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DBS Group Research • May 2018DBS Asian Insights59n

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SECTOR BRIEFING

China REITs Property Landlords to Shine

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DBS Asian Insights SECTOR BRIEFING 5902

China REITs Property Landlords to Shine

Produced by:Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Goh Chien Yen Editor-in-ChiefJean Chua Managing EditorMartin Tacchi Art Director

Ken HEEquity AnalystDBS (Hong Kong)[email protected]

Carol WUHead of Greater China ResearchDBS (Hong Kong)[email protected]

Danielle WANG CFAEquity AnalystDBS (Hong Kong)[email protected]

Derek TANEquity AnalystDBS Group [email protected]

Jason LAM Equity AnalystDBS (Hong Kong)[email protected]

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Executive Summary

China REITs Are Lagging Edging Towards Onshore REITs

Major Obstacles in Fostering an Onshore REIT Regime

CMBS/CMBNs Are Growing Faster

C-REITs Are Imminent

Which Asset Type Will Benefit More?

Modern Logistics Properties

The Rise of Active Property Asset Management

Which Developer Will Benefit From the Establishment of C-REITs?

Appendix

he real estate investment trust (REIT) has become an important investment vehicle as evidenced by its separation from the financial sector in the Global Industry Classification Standard as a sector on its own. Major Asian countries/regions have joined western countries to kickstart local versions of REITs, leaving China the last

big economy that has yet to have such an investment vehicle.

In our view, removing legislative obstacles (publicly traded funds are not allowed to hold commercial properties) is the first step that the government needs to take towards establishing a modern REIT regime. Near-term relaxation could be allowing mutual funds to invest in onshore pre-REITs. Currently, the government is fine-tuning regulations whereby a single mutual fund is not allowed to invest over 10% of its total net asset value (NAV) in one single security and a single fund management company is not allowed to invest over 10% stake in one single security.

Taxation is a more complicated obstacle as there are central/local tax (國稅地稅) systems in place. We think a waiver of taxes related to asset transfers is required to develop a REIT regime, as this is one of the biggest concerns for – and a huge burden on – landlords to build a REIT platform. So far, under the current taxation scheme and regulations, onshore pre-REITs have complicated structures to save on/avoid some taxation. Having said that, taxation, in our view, is a factor determining the market size of China REITs (C-REITs), rather than an obstacle preventing the establishment of C-REITs, as offshore C-REITs also need to pay various taxes in China.

Other areas that China needs to fine-tune to foster an ecosystem for C-REITs include a unified product structure, a standardised valuation methodology, a transparent credit rating system, and supervision of special-purpose vehicles (SPVs).

The origin of C-REITs can be traced back to 2005, when the first red-chip REIT – Yuexiu REIT – was launched on the Hong Kong Stock Exchange (HKEx). However, the development of the sector has largely stagnated until the emergence of onshore REIT-like securities in 2014. Currently, there are 28 quasi-/pre-REITs (類/類REIT) which are primarily debt-like vehicles and barely resemble an equity-REIT in other countries, as the government aims to manage the risks of such products at the initial stages and believes that a debt structure is more secure than an equity one.

But the fact is those pilot debt-like products have a less favourable risk/return profile compared to offshore C-REITs as (i) their leverage is high, ranging 50-70% versus 20-40%

Executive Summary

No REIT regime yet

Two major technical obstacles

Onshore pre-REITs


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of their offshore peers’; (ii) the coupon rate has been low at 4-7%, versus an average yield of 6-9% of offshore peers’ (total returns could be higher, including capital gains); and (iii) those pre-REITs are all held by private funds with fewer than 200 investors, pointing to limited liquidity. Other problems existing in some products include low interest coverage, having a single underlying asset or single end-customer, the parent company’s credit enhancement, and a vague credit system. In our view, relaxation of policy and taxation is needed to foster a better ecosystem for growing equity-REITs.

The big difference is, compared to REITs, that commercial mortgage-backed securities (CMBS) do not involve asset transfers, avoiding the two key obstacles faced by onshore REITs. Compared to traditional bank loans, CMBS enjoy lower funding costs and better liquidity. CMBS kicked off in August 2016 and have witnessed faster growth since then.

A recent spate of policies has led us to believe that the long-awaited C-REIT is imminent, even if the initial structure of the REIT may not be similar to that of offshore REITs.

(i) Continuous deleveraging efforts: Top governors have reiterated the need to put more effort into ensuring financial security and healthy economic growth. This can be tracked from the deceleration in the growth in banks’ assets. According to Standard & Poor’s, growth in banks’ assets was 5.5% in 8M17, much lower than an average of 15.2% during the past five years, and also the first time this figure has dipped below the corresponding GDP growth. The government has been pushing other sectors to swap debt for equity to help them deleverage. But unfortunately, the property sector is one of the few sectors that have been gearing up despite strong property sales. We believe the government may switch its focus to deleveraging in the sector after successful destocking, and C-REIT could be an effective way.

(ii) Weaken residential properties’ attractiveness as investments: Local governments have implemented a series of policies (including purchase/sell/mortgage limitations) with the intention of managing residents’ expectations on housing prices. Meanwhile, the central government has attached more importance to long-lease rental apartments, proposing to give more incentives (including land supply and tax incentives) to this segment. Three million units of rental housing are targeted to be supplied in trial cities, which is huge compared to the average annual sales of 1.7mn units during 2013-2016 in those cities. And we believe China needs the REIT platform to hold these rental-housing assets over the long term. In addition, the first pre-REIT for long-lease rental apartments was launched on the Shenzhen Stock Exchange on 3 November 2017, prompting some industry experts to expect the breakthrough in onshore REITs to come from long-lease rental apartments.

(iii) Develop commercial properties’ function as investments: The regulators have been speeding up the drafting of the REIT code recently. In addition, the issuance of onshore pre-REITs has also accelerated. Apart from this, a new policy which aims to encourage the conversion

CMBS are growing faster


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Commercial properties to outperform?

Which asset type to benefit more?


of commercial land/properties to long-lease rental apartments was introduced. As mentioned above, the upcoming C-REITs could be public funds with investment targets in onshore pre-REITs, which do not look exactly like REITs envisioned by overseas investors. Yet, this vehicle should greatly improve the liquidity of commercial properties and unlock book value.

We expect the investment focus to gradually switch from residential properties to commercial properties. Based on our study, the capital value of commercial properties in Japan and Hong Kong has outperformed residential housing prices after the introduction of local REITs. In addition, we are seeing big potential in C-REITs. REITs’ market cap as a percentage of local GDP average 6.0% in major Asia-Pacific countries. Even if we conservatively assume a 1% figure for China, C-REITs’ market cap could potentially be US$115bn. In our view, the required yield return of C-REITs will likely fall in the 5.5-6.0% range, compared with the current China 10Y government bond yield of 3.9%, the latest weighted-average rate of 4.5% for wealth management products (WMP), and the current offshore C-REITs’ yield of between 6% and 9%. The yield spread (above China 10Y government bond yield) is likely to be 2%, compared to c.3% for HK REITs and Singapore REITs (S-REITs), which could be justified by higher asset appreciation potential in China.

We expect hotel and retail mall assets to benefit more from liquidity improvement. In addition, in anticipation of C-REITs, active property asset management / redevelopment and conversion of hotel or retail malls to offices are rising, especially in Beijing and Shanghai.

Both assets generate relatively stable cashflow and require less operating capability. Therefore, both assets have been chased by financial investors and insurance companies during the past two years. As the renminbi (RMB) has reversed its downward trend, foreign capital has also been flowing into these two assets. This, coupled with stricter capital outflow, should continue to drive up the capital value of both assets.

We are positive on the logistics property sector and we expect state-owned enterprises (SOEs) and market consolidators that have better access to industrial land to benefit more from the potential establishment of C-REITs. Shenzhen Chiwan used to be the second-largest warehouse play in China, but its development over the last two years has been dragged by its B-share status. The company is expected to leverage the potential establishment of C-REITs to quicken its asset turnover and grow its portfolio. Vanke-H/A, being the largest warehouse play (a part of a consortium involved in an ongoing transaction to take GLP private), is also a key beneficiary.

For Grade-A offices, we are positive on Shanghai, Guangzhou, and Shenzhen, but cautious on Beijing traditional core areas as long-term demand in Beijing will likely be diluted by the rise of Tongzhou and Xiong An New District. We expect SOHO to benefit more from asset disposals, given investors’ appetite for prime office assets.

Modern logistics properties and Grade-A

offices

In our view, the market is overestimating the risk of oversupply and underestimating the recovery in retail sales. Our analysis suggests that four types of malls will outperform: (i) Existing luxury malls in Tier-1 cities, as they will benefit from strong retail sales recovery in the luxury segment; (ii) suburban malls in high-tier cities with strong population influx; (iii) malls with first-mover advantage in low-tier cities; and (iv) malls with strong management teams. We expect CR Land and Joy City to benefit more from the recovery in retail sales, given a high proportion of turnover rents. Both companies could also potentially benefit from the establishment of C-REITs to quicken their asset turnover and expand their national footprint. In the US, the largest REIT in terms of market cap is Simon Property, which focuses on retail malls.

Hotels have been the least favourable assets among commercial properties, due to their low profitability and oversupply concerns. But we are positive on luxury hotels in Tier-1 cities, as (i) the trading up by consumers has already driven up occupancy, and will eventually reverse the downward trend in room rates; (ii) EBITDA will likely see a larger rebound, given a high operating leverage; and (iii) hotel supply has slowed substantially over the past two years. In addition, judging from the experience of hotels in the US which also suffered from oversupply in the early 1990s, we believe there will be a gradual recovery in profitability after the supply of new assets slows down. Coupled with the emergence of modern equity REITs, this has resulted in mounting acquisition activity by REITs and a larger number of hotel rooms being controlled by fewer players. This has also led to a continuous increase in revenue per room (RevPAR), except during the two ’Black Swan’ periods (9/11 and the housing/banking crisis). Hotels in China will likely follow suit.

