RICO CHAN ANALYSES HOW THE FAST-GROWING ABS MARKET MAY HELP CHINA’S REAL ESTATE SECTOR FIND A BLUEPRINT FOR NEW FUNDRAISING PRODUCTS
The Asset-backed securitization (ABS) market in China has been growing rapidly since 2015. The direct reason was deregulation of ABS transactions starting in late 2014, when China moved from an approval system to a registration system for ABS products. The underlying policy reason for the deregulation was that the central government needed to reduce leverage in many business sectors. When the global financial crisis occurred in late 2008, China quickly responded with its massive economic stimulus programme at the national level.
For various political and economic reasons, these national and local economic stimulus programmes could not fundamentally re-invigorate China’s economy. China then faced the situation of a slowing economy, while many business sectors, such as real estate and infrastructure, struggled with over-capacity and over-leverage.
In order to avoid the over-leverage in these oversupplied sectors translating into a systemic risk in the country’s banking system, China had to find ways to quickly reduce financial leverage in these sectors. ABS was one of the central government’s chosen methods to achieve this policy objective. By allowing companies and financial institutions in these sectors to use their assets to issue ABS products more easily, the central government could achieve deleveraging in these sectors more quickly.
Apart from the above-mentioned reasons, in the real estate sector different market players have been testing ABS and other securitization structures with a view to establishing a blueprint for China’s future markets for real estate investment trusts (REITs) and commercial mortgage backed securitization (CMBS).
ABS in essence means a company or financial institution (typically called the “originator”) issuing securities to investors on the basis of the cashflow derived from a specific pool of business assets of the originator, such as loan portfolios, account receivables or certain contractual rights.
ABS securities are often, though not always, listed and traded on an exchange to give the securities liquidity. Quite often certain internal or external credit enhancement features are structured into the ABS securities to strengthen their credit standing. ABS securities are often rated by local or international rating agencies.
There are two types of ABS products in China. The first is “credit asset ABS products”, originated by banks and other financial institutions using their loan portfolio such as corporate loans, residential mortgage loans, auto loans, credit card loans, etc. These ABS products are regulated by the China Banking Regulatory Commission (CBRC) and are traded on the China Inter-bank Bond Market (CIBM) in Shanghai among “qualified institutional investors”.
The second is “corporate asset ABS products” originated by companies using a wide range of business assets such as real estate ownership, real estate rental income, property management fees, hotel operating income, toll road fees, account receivables, etc. These ABS products are regulated by the China Securities Regulatory Commission (CSRC) and are traded on the block trade section of the Shanghai or Shenzhen stock exchanges among qualified investors.
Actually, there are two other types of ABS products. There are “insurance assets ABS products” originated by insurance companies using their insurance assets. These ABS products are regulated by the China Insurance Regulatory Commission (CIRC) and are traded on the Shanghai Insurance Exchange. There are also “asset backed notes” (ABN) regulated by the National Association of Financial Market Institutional Investors (NAFMII) and traded on the CIBM. But the market scale for these two types of ABS products is much smaller compared with credit and corporate assets ABS products.
CMBS-TYPE ABS PRODUCTS
A recent and typical example is the “Financial Street (Phase 1) Special Asset Management Plan” originated in 2016 by the Financial Street Holdings Group (FSH), a state-owned real estate development group listed on the Shenzhen Stock Exchange. Some market commentators regard it as China’s current version of “commercial mortgage backed securitization” (CMBS).
In this case FSH engaged China Merchant Securities Asset Management to set up a “special asset management plan” (the ABS Plan), which is divided into senior notes worth RMB6.317 billion (US$930 million) and subordinated notes of RMB63 million. The senior notes were sold to qualified investors. Both the senior and subordinated notes are tradable on the block trade section of the Shenzhen Stock Exchange. The funds raised under the ABS Plan were used to acquire all the interest in a private trust. The private trust was set up by a Beijing subsidiary of FSH solely to provide a 12-year loan to refinance the existing loan owed by FSH. This 12-year loan is secured by the buildings and related rental income of the Beijing subsidiary.
Through this structure, investors in the ABS Plan effectively own unitized interests (i.e., the senior and subordinated notes) in the 12-year mortgage loan and such notes are tradable on the Shenzhen Stock Exchange. The investors will get back their investment principal and the agreed fixed return upon the maturity of the ABS Plan. The investors’ interests are primarily protected by the building mortgage held for their benefit through the private trust and the ABS Plan. The ABS Plan has incorporated various credit enhancement mechanisms, such as a commitment by FSH to cover income shortfall situations, as well as put and call rights between FSH and the investors of the ABS Plan.
REIT-TYPE ABS PRODUCTS
The most notable example is the CITIC Qihang Special Asset Management Plan originated by CITIC Securities in 2014. This is the earliest and one of the very few “equity-type” ABS products in China. It is called equity type because the ABS product indirectly owns the title of the underlying real estate assets. This was a pioneering ABS product by CITIC Securities using its own real estate assets, apparently in the hope that the central government would establish an equity-type REIT regime in the near term and this ABS product could then be converted into the first public REIT product in the Chinese market. However, to date China still does not have an equity-type REIT market similar to those in the US and other countries.
In this case, CITIC Securities set up a special asset management plan (SAMP) (the ABS Plan), which is divided into senior notes of RMB3.65 billion and subordinated notes of RMB1.56 billion. The senior notes were sold to institutional investors, and part of the subordinated notes were subscribed by CITIC Securities. Both the senior and junior notes were tradable on the Shenzhen Stock Exchange. The funds raised under the ABS Plan were used to subscribe for all the interest in a non-public investment fund set up by a subsidiary of CITIC Securities.
This investment fund then used the funds to acquire certain office properties in Beijing and Shenzhen owned by CITIC Securities through a “sale and lease back” transaction. The acquisition was done through purchasing the shares in two special purpose companies that own the office properties. Although the tax liability for acquiring the shares in the holding companies is much lower than acquiring the buildings directly, the actual tax liability involved was rather substantial. As it is still uncertain when the public REIT market will happen, it appears that other market players are not willing to adopt this equity-type ABS model and bear the heavy tax liability associated with it.
Through this transaction, the investors in the ABS Plan effectively own unitized interests (i.e., the senior and subordinated notes) in the ownership of the office properties, and these notes are tradable on the Shenzhen Stock Exchange. The ABS Plan has a fixed term of five years, during which distributions to the investors will be derived from the rental income of the properties. If a public REIT market becomes available in China during the five-year term, the ABS Plan will either be converted into a public REIT and the investors will receive units in the public REIT as their final distributions; or alternatively, if the properties are sold to the public REIT, the investors would receive final distribution in cash. If there is still no public REIT market at the end of the five-year term, the properties will be sold in the market and the investors will receive final distributions in cash. It is unclear from public information whether CITIC Securities enjoys any priority right to purchase the properties at or before the end of the five-year term.