Hong Kong REITS: Investment Rules Too Tight

Stephen Chung

Executive Director

Zeppelin Real Estate Analysis Limited

March 2003 

Hong Kong is contemplating the set up of Real Estate Investment Trusts (REITS) and recently the Hong Kong Securities and Futures Commission (HKSFC) has issued a draft code. It is seeking feedback and comments as well and interested parties may log onto the link below for details. Suggestions are to be sent on or before April 9, 2003:  

http://eapp01.hksfc.org.hk/apps/ip/reit.nsf/Download/1/$FILE/reits_consult_eng.pdf  

To recap, REITS have a long history in the USA and have in recent decades spread gradually to other places including Australia, Japan, Singapore and so on. Typically, through REITS investors-shareholders would collectively own a portfolio of properties (or mortgages if the REITS are debt-focused) and receive most if not all of the proceeds generally tax-free from rentals and dispositions after relevant expenses. To date and based on the published media, there are people who welcome REITS and there are those who oppose them. Your humble author tends to like the idea of REITS and have a few comments on the draft code after having read it briefly:  

A)     Tight on REIT administration rules, light on REIT investment rules = Like publicly listed companies, REITS being mostly public ones ought to be subject to certain regulatory frameworks in particular aspects related to their administration, financial accounting, reporting (to shareholders) and the like. However, as a general suggestion, REITS should be given much freedom on setting their investment parameters, strategies, and preferences including such aspects as where to invest, what to invest, how much to invest, when to invest (or disinvest for that matter), and so on. It is understandable that initially there may be tendency to control more tightly probably out of a concern that REITS are new to Hong Kong investors, yet in the long run certain investment rules may actually hinder the (healthy) development of REITS. A balance may be needed.

B)     Restriction to Hong Kong properties reduces investment appeal = According to the HKSFC, there were internally 2 broad views, with one group urging inclusion of non-Hong Kong properties while the other suggesting only Hong Kong properties. The draft code now allows only Hong Kong properties though it does not entirely rule out non-HK properties in future. While this restriction may reflect an intent to safeguard REIT investors, given non-HK properties may involve China / Asia markets that are less than developed, it greatly reduces the investment appeal for REITS in the long if not short run, bearing in mind REITS are (meant to be) managed by qualified and experienced executives who help reduce the risks associated with non-HK properties in the first place. Also, limiting the REITS to Hong Kong does away the option to spread the investment risks via investing in different geographical locations, markets, or regional economies, in particular ones having different market cycles and structures. This in turn means any HK REIT can only spread the risk via investing in different market sectors in Hong Kong. As these market sectors are in many ways correlated, this renders such diversification less meaningful. Please note the allowance of investing in non-HK properties does not necessarily mean a REIT has to invest elsewhere if it chooses not to.

C)    Leverage limited to 35% = This is in line with a few of the practices in other places such as Australia, and the USA has no stated ceiling though reportedly the level is usually around 50% or so. While such limitations are there to ensure fiscal health and thus reduce financial risks, they also reduce the chance to produce higher returns where feasible. Perhaps easing such leverage to 40 to 50% may be considered though again noting this does not mean a REIT has to have such a leverage if it chooses not to.

D)    No land development, real estate development, hotel, or recreational projects etc = Perhaps this is intended to ensure the REITS invest only in properties which can provide instant income-revenue-rental streams. Also, development projects and the like generally require a range of professionals and experts from architects and engineers to project managers, hoteliers, and so on and this not only increases expenses and overheads but also requires a lot more coordination effort. Nonetheless, and assuming the eventual allowance of non-HK properties, many markets in China / Asia are emerging-developing economies, and as such, the promising returns may lie in their development projects. Allowing a certain % of development projects can enhance market appeal and / or REITS can take a passive role in a development joint venture etc. 

E)     Holding period of not less than 2 years = This restriction is understandable, designed probably to reduce undue speculative activities, and may be workable in most cases yet there are always chances that markets may change unexpectedly, for the worse, and rapidly. If so, the restriction and procedural process may actually render the REITS being exposed to higher risks.  

The above are simple preliminary observations looking from a real estate investment angle and further details need to be studied. In any event, it is felt that while the HKSFC or governing authorities have a responsibility to set up, monitor, and enforce the regulatory framework and the various administrative rules and regulations to ensure proper REIT and efficient market operations, it does not have the same level of responsibility for ensuring the investment performance or success of REITS (just as no one guarantees the business-financial performance of a public listed company or for that matter even a bond). The restrictions on investment parameters may reflect good intent, yet these by themselves do not ensure a viable or healthy market for REITS.  

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