Mature hotels in prime locations in top-tier cities should benefit more. Jinmao Hotel, owning eight luxury hotels in key Tier-1 cities and tourist hotspots, should ride on the recovery of the hotel business. Guangzhou R&F currently owns 18 luxury hotels in key Tier -1 and -2 cities and is acquiring 77 hotels from Wanda. We think it could be a potential beneficiary.

To sum up, we expect three categories to potentially benefit from the upcoming C-REITs:

1. Developers with businesses encouraged by the government – public-private partnership (PPP) projects, long-term rental apartments, and senior housing – as these areas would be the first to see a breakthrough in C-REITs.

2. Developers with a high proportion of hotels and investment properties.

3. Companies with property funds, such as Vanke, Sino-Ocean, and Joy City. Their property funds are existing structures which might be more easily converted to C-REITs in the future.

Premium retail malls

A recent spate of policies has led us to believe that the establishment of the long-awaited C-REIT is imminent


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Luxury hotels


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EITs were separated from the GICS (Global Industry Classification Standard) financial sector as a sector on their own, indicating the importance of REIT products globally. This also raises the question about the time frame for the development of C-REITs, given that China is now the world’s second-largest economy as well as the second-

largest market for commercial real estate transactions (according to JLL), with Shanghai ranked the top city for real estate investment in Asia-Pacific in 2016.

So far, China has no real equity REIT or any investment trust commonly acknowledged as one domestically. However, neighbouring countries/regions have experienced tremendous growth in the past decade. Japan introduced its first REIT in 2000 and has since then launched more than 50 REITs, with an aggregate market cap of US$106bn, making up 2.1% of its 2016 GDP. REITs’ market cap as a percentage of 2016 GDP averaged 6% in key Asia-Pacific countries. Even if we conservatively assume a 1% figure for China, its REIT market cap could potentially be US$115bn. India kicked off its infrastructure REIT sector in 2014, leaving China the last big economy that has yet to have such investment vehicles.

China REITs Are Lagging

R

Country / region

The year the first REIT was launched

No. of REITs as of Sep 2017

Mkt cap of all REITs

(US$ bn)

Mkt cap of REITs

as % of 2016

GDP

2016 GDP (US$ bn)

US 1960s 190 998.7 5.38% 18,569

Australia 1971 53 93.7 7.78% 1,205

Malaysia 1980 18 10.2 3.44% 296

Japan 2000 58 105.5 2.14% 4,939

Korea 2001 6 1.6 0.11% 1,411

Singapore 2002 41 60.6 20.40% 297

Hong Kong 2003 13 34.8 10.85% 321

Taiwan 2003 5 2.1 0.39% 531

Thailand 2003 63 12.5 3.08% 407

Diagram 1. REIT markets in Asia and the US

(1) inclusive of Property Funds for Public Offerings (“PFPOs”)Source: NAREIT, Bloomberg Finance L.P., DBS Bank, CEIC

Limited progress


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The development of C-REITs can be traced back to 2005, when the first offshore REIT- Yuexiu REIT was launched on the Hong Kong Stock Exchange (HKEx). Yuexiu REIT’s structure was relatively simple, with four British Virgin Islands (BVI) companies holding the four domestic buildings, respectively. The four BVIs were fully owned by a holding company (holdco) which is the REIT platform. However, the government subsequently announced a new regulation on the entry and administration of foreign investments in the real estate market, which banned offshore holding companies from holding domestic properties directly. The government also raised the requirement for the registered capital of foreign-invested onshore real estate companies, making it more difficult for offshore C-REITs. As a result, CR Land and Wanda had to abandon their plans to follow in Yuexiu REIT’s footsteps.

CapitaRetail China was the first offshore China REIT under the new regulation. Compared to Yuexiu REIT, CapitaRetail China needs to form one onshore holding company, adding additional operation costs and audit expenses. In terms of taxes, Yuexiu REIT is only subjected to 10% withholding tax (on revenue) for the four projects in its initial portfolio, while CapitaRetail China has to bear 25% corporate income tax.

Year Event2003 Trust financing started becoming an important source of funding for developers 2005 The first offshore REIT, Yuexiu REIT, listed on HKEx

Banking regulator raised threshold for the issuance of REITsOnshore ABS kicked off

2006 Regulation on the entry and administration of foreign investments in the real estate marketCapitaRetail China Trust listed on SGX

2007 RREEF China Commercial Trust listed on HKEx2008 PBOC encouraged the initiatives in the financial sector and planned to launch REITs

Insurance companies were allowed to invest in real estate2009 PBOC worked out a pilot programme for REITs in Beijing, Shanghai, and Tianjin2011 The first RMB REIT, Huixian REIT, listed on HKEx

Perennial China Retail Trust listed on SGXPenghua US REIT was listed

2013 NC REIT and Spring REIT listed on HKExMapletree Greater China listed on SGX

2014 Regulator promoted the pilot programme for REIT productsTwo onshore debt-like REITs, CITIC Qihang and CITIC Suning, kicked offJinmao Investment (renamed Jinmao Hotel) was listed on HKExRMBS kicked off

2015 More onshore debt-like REITs issuedThe first onshore quasi-REIT, Penghua Vanke Qianhai, was listedBHG Retail REIT listed on SGXA number of developers issued various ABS productsHPF RMBS kicked off

2016 Insurance companies were allowed to invest in ABS productsEC World REIT listed on SGXCMBS kicked off

2017 Dasin Retail Trust listed on SGXPre-REIT asset-backed note (ABN) on the interbank marketGolden Eagle issued the first CMBNThe first long-term rental apartment pre-REIT (with Equity element) issued

Diagram 2. Milestones of China’s REITs

Source: DBS Bank

CITIC Qihang as a milestone

Pre-REITs


Edging Towards Onshore REITs

The regulator had also made some progress towards fostering an onshore REIT platform, albeit at a slow pace, until 2014, when it gradually relaxed the approval process for domestic asset-backed securities (ABS) and encouraged the pilot programme for REIT products. The successful issuance of CITIC Qihang in May 2014 was a milestone for onshore C-REITs, although it is not a “real” REIT like the ones in other countries and it is under a private fund structure as constrained by Law on Securities Investment Fund (證券投資基金法). Onshore residential mortgage-backed securities (RMBS) also kicked off in 2014. Subsequently, onshore REITs (or pre-REIT/quasi-REIT, as we call them), RMBS and other ABS enjoyed rapid growth in 2015. In 2016, ABS and RMBS (including housing provident fund RMBS or HPF RMBS) continued their growth, with the emergence of commercial mortgage-backed securities (CMBS) or commercial mortgage-backed notes (CMBN).

Categories of Onshore REIT-like ProductsConstrained by regulations, the prototype onshore REITs are not similar to traditional equity REITs and there are vague classifications or various definitions of onshore REITs. We classify these REIT-like products into two categories –Quasi-REIT (類REIT) and Pre-REIT (類REIT). An example of a quasi-REIT is Penghua Vanke Qianhai, which is a publicly-traded fund half invested in Vanke’s rental property in Qianhai (RMB 1.27bn) and the other half (RMB 1.73bn) invested in fixed-income securities. The Vanke Qianhai office is owned by the local government and managed by Vanke. Therefore, Penghua Vanke Qianhai looks like a combination of income rights ABS (收益權ABS) and fixed-income securities.

The 27 widely-discussed REIT-like products are classified as pre-REITs, as they are all under a private fund structure and hold certain commercial properties. They are expected to be converted into real REITs in the future following the relaxation of regulations. Such products

Diagram 3. Onshore development of ABS, REITs, CMBS, RMBS, and HPF CMBS

Source: CNABS, DBS Bank

Overall ABS Pre-REIT CMBS RMBS HPF RMBS

Rmb bn no. Rmb bn no. Rmb bn no. Rmb bn no. Rmb bn no.

2011 1 1

2012 22 7

2013 23 14

2014 322 94 10 2 7 1

2015 610 317 13 4 26 8 10 9

2016 905 509 13 8 21 4 105 15 39 9

11M17 1,559 744 25 13 45 14 171 19 0 0


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are similar to Taiwan’s real estate asset trusts (REATs), which are slightly different from REITs, given the limited number of assets in the portfolio and no capability to acquire new assets. Also, there is no need to actively manage assets in the portfolio. Most pre-REITs are tradable in the Shanghai or Shenzhen stock market, despite being regulated by the China Securities Regulatory Commission and having limited liquidity.

These pre-REITs are all debt-like vehicles and barely resemble an equity-REIT familiar to investors, as the government aims to manage the risks of such products at the initial stage and believes a debt structure is more secure than an equity one. Given the debt-like structure, such products also extended into the interbank market. The first asset-backed note (ABN) with property being the underlying asset is Industrial Wanxin Media (興業皖新閱嘉). It is regulated by the People’s Bank of China (PBOC).

