow Start To This Market
Restrictions on use of proceeds will discourage asset owners. China's commercial property REIT framework is currently the most stringent in the region or in terms of the use of proceeds from the listing of REITs. For example, China's current regulations prohibit funds raised from commercial-property REITs to support residential property development.
Such rules can be a disincentive for issuers. If they don't spin off their assets into REITs, developers have the flexibility to use cash flows from rental or leverage the value of the properties for new development, land acquisitions, debt repayment, and interest payment etc.--all prohibited under the REIT structure.
Investment property-heavy developers such as China Resources Land Ltd., Longfor Group Holdings Ltd., Seazen Group Ltd., and Hopson Development Holdings Ltd. had 4%-13% of revenue generated from rental income while rental income to interest coverage ranging from 0.5x to 1.8x by the end of 2022.
While REIT issuance can provide additional funding for commercial property development, property developers would weigh the benefit of having a separate funding platform from the REIT listing versus the cost of limiting the fungibility of its cash flows and financing. With banks funding for commercial properties on less-stringent terms, it's likely that only a small number of property developers would likely pursue spin-offs at this stage.
Pure commercial property companies will be less constrained from a REIT initiative, in our view. Because the use of funds raised and cash flows will generally fit their investment needs.
Existing funding channels are flexible. Commercial property owners will continue to have good access to asset-backed bank funding channels. This is supported by improved bank funding environment since a series of supportive measures by the Chinese government for select property developers since the beginning of November 2022.
Usage of the proceeds from commercial property-backed financing channels are not restricted. Property companies are routinely able to obtain commercial property-pledged working capital loans with tenors of five to 15 years at interest rates of 3.5%-4.5%. For instance, Longfor's working capital (property-backed financing) loans have tenors of 12 years or above, ranging from 3.5%-4.5%. Seazen drew down RMB6.4 billion at 6%-8% during 2022. Hopson refinanced a RMB6.5 billion 15-year working capital loan at a cost of 4%-4.5% in December 2022.
Commercial mortgage-backed security are also an option available to commercial property owners. They are typically callable every three years with interest rate costs of 4%-6%.
Moreover, companies have been able to monetize commercial properties through introducing strategic partners and disposing partial or entire interests of assets. These divestments are a way to get additional funding.
REIT-issuance costs can be burdensome. For commercial assets not legally separated from mixed-used projects , we expect segregation of the renal asset into an independent legal entity could be costly. According to China's commercial property REIT policy, issuers of REITs should be independent legal entities holding the commercial property assets and carrying out related business and should not be engaged in residential development.
Typically, property developers in China acquired commercial properties incidentally—the assets were developed as part of a mixed used projects as specified in the land title when the land was acquired. This means that these rental properties would need to be extracted from the mixed used projects before they can be eligible for REIT listing. ("step 1" in chart 1).
Extraction of commercial property from mixed used projects could entail hefty legal fees and taxes. For example, the land appreciation tax and fair value gain on asset revaluation for REIT issuance involve substantive taxes on the underlying assets.
Chart 1
Performance threshold could ensure quality of assets. China's commercial property REIT framework requires the underlying assets to generate a cash yield of at least 3.8% annually for three years after listing. This requirement is unique in the region. In other markets, REITs are required to distribute the bulk of their income.
Established property developers such as Longfor and China Resources generated net rental yields of 3.6% to 5.7% in 2022. Most of these established developers would meet this requirement. However, the vast majority of commercial property owners might struggle to meet this requirement at this stage.
Credit Quality For The Niche Should Be Solid
High quality commercial property REIT listings could create a virtuous cycle. Investors such as pension funds and insurance companies have a dearth of long-term investment opportunities. REITs could meet this need by providing high quality and stable income.
REITs that generate stable rental income are also, in general, of higher credit quality than more cyclical developers. That said, performance varies widely among China's commercial property sector. Given the regulatory hurdles for REIT issuance, we expect only larger and more experienced developers can initially launch in this market (see "Key Credit Factors For The Real Estate Industry," published on RatingsDirect on Feb. 26, 2018).
What's On The Horizon?
Property is by nature a volatile asset class, and in Asia, this sector is known for its boom and busts. We think the settings on China's property REITs reflect these inherit risks, and are aimed at avoiding bubbles or capital misallocation.
It is also a young market. We expect the lessons and experience from the pilot program will reap more targeted and supportive policies for REITs development. This will likely include regulatory overhauls to allow tax benefits and other incentives.
Over the next decade, if 5% of China's retail properties were securitized as REITs, the market would be US$150 billion-US$2500 billion in size. By comparison, the U.S. has around 6% of commercial properties (retail, office, hotels) securitized as REITs.
We think it's safe to say that the market will continue to expand; what's harder to predict is the pace of expansion. Next steps would likely include offices and hotels and--perhaps somewhere down the line--residential.
Related Research
- China Developers' Earning Weakness To Persist Another Year, April 11, 2023
- Credit FAQ: China Property Is On The Cusp Of A Recovery, Jan. 12, 2023
- China's Defaulted Developers Hope For The Best, Prepare For The Worst, Jan. 10, 2023
- China Property Is Heading For A Transformation, And Maybe A Turnaround, Nov. 21, 2022
This report does not constitute a rating action.
| Primary Credit Analyst: | Wilson Ling, Hong Kong +852 25333549; wilson.ling@spglobal.com |
| Secondary Contacts: | Edward Chan, CFA, FRM, Hong Kong + 852 2533 3539; edward.chan@spglobal.com |
| Lawrence Lu, CFA, Hong Kong + 85225333517; lawrence.lu@spglobal.com | |
| Research Assistant: | Sylvia Zhao, Hong Kong |
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