The report of the 19th National Congress of the CPC has made it clear that “houses are built to be inhabited, not for speculation”. Therefore, accelerating the establishment of a housing system that draws and guarantees supplies from multiple types of players and via multiple channels, and places equal emphasis on rental and purchase to achieve the goal of housing all Chinese people, will be a strategic priority for China going forward. This is where rental housing REITs come into the picture by providing an innovative financing channel and investment exit path for enterprises through asset securitization.
Policy background. Since 2016, the General Office of the CPC Central Committee, the General Office of the State Council, the China Securities Regulatory Commission, the Ministry of Housing and Urban-Rural Development and other departments have promulgated for implementation a series of policy documents on developing the housing rental market, actively and steadily lowering the gearing ratio of enterprises and innovating the ways of government resource allocation, including the Several Opinions on Accelerating the Cultivation and Development of the Housing Rental Market, the Opinions on Actively and Steadily Lowering the Gearing Ratio of Enterprises, the Guiding Opinions on Innovating the Ways of Government Resource Allocation and the Notice on Accelerating the Development of the Housing Rental Market in Large and Medium-sized Cities with Net Population Influx.
These documents have clearly raised goals and initiatives such as “supporting eligible housing rental enterprises to issue bonds and real estate securitization products”, “steadily advancing the pilot program of real estate investment trusts (REITs)”, “supporting real estate enterprises to shift to an asset-light business model by developing REITs”, etc., creating a favorable policy environment for the rapid and virtuous development of rental housing REITs.
Renting housing REITs push real estate enterprises to transform their business models. Rental housing REITs serve to help real estate enterprises “destock and deleverage”, provide solutions for the dilemma of high investment and slow return faced by such enterprises on the housing rental market, and will vigorously promote real estate enterprises to transform from the traditional business model of “development and sale” to the new model of “development – operation”.
Real estate enterprises hold a large existing stock of housing assets, many of which are assets subject to sales or price controls or are balance flats. Such assets can all be effectively revitalized through REITs. Real estate enterprises will manage to solve various problems existing in their underlying assets in the context of present rental housing policies by engaging the active coordination of regulatory authorities. As such, making every effort to promote rental housing REITs at this stage will help real estate enterprises maximize their own interests.
KEY LEGAL CONSIDERATIONS
As rental housing REITs involve many legal considerations such as complex product structures, a large number of participants and a litany of difficulties, during product promotion, it is necessary to not only conduct full and detailed due diligence of the underlying assets, but also offer legal solutions for the problems detected, including property ownership confirmation, rental arrangements and cash flow guarantee, mortgage of property assets as security, shortfall replenishment, arrangements for preemptive rights, arrangements for rating downgrades, structured tranche design, margin mechanisms, etc. This article analyzes the key issues as follows:
Mortgage of property assets as security. In practice, the project companies of a rental housing REIT will generally mortgage their respective property assets to the REIT trustee as security for their respective borrowings under loan contracts. If a project company fails to repay the loan in full and on time according to the relevant local contract, the REIT trustee shall be entitled to service the debts with the cash obtained from disposing of the mortgaged assets.
Margin/reserve fund mechanisms. To fully protect the rights and interests of investors, a REIT may set up a margin/reserve fund mechanism whereby the originator may, after the establishment of the REIT’s special scheme, pay initial reserve funds to the special scheme account under the accounting subject of margin, and top up the reserve fund to the amount required after the follow-up valuation of property assets falls below their initial valuation and/or after distributable reserve funds have been transferred from the accounting subject of the reserve fund.
Open for exit and liquidity support of priority asset-backed securities. The originator provides liquidity support for the exit of priority asset-backed securities in the REIT’s special scheme. Should all or part of the priority asset-backed securities that have applied for exit within the registration period corresponding to the date when application for exit is open and have had their applications confirmed fail to complete such exit, the manager of the special scheme shall notify the originator to purchase such priority asset-backed securities on the date when exit opens.
Holders of preemptive rights and rights maintenance fees. The REIT will arrange for the originator or a designated third party to act as the holder of preemptive rights, who shall be entitled to acquire, according to transaction documents, the equities of the project companies held directly or indirectly by the REIT, its claims in such project companies and the property assets held by the project companies on a priority basis. It should be noted, however, that a holder of preemptive rights shall pay rights maintenance fees to the special scheme account according to the agreement on preemptive rights as consideration for enjoying such rights.
Rental housing REITs are bound to become a hot topic in the market going forward, and the issues mentioned above will surely see new breakthroughs and developments in different products. The prospects for rental housing REITs are certainly promising.