Diagram 4. Types of Chinese REITs and other securitisation

Category Market Structure Examples

Offshore China REITs

Hong Kong Listed REITs / BTs (business trusts) on HKEx

Yuexiu REIT, Huixian REIT, New Century REIT, Spring REIT, Jinmao Hotel (BT)

Singapore Listed REITs / BT on SGX

Mapletree Greater China, CapitaRetail China Trust, BHG Retail REIT, EC World REIT, Dasin Retail Trust

Onshore China REITs

Shenzhen stock exchange

Quasi-REITs − mutual fund structure with full rights to the rental of certain commercial properties

Penghua Vanke Qianhai (鵬華前海万科)

Shanghai / Shenzhen stock exchange

Pre-REITs − private fund structure holding certain commercial properties, with expectation of being transformed into real REITs in the future after the relaxation of regulations

CITIC Qihang (中信啟航), CITIC Suning (中信華夏蘇寧雲創/雲享), Hengtai HNA SPDB (恒泰浩睿海航浦發), CM Chuangrong Rainbow (招商創融天虹商場), Hengtai Caiyun Hotel (恒泰浩睿彩雲之南), TF AVIC Redstar (天風中航紅星愛琴海), Oriental Injoy Plaza (東證資管青浦吾悅廣場), EBP Capital Imix Park (首譽光控安石大融城), CITIC SanPower Nanjing IFC (中信華夏三胞南京國際金融中心), CITIC Wanxin Yuejia (中信皖新閱嘉), Changjiang Chuyue Zhongbai (長江楚越中百), Pingan Suning Plaza (平安蘇寧廣場 ), TF Everbright Elion (天風光大億利生態廣場), Hengtai Hongze HNA (恒泰弘澤廣州海航雙塔 ), BOC Inv CMS Kaiheng (中銀招商北京凱恒塔樓 ), Kaiyuan HNA (開源北京海航實業大厦), CM Chuangrong Fusheng (招商創融福晟), First Qianhai Fund LerThai (中聯前海開源勒泰一號), GoHigh Red Star (暢星高和紅星), Bohai Huijin Yuefang ID mall (渤海匯金中信資本悅方ID mall), Bohai Huijin CYPA (渤海匯金新派公寓權益型)


Structure of Onshore Pre-REITsCurrently, pre-REITs have quite a complicated structure, in order to save/avoid taxes under the existing tax regime.

Firstly, target properties (標的物業) are usually held by project companies, with the aim of reducing land appreciation tax and deed tax during asset transactions. So far, there has been one exception – CM Chuangrong Rainbow (招商創融天虹商場). The target property - 天虹商場 - was directly held by an asset-backed programme (資產支持專項計畫), but has been facing various taxation problems.

Interotc* Pre-REIT, not publicly traded

Hengtai Hongze Yindu (恒泰弘澤華遠盈都商業), CITIC Goldstone Country Garden (中信金石碧桂園鳳凰飯店)

Interbank Pre-REITs, ABN (asset-backed note)

Industrial Wanxin Media (興業皖新閱嘉)

Onshore CMBS/CMBN


Publicly traded CMBS (commercial mortgage-backed security)

Go High CM Chemsunny (高和招商金茂凱晨), Hengtai Yintai Centre (北京銀泰中心), Sinolink Sinar Mas Arch (國金金光金虹橋國際中心 ), Shenzhen YT Holiday Plaza (深圳益田假日廣場), Huifu JIC SOHO Fuxing Plaza (匯富建投匯宇搜候復興廣場), TF China Central Place SKP (天風華貿SKP), Financial Street (金融街), HTAM Poly Property (華泰資管保利置業), CITIC Poly RE (中信保利地產), Hongbo (紅博會展), CICC SCPG SCP Plaza (中金印力深國投廣場), Pingan Winbond Intime (平銀國君華邦銀泰城), Harvest Capital Zhongjieneng (嘉實資本中節能綠色建築), GoHigh Tebon Forte (高和德邦複地商業物業)

Interotc* CMBS, not publicly traded

Minsheng FuWah Jinbao (匯富富華金寶大厦)

Interbank CMBN (commercial mortgage-backed note)

Shimao Int'l ABN (世茂國際ABN), Golden Eagle ABN (金鷹ABN), Future Land ABN (新城控股ABN)

Other securitisation


Various types of ABS (asset-backed security) on property management fee or receivables, as well as RMBS (residential mortgage-backed security) and HPF (housing provident fund) RMBS

So far, there are 18 HPF RMBS, 43 RMBS listed, and a number of developers have issued various ABS products

Diagram 4. Types of Chinese REITs and other securitisation cont.

* The quotation and service system of private products for institutions (機构間私募產品報價與服務系統)Source: DBS Bank

Private equity fund


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Secondly, a SPV is needed to hold both the equity and debt of project companies. The equity-plus-debt structure is to reduce income taxes and enhance return/yield, as interest on debt is tax-deductible. Therefore, most underlying assets (底層資產) of pre-REITs are equity-plus-entrusted loans of project companies. Two exceptions are CITIC Qihang (中信啟航) and CITIC Suning Yunxiang/Logistics (中信華夏蘇寧雲享). Both only own equity of project companies.

Thirdly, there is the private equity or PE fund (契約型私募基金) holding the abovementioned SPV(s). The purpose is to set up a platform which could be easily transferred into a public REIT after policy relaxation in the future. In addition, the structure enables potential introduction of professional real estate investors as PE fund managers for managing operations of the target properties.

On top of PE funds, there usually is another SPV (trust or asset-backed programme), which is designed for securitisation.

Diagram 5. Typical structure of onshore pre-REITs

Source: DBS Bank

Required return

Domestic rating

3.8-5.8%

AAA

Senior tranche A(more ilke bonds/CMBS)

4.3-7.0%

AAA, AA+, AA

Senior tranche B(more like bonds/CMBS)

SPV(trust or asset-backed

programme)

SPV

Project companies

Target property (標的物業)

Private equity fund (契約型私募基金)

no guaranteed return

normally no rating

Subordinated tranche(more like equity)

The reasons for the PE fund structure are: (i) For potential transfer into public REITs and (ii) for potential introduction of a professional real estate investor as PE fund manager in the future.

The equity + debt structure is to reduce income tax, as interest on debt is tax-deductible.

Compared to an asset transfer, a share transfer of a project company could reduce land appreciation tax and deed tax.

Interest on debt + income on equity

100% equity and debt


There are 2-3 tranches of end securities for each pre-REIT, including 1-2 senior tranches and 1 subordinated tranche (some may not have subordinated tranche). Senior tranches resemble bonds or CMBS and require high credit (onshore) ratings as well as fixed returns, while subordinated tranches (usually fully or mostly owned by originator) look like equity and usually no credit rating or guaranteed return is needed.

While most pre-REITs are debt-like instruments, some have equity elements built in the subordinated tranches. We are also seeing pre-REITs gradually evolving toward equity-REITs. The first pre-REIT for rental housing, Bohai Huijin CYPA (渤海匯金新派公寓), was issued on 3 November 2017. Investors could also invest in its equity tranche and are entitled to 80% of asset appreciation when they exit. The key characters of pre-REITs with equity elements are summarised in the table below. Investors of those subordinated tranches usually enjoy asset appreciation. Poly CN plans to issue the first batch of its rental housing pre-REIT (保利地產租賃住房一號), with an initial size of RMB 1.7bn. Different from other pre-REITs, this product is scalable in the future, with a potential size of up to RMB 5bn.

Diagram 6. Some pre-REITs have equity elements

Pre-REITs with equity elements

Other pre-REITs

Structure Senior + subordinated (or equity) tranche

2-3 senior tranches

Rating High rating for senior tranche, but no rating for subordinated tranche

High rating for senior tranches

Tenure Usually 3-5 years Usually 18-24 years, with interest-rate adjustment or call/put option every 3 years

Investors Previous asset owner usually subscribes to all or part of subordinated (or equity) tranche; investors of the subordinated (or equity) tranche may enjoy asset appreciation

Senior tranche investors won't enjoy asset appreciation

Examples CITIC Qihang (中信啟航), CITIC Suning Yunxiang (中信華夏蘇寧雲享), CM Chuangrong Rainbow (招商創融天虹商場 ), Bohai Huijin CYPA (渤海匯金新派公寓)

Others

Source: DBS Bank

Falling interest rates


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Risk/Return Profile of Onshore Pre-REITsAs abovementioned, the government aims to manage the risks of such products at the initial stage and believes that a debt structure is more secure than an equity structure. In fact, those pilot debt-like products appear to be riskier, as gross gearing ratios (if treating senior parts as debt and subordinated parts as equity) ranges from 50-70%, compared to a cap of 45% as required by REIT codes in Asian countries. The coupon rate or interest rate of those products has gradually fallen from 7% at early-2014 to <4% in mid-2016 and rebounded to >5% lately, compared to an average yield of 6-9% for offshore C-REITs listed in Hong Kong/Singapore. This has made such products less attractive to investors who want to climb up the risk curve to generate higher returns. Also, those pre-REITs are all held by private funds, with fewer than 200 investors in total, pointing to limited liquidity. Moreover, offshore C-REITs are usually issued at a price below NAV, providing a cushion in the case of any decline in asset value; onshore pre-REITs are usually issued on par with valuation, leading to potential risks if assets devalue.

Other problems faced by onshore pre-REITs include:

1. The domestic system of credit ratings is confusing and remains a black-box to most investors, especially offshore investors. For example, the underlying assets of Hengtai Caiyun Hotel (恒泰浩睿彩雲之南) are two five-star hotels in Beijing and Yunnan, but they generate a negative cashflow. Yet, three tranches of the product were initially rated

Diagram 7. Typical structure of offshore equity REITs

Source: DBS Bank

REIT

Unitholders

Trustee

Cash distributions

Service

Service

Ownership

Loan/bondInterestNPI

Service

Fees

Fees

Fees

Equity stake

Debt(lenders)

Sponsor

REIT manager

Property manager

Real estate assets


AAA/AA+/AA+, respectively, and were upgraded to AAA/AAA/AAA one year later. The upgrade was mainly due to credit enhancement from the originator which is a local SOE in Yunnan. Normally, a high-quality portfolio would have higher credit rating and attract cheaper capital. Offshore REITs usually have higher or equivalent credit ratings than those originators/parentcos, while onshore pre-REITs usually need credit enhancement from originators/parentcos.

2. Interest coverage ratios for some products are close to 1x. CM Chuangrong Rainbow (招商創融天虹商場)’s cash flow in 2015 was only 1.03x of annual coupon payments.

3. Some products have only a single underlying asset or underlying assets that serve a single end-customer. Half of those pre-REITs have only one underlying asset, which may expose investors to concentration risks. For example, the CITIC Suning series (中信蘇寧系列) has multiple underlying assets, but those assets are serving only one end-customer, which is Suning.

