This year promises big developments in financial governance in Hong Kong. Many investors are focused on the pending consultation on company structures, which will address elements of the debate surrounding Chinese e-commerce giant Alibaba’s controversial IPO proposal. In the meantime, governance advocates have been offered an appetizer. A just-released consultation on Real Estate Investment Trusts (REITs) should be a trigger for investors to review governance at their holdings in Hong Kong, one of the world’s most expensive property markets. In January, the Hong Kong Securities and Futures Commission released a Consultation Paper on Amendments to the Code on Real Estate Investment Trusts. The proposals aim to increase flexibility for the trusts, aid growth, and encourage more REITs to list in Hong Kong. The Hong Kong REIT code was enacted in 2003 and there are currently eleven REITs listed. The sector’s market cap of around USD 21.2 billion is dominated by LINK REIT and is only around half the size of the Singapore REIT sector. This has been a disappointment in a market that many believe should grow much bigger to be a major, indirect property investment gateway into Asia. The reforms were flagged in November in a research report from the Financial Services Development Council. Initial hopes that the reforms would include favourable tax treatment have not been realised, however the restrictions on ownership of development properties and financial instruments are being loosened. While the changes seem timely given tricky market conditions they could alter REITs future risk/return profile and create extra demands of their trustees and management teams. Investors should check they are comfortable with the changes and with governance arrangements at their holdings.
What is going on and why?
REITs are widely held vehicles for receiving a consistent and rising yield through exposure to rented properties. The rules in Hong Kong relating to permissibleinvestments by REITs have historically been stricter than elsewhere. Currently, Hong Kong based REITs can only acquire uncompleted properties or redevelop properties up to 10% of the Net Asset Value (NAV) of the portfolio. These restrictions are tighter than in many other markets and given the maturity of the HK property market, this gives domestic REITs few options for expansion and in some cases can make it difficult to redevelop buildings where it makes more sense to enhance an asset than sell it. There is also a timing question. Many believe that the Hong Kong property market has reached a valuation peak and is due for a correction this year. Valuations are starting to reflect this, with some REITs trading at discounts to NAV of up to 30%. The new rules would give the REITs more flexibility to manage their assets in a downturn. The main proposals are to relax the restriction on new developments to 10% of Gross Asset Value (GAV), to allow investments in vacant land where this is part of a development deal, and to allow REITs to invest up to 25% in various financial instruments: listed securities, unlisted debt, government securities and property funds. These allowances are subject to a minimum of 75% of GAV being held in real estate that generates recurrent rental income. There is a disclosure requirement where a REIT has used these provisions. It is argued that the proposed changes would give the required flexibility, and, the consultation points out, broadly bring Hong Kong into line with other markets such as Singapore. Regarding the increase in development limit from 10% of NAV to 10% of GAV, an argument in favour is that the need to redevelop is related to the size of the portfolio not whether there is debt attached. Why should funds with high levels of debt have a lower need for redevelopment or growth at the portfolio level? For any ungeared funds, this doesn’t represent a change, while for a fund with a 50% debt to GAV ratio, the level of returns to unit holders associated with redevelopment would only rise from 10% to 20%.
Should investors just nod these changes through?
Before they do, investors may wish to consider two key questions: could the changes raise risks to the investment thesis; and what practical considerations or governance mechanisms minimise these risks? As many investors own REITs for their yield, one key risk is that yields could decrease. This could come about if the some of the 25% allowance were invested in low or no income generating assets, whether development properties or financial instruments, even for relatively short periods of time. While this would reduce gross income by 25%, the effect on yields could be much more significant due to the relatively fixed charges of property related costs, management fees and interest charges. Investors should eventually benefit from a capital uplift, but this may not serve their purposes if they are yield hungry income funds or retired individuals. A second risk is that future deals are made that support connected parties, rather than undertaken for the benefit of investors in the REIT. Many REITs are tied to a property developer (or other company) that uses the REIT to optimise its balance sheet. The developer puts its property assets together with some debt and offers the package to investors through an IPO. Usually the developer group keeps a significant, perhaps controlling, interest. In many cases the management company is also a part of the developer. In such situations a REIT can become a captive buyer, forced to buy completed properties at a price determined by the developer. The increased flexibility raises risks of overpayment as development properties are harder to value than let properties and so transparency is reduced. In addition, the flexibility to purchase financial instruments could be used to further the narrow interests of the developer, such as when taking stakes in other group assets or, worse, supporting the developer’s share price.What mitigates these increased risks?
Under the current rules, REITs have a very transparent structure, with a profit formula of rent, less charges, fees and interest, which is paid out as dividends. The restrictions on investments thus give investors a great deal of protection. Under the new proposals, there would be more pressure on governance arrangements. The governance structure of REITs is based on a management company with a Board of Directors that is overseen by a trustee. The assurance that investors’ interests will be protected comes from the level of alignment between the management company and the investors (through the fee arrangement and executive incentives), the independent directors on the Board and the independence of the trustees as well as skills and experience of each party. The independence of directors and trustees is particularly important where the management company is tied to or a subsidiary of a controlling shareholder. Their skill and judgement will be tested in different ways if the rules are implemented. This will involve ownership issues such as balancing yield with growth. It will also involve supervisory questions. Developing properties and timing the property cycle present different challenges from letting and management. Those teams with a broader skills base may be able to take advantage of the new rules. Investors may be more wary if teams without the breadth of experience decide to try their hand at development. A further protection, where there are deals with related parties, is the requirement for independent advice and valuation. Of course, not all valuers are as independent as they appear on paper. For example, they may have been providing advice as a service to the REIT or to other group entities for many years, which could create too cosy a relationship with the management team. There is a broader range of valuations for development properties,
rather then let properties; and greater scope for subjectivity. Consequently, the proposals will introduce new challenges for trustees and management as well as their advisors.
What should investors do?
Ultimately investors will need to decide if they are comfortable that the independent directors, trustees and management teams running REITs in which they are invested have the skills and independence to appropriately use the extra flexibility the new regulations would provide.This may mean meeting with management teams and asking how they would use the new allowances and how they might manage the issue of balancing income with development.
If investors are uncomfortable, then it may be appropriate to participate in the consultation arguing against the proposals or suggesting further protections. Where there are governance concerns at specific REITs, this is a good time to ensure they are addressed. Otherwise, there is chance investors find one day own something different from what they had initially bargained for. The deadline for comments on the consultation is 26 February 2014.
Benjamin McCarron is Managing Director of Asia Research and Engagement (ARE)