When structured finance meets the property industry

By Li Kailun, Merits & Tree Law Offices
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Data from the National Bureau of Statistics (NBS) show that up to RMB3.06 trillion was invested into real estate development across China from January to April 2018, representing a nominal growth rate of 10.3% on a year-on-year basis. Of that amount, 69.73% goes into home developments. Being a “capital reservoir”, the housing market has a critical impact on the economy and people’s livelihood in China.

李凯伦 Li Kailun 植德律师事务所 高级律师 Senior Associate Merits & Tree Law Offices
李凯伦
Li Kailun
植德律师事务所
高级律师
Senior Associate
Merits & Tree Law Offices

As regulatory policy is concerned, the People’s Bank of China said at its 2018 work conference that it would support the cultivation and development of a home leasing market, while further improving the macro-prudential policy framework to strengthen macro-prudential regulation, especially over shadow banking and real estate financing activities. Real estate developers are having less access to financial capital, given the three core regulatory principles being implemented for the extensive asset management system, including prohibition of “passageway business”, restrictions on “leverages”, and “piercing into underlying assets” review.

Against this background, commercial banks, trust companies, fund company subsidiaries, securities companies and private equity funds are exploring new approaches to investing in the real estate industry that adapt to the era of the extensive asset management system. Current regulatory policies, aimed at creating more sources, also bring new opportunities for these players.

The form and substance of the transformation of conventional financing models. Investing activities using a conventional business model that features “fund + entrusted loan” are shrinking sharply due to the promulgation and implementation of a series of regulations and supervision policies, which are believed to be a significant restriction on the non-standardized investments of asset management divisions of securities companies, asset management companies, and private equity funds with a focus on the real estate industry.

At the same time, the financing model used by commercial banks, trust companies and other institutions for the real estate industry, which combines equity investments with debt investments, also faces great regulatory pressure given the recent regulatory guidelines.

It is against this background that financial products resulting from the transformation of the above-mentioned “equity plus debt” investment model emerge, with the intent of meeting the formal requirements of regulators. Take trusts as an example. On the basis of investments in equities or right-to-proceed from specific assets, new business models, such as shareholder loans, perpetual capital securities, arrangement of payments for deficiency of specific assets actual proceeds over expected proceeds, investment withdrawal on the ground of VAM (valuation adjustment mechanism), simulated clearing/valuation, etc., are added into some products. There are some other products in which secondary principals commit to make payments for deficiency of trust actual returns over expected returns.

To some extent, these products fall under the scope of transactions of equity investments and debt investments, simultaneously. The promulgation and implementation of the Guiding Opinions on Regulating the Asset Management Business of Financial Institutions worsen the legitimacy of the above-mentioned business models. It is hard to expect any material breakthrough if the conventional “equity plus debt” model is transformed merely for the purpose of complying with different regulatory guidelines. Worse still, a stringent regulatory environment can pose further threat to the survival of these transformed products.

The emergence of quasi-REITs. In April 2014, CITIC Qihang Specific Asset Management Plan, the first REIT product in China, was established by CITIC Securities. According to data from China Securitization Analytics, 42 REIT products have been issued as of 20 May 2018, which represented a combined size of approximately RMB96.04 billion and grew dramatically compared with the same period of the previous year.

Having come into being in the 1960s in the US, REITs have played a key role in the real estate financing history of the US. However, replicating foreign REIT transaction models is impractical for China, given the special characteristics of its real estate development models, financial regulatory environment, and the supporting taxation and real estate policies. Innovatively, the Chinese market nurtures quasi-REIT products to adapt to the local financial environment.

It is undeniable that the creativity of quasi-REITs in the Chinese housing market is restricted due to the lack of supporting tax policies and systems, which has an immediate impact on quasi-REITs in terms of rate of return and access to capital. However, in anticipation of favourable policies for the home leasing market, equity REITs with equities as underlying assets will progressively benefit from their advantages on the market, making up for the deficiencies of mortgage REITs with debts as underlying assets, particularly in terms of costs and the “exit” of originators from the REITs, thereby bringing the fundamental role of REITs back into play. Hopefully their derivative models may serve as effective transitions to public REITs.

In view of the prevailing influence of the current policy and regulatory environment, it is foreseeable that REITs introduced from abroad will build a robust presence in the huge real estate financing market in China, although the process during which remolding of old models into new ones is exposed to uncertainties that need to be addressed with system improvements in the long run. Benefiting from their creativity and advantages of legitimacy, REIT products will provide real estate companies with access to capital while helping to achieve regulatory objectives.

The “diversification” and “specialization” of real estate financing programmes. The availability of a range of real estate financing programmes enables investors to diversify their portfolios. However, given the existing regulatory policies, investors’ choices will push trading parties to select transaction models that meet both regulatory requirements and market demand. A large number of products have been accepted in the market, examples of which include asset-backed securities (ABS) products with underlying assets of claims to property management fee, real estate supply chain and rental incomes, as well as bonds and commercial mortgage-backed securities (CMBS).

This development trend will drive the evolution of the conventional real estate development models, facilitating the maturity of the home leasing market and progressive improvement of property management capabilities. As a result, real estate companies, financial institutions and private equity funds will gradually shift to specialized asset management services moving to build up their presence in the local real estate financing market under a new situation where existing home sales dominate.

Li Kailun is a senior associate at Merits & Tree Law Offices

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