4. The valuation methodology of onshore valuers are unknown to investors. Domestic valuers look more aggressive than international valuers. For example, China Jinmao’s Beijng Chemsunny World in Beijing was valued at RMB 12.9bn when issuing CMBS, compared to its book value of RMB 8.3bn. CITIC Qihang (中信啟航) bought back the first pre-REIT in mid-2016. Subordinate (or equity) tranche investors were supposed to enjoy 90% of asset appreciation when exiting, but failed to enjoy such returns, as the manager of the asset-backed plan changed its valuer in 2016 and recorded an asset depreciation in 2016, which is contrary to market reality.

5. There is limited information on pre-REITs, as current pre-REITs are based on the private equity platform and information is only disclosed to selected investors.

6. Domestic brokers are striving to design a better structure under the current legislative and taxation regime but there is no standardised structure for these pre-REIT products. This makes transacting these products more difficult as it takes time for investors to study the structure case by case.

Key Differences Between Onshore Pre-REITs and Offshore REITsIn terms of structure, most onshore pre-REITs are under private funds with a multiple-tranche debt structure. As mentioned, only a couple of them have an equity element with the equity tranche enjoying/entitled to asset appreciation or can be converted to shares of a public REIT if the product is listed in the future. Pre-REITs are tradable on the Shanghai and Shenzhen stock markets or interbank market. Offshore C-REITs are all equity REITs listed on stock markets.

In terms of credit rating, onshore REITs usually need credit enhancements from their parentcos or originators, while offshore REITs usually have an equal or higher credit rating


17

than their parentcos or originators.

Yet, offshore C-REITs usually face currency-mismatch problems, while onshore pre-REITs bear no foreign exchange risks, which could lead to lower costs of capital.

Diagram 8. Key differences between onshore pre-REITs and offshore REITs

Onshore pre-REIT Offshore China REIT

Structure

Platform Private fund Corporates or trusts, publicly traded

Assets transferred to platform

Yes Yes

Underlying assets Usually equity + debt of target properties Equity

Target properties Office, mall, hotel, warehouse, rental housing

Office, mall, hotel, serviced apartment, warehouse

Transparency Limited public information Public announcement

Operation Passively managed Actively managed

Scalability No capability to acquire new assets Can acquire new assets as long as gearing is below cap

Tenure 3-5 years Nil

Exit Limited liquidity; normally need to wait for expiry, public listing, buyback from originators and selldown to third parties, senior tranche could also exit via CMBS

Dispose on the stock market

Market Stock market and interbank market Stock market

Risk profile

Rating agencies Domestic rating agencies Foreign rating agencies

Credit enhancement A pre-REIT usually needs credit enhancement from originator/parentco

No such need as the REIT usually has an equal or higher rating than that of its originator/parentco

Underlying asset Some own a single asset or multiple assets servicing a single end-customer

Multiple assets with multiple tenants

Leverage (gross gearing) 50-70% 20-40%

Currency risk No Yes

Return profile

Capital gain Subordinated tranche may enjoy capital gain, but normally owned by previous asset owners or originators

All shareholders enjoy capital gain

Interest / dividend Fixed coupon rate Depending on cashflow

Yield / coupon AAA: 4-6% 6-9%

AA+: 5-7%

AA: 6-7%

Source: DBS Bank

US

NetherlandsNew Zealand

Australia

MalaysiaHong Kong

TaiwanBulgaria

UKDubaiIsrael

Pakistan

France

BrazilCanada

Italy

BelgiumTurkey

Singapore

he first obstacle is the lack of a suitable platform to hold assets, as constrained by regulations.

One obstacle is the specification that a public-traded fund platform is not allowed to hold underlying assets. According to existing laws/regulations (Law of PRC on Partnerships 合夥企業法, Trust Law 信託法, Law on Securities Investment Fund 證券投資基金法), publicly traded funds are not allowed to hold commercial properties, which is why existing onshore pre-REITs are set up as private funds. This could lead to liquidity concerns as the number of investors under a private fund structure is capped at 200.

Major Obstacles in Fostering an Onshore REIT Regime

Absence of a specific REIT code

TDiagram 9. 33 countries/regions have drafted REIT codes so far

1960 1970 1980 20001990 2010 201520051995198519751965

RussiaKoreaJapan

Germany

SpainFinland

Bahrain

Hungary

South AfricaIreland

PhilippinesMexico

IndiaKenya


Source: NAREIT, DTZ, DBS Bank

In our view, this obstacle should be easy for the government to remove. A specific REIT code is required to foster an ecosystem for REITs.

In 2003, the Hong Kong Housing Authority had planned to fund welfare housing via REITs, and Link REIT listed on HKEx in late-2005. Subsequently, the REIT platform was expanded to include non-government sponsors. In 2014, India also kicked off its first REIT to fund infrastructure projects. This is targeted to open new investment avenues to private capital as well as foreign investors.

In our view, China could follow Hong Kong and India in kickstarting the REIT code for the first REIT to fund welfare/infrastructure projects. This could alleviate local governments’ burden and their reliance on bonds, and the established REIT code could gradually expand from the public sector to the private sector.

Another obstacle is the current tax regime in China, which leads to multiple levels of taxation for C-REITs.

When injecting projects or project companies into the REIT platform, there will be transaction taxes such as stamp duty tax, deed tax, value-added tax (VAT), appreciation tax (LAT), and income tax, although some taxes might be negotiable with local governments. Yet, project companies with offshore structures are not subject to transaction taxes, and therefore, they could save on tax expenses when setting up an offshore REIT platform; an example is Jinmao Hotel. The holding of assets is also subject to property tax, VAT (previously business/sales tax), and income tax, which will dampen yields.

Being a “mutual fund” investing in commercial properties instead of listcos, REITs see most of their income go to investors after deducting management fees. Therefore, a REIT can be seen as a tax “conduit” and is exempt from corporate income tax. A pass-through income tax structure when injecting assets into a REIT platform is also needed to attract interest. However, different countries have different tax regimes, and it may not be easy to come up with a clear-cut solution.

In the US and major European countries such as Germany, France, and the UK, REITs usually enjoy tax benefits and are exempt from capital gains tax for asset transfers as well as corporate income tax. This is attractive to investors and makes the REITs’ pricing-correction role more effective. Asian countries are generally cautious on REIT taxation. The Singapore government has been quite supportive of REITs, and S-REITs are exempt from any transaction tax as well as income tax on profits to be distributed. As a result, the S-REIT sector has grown at the fastest pace in Asia. By comparison, HK REITs are subjected to stamp duty tax for asset transfers. HK REITs are also subjected to income tax, given the absence of taxation on dividends. Thus, HK REITs are less attractive than S-REITs; the development of HK REITs has been lagging that of S-REITs’.

Following in Hong Kong’s and India’s

footsteps

Multiple levels of taxation currently

Tax “conduit” by nature


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In China, most taxes related to asset transfers and commercial property operations are local taxes. Therefore, the central government has an incentive to remove these taxes to develop the REIT sector, but there could be resistance from local governments. The situation is becoming even more complicated after the VAT reform (from business tax to VAT), as tax revenue collection continues to be in the hands of the central government, which further weakens local governments’ taxation capability. As a result, local governments have started to strengthen the levy of remaining local taxes lately. The central government has unified its property tax from either 0.84% of the cost of buildings or 12% of rental income previously to 12% of rental income, which has had a large impact on old buildings in premium locations as they carry relatively low costs but high rent.

Balancing the central government’s and local governments’ interests

Diagram 10. Taxes related to commercial property transactions/operations in China

Tax Central or local tax (國稅 or 地稅)

Tax base Tax rate

Taxes related to asset transfers

Stamp duty Local Transaction price 0.05%

Deed tax Local Transaction price 3%

Value-added tax Central Depends on price and cost

11%

Land appreciation tax Local Depends on price and cost

30-60%

Income tax Mainly local tax; central SOEs’ and financial

institutions' income tax is central tax

Profit before tax 25%

Taxes related to commercial property operations

Property tax Local Original cost / rental income

0.84% / 12%

Value-added tax Central Revenue - deductible items

Hotel/industrial: 6%

Office/retail: 11%

Income tax Mainly local tax; central SOEs’ and financial

institutions' income tax is central tax

Profit before tax 25%

Source: DBS Bank


Based on our study, the land appreciation tax (LAT) for project transfers or income tax for transfers of project companies are major considerations for landlords that want to inject their properties into a REIT structure. Local governments may need to change their mind-set as removing one-time transaction taxes could help digest idle assets in cities and enhance taxes from operations of those idle assets. Again, welfare/infrastructure projects could be a good start to enjoy tax benefits while alleviating local fiscal burdens.

A pass-through income tax structure may not be easy to implement in the short term, given the absence of capital gains tax and dividend tax (nil for onshore incorporated companies, 10% withholding tax for offshore companies; for individual investors: 20%/10%/nil if holding shares <= 1 month/ 1-12 months / > 12 months). But, we think there could be some tax benefits in some pilot cities like Beijing, Shanghai, and Tianjin. For example, CITIC Qihang (中信啟航) has two SPVs in Tianjin holding two buildings in Beijing and Shenzhen, respectively. Property tax and VAT will be taxed in Beijing and Shenzhen, respectively, while income tax will be at 18% in Tianjin (versus the normal level of 25%). Also, welfare/infrastructure projects could be packaged as pilot programmes to enjoy tax benefits. The central government has just drafted regulations on housing lease and sales management (住房租賃和銷售管理條例), proposing to extend tax incentives to housing lease operators. This could be easily extended into welfare/infrastructure projects.

Having said that, taxation, in our view, is more a factor determining the market size of C-REITs, rather than an obstacle preventing the establishment of C-REITs, as offshore C-REITs also need to pay various taxes in China. So far, only Yuexiu REIT’s initial batch of four assets in Guangzhou and Spring REIT’s office in Beijing are directly owned by offshore SPVs/funds before the new regulation in 2006, and subject to 10% withholding tax on revenue; the rest of the assets under offshore C-REITs are subject to 25% income tax. All China assets owned by offshore C-REITs are subject to property tax and VAT.

As discussed previously, there are several techniques used by pre-REITs to avoid some taxes.

For asset transfers, transactions of project companies instead of a direct asset transfer are generally implemented to avoid LAT and deed tax. Domestic securities companies are also working on the design of the pre-REITs’ structure to further reduce taxes incurred during asset transfers.

To reduce income taxes for target properties’ operation, a SPV is structured to hold both equity and debt of project companies. Most underlying assets of pre-REITs are equity plus entrusted loans of project companies.

A pass-through income tax structure?

Tax waivers necessary

Current tax-saving measures


21

Diagram 11. Simplified structure of Yuexiu REIT Diagram 12. Simplified structure of Spring REIT

Diagram 13. Typical structure for offshore C-REITs

Sources: Company, DBS Bank

Yuexiu REIT Spring REIT

Offshore China REITs

Offshore Offshore

Onshore Onshore

Offshore SPV/BVIs

Onshore project companies

GZI REIT 2005 Co. Ltd.

RCA01 RUK01

Offshore SPVs

Four offshore SPV/BVIs

Onshore project companies

Four assets acquired

UK properties

Four initial assets

Initial assets in Beijing

RE assets in China

Offshore

Onshore


CMBS/CMBNs Are Growing Faster

CMBS is a type of mortgage-backed security with commercial properties being the underlying asset. Compared to pre-REITs, the big difference is there is no asset transfer – avoiding the two key obstacles faced by onshore REITs. Compared to traditional bank loans, CMBS enjoy lower funding costs and better liquidity. Compared to other property-related ABS (such as property management ABS or receivables ABS), the underlying assets of CMBS are commercial properties that generate rental income from institutions, which are more stable and predictable than other underlying assets.

The first public-traded CMBS – Go High CM Chemsunny (高和招商金茂凱晨) kicked off in August 2016, although some say that Hengtai Yintai Centre (北京銀泰中心) was the first one. The missing element of Hengtai Yintai Centre is an individual servicer to manage assets and isolate risks, while Go High CM Chemsunny has a joint venture between Go High Fund and China Jinmao as an individual servicer. Originators – China Jinmao and China Yintai – have subscribed for all the subordinated tranche of both CMBS. This is slightly different from CMBS in US, where the subordinated tranche is usually purchased by servicers.

So far, we have seen 18 CMBS issued, worth about RMB 66bn, compared to 27 existing pre-REITs worth RMB 61bn. The average size of CMBS is larger than those of pre-REITs. The reason for this is CMBS could be seen as a substitute for investment loans (經營貸) on those commercial properties and needs more scale to enjoy greater cost savings. The US had witnessed tremendous growth during 1995-2007. After the Global Financial Crisis, the annual issuance of CMBS has recovered to the level of US$80-100bn. Given the simplicity of the structure, CMBS may have better growth prospects than onshore pre-REITs in the near term. However, the pace of development may be controlled by regulators. As we learnt, a number of potential CMBS are in the pipeline, awaiting approval from the stock exchange. Shimao and Golden Eagle recently issued CMBN products on the inter-bank market.

Diagram 14. Key differences between CMBS and other property-related ABS

Source: DBS Bank

Bigger potential in the near term


23

CMBS Other property-related ABS

Underlying asset Commercial property Various debt, residential mortgages, property management fees, and receivables

Cash source Rental income Debtors' repayment

Underlying credit Tenants' credit (mainly institutions)

Debtors' credit (mainly individuals)

Residential properties’ attractiveness as

investments

Commercial properties’ function as investments


C-REITs Are Imminent

Currently, Chinese residents prefer to put their money directly into property assets, given the lack of REIT products and limited investments channels. Housing prices used to jump every three years (policy cycle). In addition, direct ownership usually enables substantial leverage (20-30% down payment when policy loosens). Leverage is a powerful tool, which could amplify the return on investment on residential properties. Local governments have implemented a series of policies (including purchase/sell/mortgage limitations) with the intention of managing residents’ expectations on housing prices. In addition, this should greatly weaken the liquidity of residential properties. Normally, price expectations should be negatively affected by tightening leverage and liquidity.

The government has attached more importance to long-lease rental apartments, proposing to give more incentives (including land supply and tax incentives) to this area. However, during the 19th CPC National Congress, the government reiterated that housing is for accommodation, not for speculation. Therefore, we expect housing prices to be more stable than before.

The regulators have been speeding up the drafting of the REIT code lately. In addition, the central government has been iterating the pilot programme for REIT products. The first pre-REIT for long-lease rental apartments was issued on 3 November 2017, and some industry experts are expecting the breakthrough in onshore REITs to come from this segment.

Diagram 15. Issuance of CMBS in the US

Source: Commercial Mortgage Alert, JLL, DBS Bank

Commercial property to outperform residential

property


25

Moreover, the issuance of onshore pre-REITs has also accelerated lately. As such, we think C-REITs are imminent, although the initial structure might not resemble that of international REITs’, as the industry is constrained by existing legislation and taxation. As abovementioned, upcoming C-REITs could be public funds with investment targets of onshore pre-REITs. Yet, they should greatly improve the liquidity of commercial properties and unlock value.

Rising risks in the residential sector after the rapid increase in land prices and the Chinese government’s latest cooling measures have led investors to switch their focus from residential to commercial properties, on expectations that this class will offer stable yields with potential for asset appreciation. In fact, several developers are building their commercial property portfolio in top-tier cities. Based on our observations, the capital value of commercial properties in Japan and Hong Kong have outperformed residential housing prices after the introduction of local REITs.

Diagram 16. Initial onshore REITs structure

Diagram 17. Commercial land prices have outperformed residential land prices in Japan since 2000

Source: DBS Bank

Source: CEIC, DBS Bank

Mutual fund (公募基金 )

Pre-REITs

Target property (標的物業 )

Pre-REITs

Target property (標的物業 )


In our view, the required yield of C-REITs will likely fall in the 5.5-6.0% range, compared to the current China 10Y government bond yield of 3.9%, the latest weighted-average rate of 4.5% for wealth management products (WMP), office/retail assets’ investment yield of 5.6-6.3% in Beijing/Shanghai, and current offshore C-REITs’ yield of between 6% and 9%. The yield spread (above China 10Y government bond yield) is likely to be 2%, compared to c.3% for HK REITs and S-REITs, which could be justified by higher asset appreciation potential in China.

Diagram 18. Office/retail prices have outperformed residential prices in Hong Kong, especially after 2005

Diagram 19. Differences in returns of banks’ wealth management products and pre-REITs

Source: DBS Bank



27

We compared the weighted average rate of return of banks’ WMPs and the AAA tranche of existing pre-REITs and found the average difference is 0.86 percentage point. We also compared the weighted average rate of return of WMPs and the weighted average coupon rate of existing pre-REITs and found the average difference is 1.47 percentage points.

Diagram 20. Differences in returns of banks’ wealth management products and pre-REITs


Which Asset Type Will Benefit More?

Asset types T


here are six Hong Kong-listed REITs holding 31 properties in mainland China, including 17 hotels, five offices, five retail/wholesale malls, and four commercial complexes. Eleven S-REITs hold 49 properties in China, including 19 retail malls, 16 logistics properties, 11 hotel/serviced apartments, and one commercial complex.

27 onshore pre-REITs hold a total of 77 properties, including 45 retail malls/chain stores, 10 offices, six logistics properties, and 16 hotels. So far, 18 CMBS/CMBN have been issued based on 25 investment properties (IPs), including eight commercial complexes, 10 offices, and seven retail malls. 18 of these IPs are in Tier-1 cities and seven in Tier-2 cities. In addition, CMBS’ IPs are larger than those of pre-REITs’.

Diagram 21. Asset types owned by onshore pre-REITs and offshore REITs

Diagram 22. Locations of assets owned by onshore pre-REITs and offshore REITs



29

Diagram 23. IPs owned by Hong Kong-listed REITs


Company Stock code Property Type Location

Yuexiu REIT 405 HK White Horse Building Wholesale Guangzhou

Victory Plaza Retail Guangzhou

City Development Plaza Office Guangzhou

Fortune Plaza Office Guangzhou

Neo Metropolis Retail Guangzhou

Guangzhou IFC Complex Guangzhou

Yuexiu Tower Office Shanghai

Wuhan Yuexiu Fortune Centre Complex Wuhan

Huixian REIT 87001 HK Beijing Oriental Plaza Complex Beijing

Chongqing Metropolitan Oriental Plaza Retail Chongqing

Sofitel Shenyang Lido Hotel Shenyang

Harbour Plaza Chongqing Hotel Chongqing

Sheraton Chengdu Lido Hotel Hotel Chengdu

New Century REIT 1275 HK New Century Grand Hotel Hangzhou Hotel Hangzhou

New Century Grand Hotel Songjiang Shanghai

Hotel Shanghai

New Century Hotel Xiaoshan Zhejiang Hotel Hangzhou

New Century Resort Qiandao Lake Hangzhou Hotel Hangzhou

New Century Grand Hotel Ningbo Hotel Ningbo

New Century Grand Hotel Changchun Hotel Changchun

New Century Grand Hotel Kaifeng Hotel Kaifeng

Spring REIT 1426 HK China Central Place T1&2 Office Beijing

Jinmao Hotel 6139 HK Jinmao Tower Complex Shanghai

The Westin Beijing Chaoyang Hotel Beijing

JW Marriott Hotel Shenzhen Hotel Shenzhen

The Ritz-Carlton, Sanya Hotel Sanya

Hilton Sanya Resort and Spa Hotel Sanya

Hyatt Regency Chongming Hotel Chongming

Renaissance Beijing Wangfujing Hotel Hotel Beijing

Grand Hyatt Lijiang Hotel Lijiang

Link REIT 823 HK Ecmall Retail Beijing

Corporate Avenue 1&2 Office Shanghai


Diagram 24. IPs owned by S-REITs


CapitaRetail China

CRCT SP CapitaMall Xizhimen Retail Beijing

CapitaMall Wangjing Retail Beijing

CapitaMall Grand Canyon Retail Beijing

CapitaMall Qibao Retail Shanghai

CapitaMall Saihan Retail Hohhot

CapitaMall Minzhongleyuan Retail Wuhan

CapitaMall Wuhu Retail Wuhu

CapitaMall Anzhen Retail Chengdu

CapitaMall Erqi Retail Zhengzhou

CapitaMall Shuangjing Retail Beijing

Mapletree Greater China

MAGIC SP Gateway Plaza Office Beijing

Sandhill Plaza Office Shanghai

BHG Retail REIT BHGREIT SP Beijing Wanliu Mall Retail Beijing

Chengdu Konggang Mall Retail Chengdu

Dalian Jinsanjiao Property Retail Dalian

Hefei Mengchenglu Mall Retail Hefei

Xining Huayuan Mall Retail Xining

EC World REIT ECWREIT SP Chongxian Port Investment Industrial Hangzhou

Chongxian Port Logistics Industrial Hangzhou

Fu Zhuo Industrial Industrial Hangzhou

The Stage 1 Properties of Bei Gang Logistics Industrial Hangzhou

Fu Heng Warehouse Industrial Hangzhou

Hengde Logistics Industrial Hangzhou

Dasin Retail Trust DASIN SP Xiaolan Metro Mall Retail Foshan

Ocean Metro Mall Retail Foshan

Dasin E-colour Retail Foshan


31



Mapletree Logistics Trust

MLT SP ISH Waigaoqiao Industrial Shanghai

Mapletree AIP Industrial Guangzhou

Wuxi Logistics Park Industrial Wuxi

Xi'an Distribution Centre Industrial Xi'an

Yangshan Bonded Logistics Park Industrial Shanghai

Zhengzhou International Logistics Park Industrial Zhengzhou

Northwest Logistics Park phase 1 Industrial Shanghai

Northwest Logistics Park phase 2 Industrial Shanghai

Ouluo Logistics Centre Industrial Shanghai

Ascott Residence Trust

ART SP Ascott Guangzhou Apartment Guangzhou

Citadines Biyun Shanghai Apartment Shanghai

Citadines Gaoxin Xi'an Apartment Xi'an

Citadines Xinghai Suzhou Apartment Suzhou

Citadines Zhuankou Wuhan Apartment Wuhan

Somerset Grand Central Dalian Apartment Dalian

Somerset Heping Shenyang Apartment Shenyang

Somerset Xuhui Shanghai Apartment Shanghai

Somerset Olympic Tower Property Tianjin Apartment Tianjin

Ascendas Hospitality Trust

ASCHT SP Novotel Beijing Sanyuan Hotel Beijing

Ibis Beijing Sanyuan Hotel Beijing

Cache Logistics Trust

CACHE SP Jinshan Chemical Warehouse Industrial Shanghai

OUE Commercial REIT

OUECT SP Lippo Plaza Complex Shanghai


We have summarised the key characteristics of the four different types of commercial properties in the table above. As shown, the performance of hotels and retail malls is highly dependent on the management’s expertise, while logistics properties and offices are relatively simple and require less management.

Diagram 25. Different IPs’ operating characteristics

Modern logistics property

Grade A office Premium retail mall Luxury hotel

Land use right Industrial Commercial Commercial Commercial

Development cycle

1-2 years 3-5 years 3-5 years 3-5 years

Key demand drivers

Third-party logistics,

e-retailers, and industrial

Tertiary industry End-user demand, population catchment

Tourist arrivals

Key barriers Land, network, and transportation

Location, unless new district/area planned by the

government

Population catchment, operating execution

Location, operating execution

Replacement or substitute

Co-working space Overseas shopping and e-retailers

Homestay

Lease term Long Short

Maintenance Low High

Management Light Heavy

Operating costs Low High

Margin High Low

IFRS accounting treatment

Investment properties:

Revalue but no

depreciation

Investment properties: Revalue but no depreciation

Investment properties: Revalue but no

depreciation

Investment properties under master lease

arrangement, otherwise PPE with depreciation but no

revaluation

Property tax 12% 12% 12% 12%

VAT 6% 11%, or 5% for old buildings

11%, or 5% for old buildings

6%

Income tax 25% 25% 25% 25%


Access to land is key

Demand from e-commerce has

rebounded

Slowdown in new warehouse supply from

2018

More capital to chase warehouse assets


33

Modern Logistics Properties

Positive on coastal cities; inland cities to suffer from oversupply in the near termModern warehouses generate relatively stable cashflow and require less operating capability. Our analysis shows that access to land, low-cost funding, talent, and tenants are key success factors. As local governments have lower incentives to supply industrial land, this creates a high entry barrier for newcomers.

Alibaba’s online sales on Singles’ Day surged 39% YoY to RMB 168.2bn in 2017, versus 32% in 2016. E-commerce retail sales sped up, registering 32% YoY growth in 10M17, outpacing the 26% in 2016 and iResearch’s full-year projection of 25.4% for 2017. Major e-retailers are actively expanding the categories of consumer goods, especially in fresh food and cross-border merchandise. Both export and import activities have picked up strongly – imports increased 17% in value terms in 10M17 while exports grew 7%.

Rentals at logistics properties in major coastal cities were relatively flat QoQ in 3Q17, while Chongqing/Chengdu continued to suffer from oversupply. Looking ahead, rents are likely to edge up in key cities in the coming six months, with Shanghai and Shenzhen to lead rental growth due to limited supply as well as potential demolition of ageing warehouses. Industrial land supply in 14 key cities dropped 19% YoY in 1H17, mainly due to substantial cuts in Chengdu, Chongqing, and Wuhan. Growth in warehouse investments also remained low at 4% in 8M17, versus 5%/28% in 2016/2015, which will likely slow down warehouse supply from 2018 onwards and support rental growth.

As the RMB has reversed its downward trend, foreign capital has also been flowing into logistics property assets/companies lately, such as Invesco and Allianz’s investments in e-Shang/Redwood. Domestic players and funds continue to chase warehouse assets, and the rebound in e-commerce growth has triggered industry-chain plays to compete for warehouses. This should drive up capital values further.

Shenzhen Chiwan used to be the second-largest warehouse play in China, but its development over the last two years has been dragged by its B-share status. The company is expected to leverage the potential establishment of C-REITs to quicken its asset turnover and grow its portfolio. Vanke-H/A, the largest warehouse play (a part of a consortium involved in an ongoing transaction to take GLP private), is also a key beneficiary.


Diagram 26. Logistics prosperity index* (LPI)

Diagram 28. Industrial land supply in 14 major cities

Diagram 27. China e-retailers’ logistics index^

Diagram 29. Rental performance in 14 major cities

Source: China Federation of Logistics & Purchasing (CFLP), DBS Bank^ reflecting overall logistics status from e-commerce, including nine sub-indexes.

Source: CRIC, DBS Bank

Source: China Federation of Logistics & Purchasing (CFLP), DBS Bank* above 50 means expansion, below 50 means contraction

Source: CRIC, DBS Bank

Location is key

Simple cost structure

Beijing: Headwinds in the medium term


35

Grade-A offices: Positive on Shanghai, Guangzhou, and Shenzhen; but cautious about Beijing in the medium termOffices require less management compared to retail malls. There are two basic parameters – occupancy and rental rate, and management needs to balance the two. Grade-A office space is usually preferred by REITs as it usually houses multi-national and large enterprises, which are less affected by cycles. The key barrier facing the segment is location. Yet, such advantages may be moot if the government plans to develop a new area. The famous example is Shanghai’s Pudong, which has seen better growth than Puxi, thanks to supportive government policies. This also applies to cities, as new planning of cities/regions could greatly affect mid-term demand.

Less management leads to lower operating costs. The major costs are property tax and VAT. Offices are classified as investment properties, which could enjoy revaluation and no depreciation. Therefore, the operating margin of office assets is usually around 80%.

Demand from domestic professional firms and IT-related companies remains decent. However, Beijing’s municipal government is moving to Tongzhou while the central government targets to build up Xiong An New District to take up some functions from Beijing, which will dilute mid-term demand for offices in Beijing’s core areas. A wave of new supply in 2018-2021 should also drive up overall vacancy from 3.9% as of end-2016 to 9.7% in 2021. In addition, we are seeing more supply coming from other commercial properties (discussed in the ‘The rise of active property asset management’ section on page 34).

Overall rental should see downward pressure starting from 2018, especially in the CBD. Capital value growth will slow down, despite the strengthening RMB in 2017 and stricter capital outflow. The Beijing municipal government’s move to change the basis of property

Diagram 30. Major players’ landbank

Source: Company, DBS Bank

REITs 2014 (mn sqm) 1H17 (mn sqm)

GLP 10.7 29.2

Goodman 1.3 4.2

e-Shang/Redwood 0.6 4.1

CNLP (Yupei) 0.7 4.0

Mapletree 0.8 2.6

Vanke 0.2 2.6

Shenzhen Chiwan (Blogis) 0.9 1.9

Beijing Properties 1.1 1.7

Shanghai: Rental hiccup

Guangzhou: High-growth potential

Shenzhen: Investment demand


tax from cost to revenue from 2H16 will aggravate the tax burden, especially for owners of old office buildings in prime locations.

Demand for office space in core areas in Shanghai is still on the rise, driven by domestic financial services, professional services, and IT-related firms. Additional opportunities might come from SOE consolidation, as some shipping and financial SOEs may move their headquarters from Beijing to Shanghai. New supply, after peaking in 2017, will shrink in 2019-2021. Including decentralised areas, total Grade-A office stock in Shanghai was 11m square metres as at end-1H17, still lower than 13m square metres in Hong Kong and 38m square metres in New York (Manhattan).

Rental will likely stay steady, given new supply pressure. But we are positive on the mid-term outlook, as rental rates in Shanghai is still lower than those in Beijing and other international financial centres, pointing to upside potential in the medium term. According to JLL, Shanghai was ranked as the top city for real estate investment in Asia-Pacific in 2016. Investment momentum has remained strong; yet, buying interest was mainly from developers, PE funds, and foreign capital in 2017, versus insurers being the key buyers in 2016. We expect buying sentiment to stay strong, given stricter controls on capital outflows and a relatively high effective yield among gateway cities globally.

Demand from domestic financial services, professional services, IT-related firms, and real estate companies remains decent. Despite a new supply peak in 2016, total prime office supply remained the lowest among the four Tier-1 cities. In addition, new supply will slow down in 2017-2020, with majority of the supply located in Pazhou. Therefore, occupancy should gradually decline from 12% as of end-2016.

After the new supply peak in 2016, we expect rental rates to post CAGR of 4-5% in 2017-2020. Grade-A office space in Guangzhou is still the cheapest among major cities in Greater Bay Area. This, coupled with limited buildings available for sale, will continue to drive up capital value.

Domestic securities and asset-management companies have been active in taking up prime office space in Shenzhen since 2016, given the Hong Kong-Shenzhen Stock Connect as well as the geographical proximity and the large rental difference between the two cities. A wave of new supply is coming, but a quarter will be occupied by developers.

The rental rate in Shenzhen will likely post CAGR of 3-4% in 2017-2020 as rental still looks low compared to Hong Kong’s. The healthy economic structure, young population, and the government’s aim to build up the Greater Bay Area will continue to attract investment demand and demand for headquarters as high-tech firms tend to form a cluster (agglomerate) to enjoy knowledge spillover.


37

Diagram 31. Prime office stock and rental rate comparison

Diagram 32. Comparison of office rental yield, risk premium (end-2016)

Source: Savills, DBS Bank

Source: DBS Bank

Source: JLL, DBS Bank

Diagram 33. Office rental outlook, Tier-1 cities Diagram 34. Office capital value outlook, Tier-1 cities

Near-term Mid-term

Beijing

Shanghai

Guangzhou

Shenzhen

Near-term Mid-term

Beijing

Shanghai

Guangzhou

Shenzhen

Execution is key


Prime retail malls: Don’t underestimate rental upside Compared to offices, retail malls require more operating expertise and are ‘closer’ to the end-customer. Rental income is usually a percentage of sales (tenants’ occupancy cost is usually 15-20%) in the mall and there are three basic parameters of sales – shoppers’ traffic, conversion rate, and sales per ticket. Cashflow from rents is usually a composition of fixed rents and turnover rents (a certain percentage of sales).

Therefore, the operating margin of a retail asset is usually 50-70%. Retail malls are also classified as investment properties, which could enjoy revaluation and no depreciation.

Based on data from JLL, the total number of malls (with gross floor area of over 10,000 square metres and not operating on a strata-titled basis) in China’s top 30 cities is expected to increase from 998 currently to 1,445 in 2019. JLL data also shows that shopping mall stock in Tier-2 cities will rise 58% on average by end-2019. But our analysis shows that the oversupply risk is overstated for several reasons: (1) New mall supply that has been delayed or cancelled is included in the analysis that points to an oversupply risk. JLL estimated that more than 30% of the new malls expected to open in 2017 would be delayed or cancelled. Also, empty malls do not compete for shoppers, as tenants usually start renovations only after the pre-leasing of the whole project reaches a certain level, usually 60-70%. (2) The supply risk in high-quality mall space might also be overstated, as brand mix and rental rates could be divergent between different malls. (3) The latest trend to convert mall space to offices and China’s new policy to allow conversion of commercial land to land for residential leasing housing will reduce the supply risk too.

We believe the consistent growth in disposable income will continue to drive retail sales in these cities. In addition, retail sales for the top 50 retailers, especially for affordable luxury and jewellery/watch players, have witnessed above-market growth since 4Q16, and we believe such momentum could hold up. Given that the top 50 retailers are the main tenants of shopping malls operated by listed mall players, their sales recovery data may more accurately reflect the rental prospects of such malls than the overall retail sales data for China.

We recently interviewed key retailers in China, including retailers of global luxury goods, jewellery, watches, sportswear, cosmetics, and lingerie. We found that a few new trends are supporting rental growth:

(i) Branded retailers have resumed expansion of their retail stores (3-8% CAGR in 2017-2018); (ii) foreign brands continue to enter the Chinese market; and (iii) price harmonisation supports luxury retail sales recovery.

Four types of malls will outperform: (1) Existing luxury malls in Tier-1 cities; (2) suburban, mass market-focused malls in districts with continuous population influx in Tier-1 cities;

The risk of oversupply is overestimated

The recovery in retail sales

New emerging trends


39

(3) the first high-quality malls opened in Tier-3 cities; and (4) malls that are managed by a strong retail management team.

CR Land and Joy City have a greater number of malls falling into the above categories. In addition, both companies generated relatively high yield on costs, given their management expertise. CR Land has a wide range of malls that could benefit from the retail sales recovery in the luxury segments and enjoys first-mover advantage in lower-tier cities, while Joy City could leverage its property fund platform to expand its national footprint. Both also have a high percentage of turnover rents and could ride the rebound in retail sales in their malls. Therefore, we expect both to potentially benefit from the establishment of C-REITs to quicken their asset turnover and expand their national footprint. In the US, the largest REIT in terms of market cap is Simon Property, which focuses on retail malls.

CR Land and Joy City to benefit

Diagram 35. Top retailers will continue to see growth momentum

6.4%

11.6%

14.6%

10.3%

16.9%

6.0%

9.1%

4.8%

9.5%

15.0%13.7%

7.7%10.3%

15.8%

10.6%

13.5%

9.2%9.9%

7.8%

3.5%5.5%

8.8%

-0.6%

2.1%

-7.0%

1.7%

-0.2%-2.2%

1.4%

-0.3%-0.1%

0.8%0.4%

1.8%0.6%

-0.3%

0.4%2.0%

0.3%

-1.4%-1.1%

-0.8%-1.2%

-5.6%-6.2%

-2.3%

2.9%

-4.1%

-0.2%

1.3%

-0.8%

2.3%1.6%

2.6%5.1%

1.6%3.1%

5.5%4.1%

2.8%4.9%

7.1%

3.2%4.5%

-10%

-5%

0%

5%

10%

15%

20%

Jan

-Feb

201

2

Ap

r 20

12

Jun

201

2

Au

g 2

012

Oct

201

2

Dec

201

2

Mar

201

3

May

201

3

Jul 2

013

Sep

201

3

No

v 20

13

Jan

-Feb

201

4

Ap

r 20

14

Jun

201

4

Au

g 2

014

Oct

201

4

Dec

201

4

Mar

201

5

May

201

5

Jul 2

015

Sep

201

5

No

v 20

15

Jan

-Feb

201

6

Ap

r 20

16

Jun

201

6

Au

g 2

016

Oct

201

6

Dec

201

6

Mar

201

7

May

201

7

Jul 2

017

Sep

201

7

Source: China Nation Commercial Information, DBS Bank


Upper upscale/luxury hotels: Growth rebound Hotels have been the least favoured assets among commercial properties, given the complexity of operation and oversupply concerns. Developers generally do not have the operating expertise to run luxury hotels and usually outsource the day-to-day operations to international hotel managers. Hotels’ revenue is mainly derived from end-user demand and will directly benefit from consumers trading up in China.

Demand for luxury hotels has been affected by government’s anti-corruption campaign since early-2014, but has been picking up in top-tier cities lately, driven by private demand. We are seeing better-than-expected improvement in occupancy. Some traditional business hotels in Tier-1 cities saw occupancy of over 80% in 1H17, as rooms were filled by private/tourism demand on weekends.

Hotel supply has been under control over the past several years as hotel investments from developers or local governments have become more rational, reflected in the declining number of hotels since 2014. In addition, the central government is encouraging the development of long-lease rental apartments and allowing the conversion of commercial projects to long-lease rental apartments (hotels should be the major beneficiary). Our channel check reveals that several PE funds are actively acquiring hotel assets and turning them into long-lease rental apartments. Developers are also turning their hotels into long-lease rental apartments or senior housing. Hotels in core areas in Beijing and Shanghai may also be redeveloped into offices (discussed in the ‘The rise of active property asset management’ section on page 34). This could be evidenced by the growing number of hotels closures over the past three years.

Diagram 36. China shopping centre development index

Source: CBRE, DBS Bank

Management is usually outsourced

Demand is picking up

Our analysis shows that the oversupply risk is overstated for several reasons


41

We have compared the revenue of all hotels with that of 5-star hotels. As shown in the chart below, 5-star hotels’ revenue is more resilient than that of the whole industry. Despite a decline in overall hotel revenue, 5-star hotels’ revenue has been picking up. Moreover, occupancy in Tier-1 cities has returned to c.75%. Based on STR Global’s study, luxury hotels’ ideal occupancy rate is 75-85% to generate the best gross operating profit (GOP). Therefore, we think the high occupancy in Tier-1 cities should gradually translate into higher average daily rate (ADR), resulting in faster growth in revenue per available room (RevPAR).

Hotels’ operating margin is relatively low compared to that of other commercial properties. GOP margin for well-managed hotels is usually 35-40%. Hotel managers usually charge 4-8% of revenue, based on operating performance. Therefore, landlords’ EBITDA margin for well-managed hotels is around 30-35%. Five-star hotels usually have a high operating leverage as they need to keep hotel staff to maintain service quality even during tough periods and it takes time for them to train staff. The high operating leverage and recovery in revenue could lead to a larger rebound in EBITDA. We have run regressions on hotel EBITDA and hotel revenues for the mature hotels of Jinmao (three hotels in Beijing/Shanghai/Shenzhen over the past eight years) and Shimao (three hotels in Shanghai over past nine years), respectively. Both correlations are 99% and slope is 2.6x and 2.0x for Jinmao and Shimao, respectively, which means EBITDA growth is usually above 2x of revenue growth.

Hotels are usually booked under “property plant and equipment”, with depreciation over time and there is no revaluation. Therefore, their book value does not indicate their true economic value. In addition, mature hotels are usually located in prime locations. Potential redevelopment of existing hotels into office space could also unlock the value of these hotels. We have seen this trend play out in Beijing and Shanghai.

Hotels in the US also suffered from oversupply in the early 1990s. But a supply slowdown led to a gradual recovery in profitability. In addition, the emergence of modern equity REITs has contributed to fast market consolidation, resulting in a larger number of hotel rooms being owned/controlled by fewer landlords/operators. This, in turn, has led to a continuous increase in RevPAR, except during the two “Black Swan” periods (9/11 and the housing/banking crisis). Hotels in China will likely follow suit.

Jinmao Hotel is well-positioned to ride the recovery in the hotel business and should be a major beneficiary. Guangzhou R&F currently owns 18 luxury hotels in key Tier-1 and -2 cities and is taking over 77 hotels from Wanda. We think it also could be a potential beneficiary.

Five-star hotels’ revenue is resilient

Larger rebound in EBITDA

Mature hotels are usually

undervalued


Diagram 37. No. of hotels and hotel closures in China

Diagram 39. Beijing 5-star hotels’ ADR and occupancy

Diagram 38. 5-star hotels’ revenue is more resilient (RMB mn)

Diagram 40. Shanghai 5-star hotels’ ADR and occupancy






43

Diagram 41. RevPAR in the US has kept YoY growth

Diagram 43. Value enhancement process

Diagram 42. Ideal occupancy and maximum GOP in the US

Based on 2015 HOST Almanac data of 5,000+ hotelsSource: STR Global, Hotel News Now, DBS Bank

Source: STR Global, Hotel News Now, DBS Bank

Source: DBS Bank

Class Maximum GOP

Ideal Occupancy

Luxury 40.2% 82.4%

Upper Upscale 39.7% 84.6%

Upscale 47.9% 75.1%

Re-tenantingimproves tenant mix

Renovation/repositioningupgrade and

refurbishment

Redevelopmentchange asset use/type

Value enhancement

Identify underperforming

assets

Enhance rental return and capital

value


The Rise of Active Property Asset Management

In anticipation of C-REITs, there has been a rise in active property asset management. This, coupled with divergent returns of commercial properties, could speed up the conversion/redevelopment of hotels and retail malls into offices, especially in Beijing and Shanghai.

Office rents in Beijing are the highest among mainland cities. Rents of prime offices in core Beijing are 19% higher than that in Shanghai. Yet, other assets in Beijing may not be superior to assets in other Tier-1 cities. For example, RevPAR for 5 -star hotels in Beijing averages RMB 629/night, 11% lower than that in Shanghai. Based on our rough estimate, EBITDA per square-metre-per-day could rise from RMB 3.07/sqm/day to RMB 10.22/sqm/day if a 5-star hotel is converted into offices in Beijing. Although the redevelopment is dependent on the suitability of the structure and conversion costs, the gap between returns of different asset types in Beijing could provide impetus for redevelopment.

A few PE funds, such as Go High Fund (高和資本), Z River Capital (中融長河), and EBP Capital (首譽光控), are actively looking for underperforming assets in Beijing and Shanghai and seeking redevelopment/asset enhancement opportunities. Examples of malls that have been turned into offices in Beijing include COFCO Plaza (中糧廣場), Crosspoints (星街坊), Pacific Century Place (盈科中心), and ZK Plaza at Big Bell Temple (中坤廣場). According to COFCO, the rental rates of its COFCO Plaza in Beijing is expected to rise from RMB 4.5/sqm/day to RMB 12/sqm/day after the conversion. Meanwhile, EBITDA per sqm per day

Redevelopment more likely in Beijing

Examples in Beijing

Diagram 44. Comparison of EBITDA per sqm for 5-star hotels and Grade-A offices in Beijing and Shanghai


5-Star hotel ADR in 8M17 Assumed room revenue as % of total hotel

revenue

Assumed GFA per room (total

GFA / no. of rooms)

EBITDA margin EBITDA per sm

Rmb/night/room

% sm % Rmb/day/sm

Beijing 592 45% 150 35% 3.07

Shanghai 671 45% 150 35% 3.48

Grade-A office Rental rate EBITDA margin EBITDA per sm

Rmb/day/sm % Rmb/day/sm

Beijing 12.47 82% 10.22

Shanghai 10.48 82% 8.59


45

could see larger enhancement. Examples of redevelopment of hotels or partial conversion of hotels to office space include Intercontinental Beijing Financial Street (洲際金融街酒店), Beijing Marriott Hotel (萬豪酒店), New Century Grand Hotel Beijing (開元酒店), and W Hotel (disposed of by Joy City on 8 December 2017).

Shanghai also experienced the same trend. Shanghai JC Mandarin Hotel (锦沧文华酒店) started redevelopment in 2H16 and is expected to be converted into offices in late-2018. Blackstone also acquired Xuebao Mansion (雪豹商厦) in late-2016 and plans to convert it into offices.

Apart from conversion into offices, new policies are also encouraging the conversion of commercial land/properties to residential uses, such as long-lease rental apartments and senior housing. This should benefit hotels and retail malls as the existing/future supply will be diluted by the conversion.

Instead of developing commercial assets, some developers have begun to acquire existing underperforming assets and repositioning/tenanting these assets to enhance returns. Joy City has kicked off its property fund to seek acquisition opportunities. Sino-Ocean has also formed a property fund to acquire office assets in Tier-1 cities.

Furthermore, some developers have changed a part of their mall space (usually the upper floors) into co-working space. CapitaLand announced that it has offered space in its malls across China to UrWork, a Beijing-based co-working space operator. The first collaboration began with a 4,100-sqm space in CapitaLand’s mall in Wuhan. Longfor has also ventured into the co-working space business with its Beijing Paradise Walk and Shanghai Paradise Walk malls under its self-developed brand, EasyWork. The rationale is (i) rental rates will decrease substantially for every additional floor, which makes co-working operations affordable, and (ii) co-working space at the upper floors of a mall could also bring in additional foot traffic and potential retail sales.

While not all the structures are suitable for conversion, the ongoing redevelopment trend should change the supply-demand dynamics and narrow the gap between the returns

Conversion of commercial properties

Repositioning and tenanting

Diagram 45. Comparison of EBITDA per sqm of COFCO Plaza, pre-/post-redevelopment

Source: DBS Bank

Rental rate EBITDA margin EBITDA per sm

Rmb/day/sm % Rmb/day/sm

Retail rate before redevelopment 4.50 66% 2.97

Expected office rate after redevelopment 12.00 82% 9.84


of different asset types. Thus, we expect hotels and retail malls to see improving supply-demand dynamics, while offices will likely face additional supply from redevelopment.

Which Developer Will Benefit From the Establishment of C-REITs?We expect four types of developers/companies to benefit more from the establishment of C-REITs:

(i) Those with a high proportion of commercial properties and hotels, as REITs are all about commercial properties.

Diagram 46. Attributable investment property book value/valuation as a percentage of market cap

Diagram 47. Attributable investment property book value/valuation as a percentage of enterprise value (market cap + total debt − cash)

Source: Company, DBS Bank* excl. the latest disposal

Source: Company, DBS Bank* excl. the latest disposal


47

In terms of attributable investment property book value (1H17) as a percentage of market cap, Shui On Land tops the table. But if we factor in net debt and look at attributable investment property book value as a percentage of enterprise value (market cap + total debt − cash), SOHO leads. Along with their investment property valuation methodology on the book (namely capitalisation rate used and whether property under development is revalued), we believe the key beneficiary should be SOHO, Joy City, Yuexiu Property, Jinmao Hotel, CR Land, and Sino-Ocean.

(ii) Developers with businesses encouraged by the government – PPP projects, long-term rental apartments, and senior housing – as these areas are expected to be the first to see a breakthrough in REITs.

First movers in long-lease rental apartments, including Vanke and Longfor, could benefit from the establishment of C-REITs to grow their portfolio and unlock the value of their assets. In the US, the largest residential REIT operates 77,000 apartment units in total, rakes in US$2.4bn in revenue, and has a US$24bn market cap. If Vanke and Longfor can clinch their respective targets, the number of units under management could reach and even exceed the scale of top players in the US. Based on 10x P/S, their target acquisitions could add c.10% to their market cap by 2020.

First movers in senior housing, including Sino-Ocean and Poly CN, could benefit from the establishment of C-REITs to quicken their expansion and strengthen their domination in the sector. China Fortune Land Development, one of the largest PPP operators, should also benefit from the government’s supportive policies.

Local SOE developer, Yuexiu Property, is widely expected to kick off the first C-REIT, as it is the first to have an offshore REIT platform and has experience in structuring REITs. In addition, local governments may offer tax incentives to support local financial initiatives.

(iii) Companies with a property fund business, such as Vanke, Sino-Ocean, and Joy City, whose existing structures could be easily converted into C-REITs in the future.

In our view, CMBS can keep growing rapidly, given its simple structure and how it could be of more benefit to private companies with low credit ratings and good-quality assets.

As mentioned, CMBS is supposed to replace investment loans for commercial properties. Therefore, the key motivation for CMBS is to save on interest costs. Therefore, we think SOEs, especially Hong Kong-listed ones, have less incentives to set up such products:

(i) SOEs, especially those owned by the central government (央企), have easier access to cheaper funding. The costs of their investment loans for commercial properties are usually on par with the benchmark rate or even lower. Based on our observation, the cost of CMBS

Onshore CMBS


or pre-REITs is more correlated to Shibor rates than PBOC benchmark rates. The reason China Jinmao kicked off the first CMBS in mid-2016 was the low funding rate of just 3.3% (Shibor was relatively low at 3.0% then).

(ii) Large SOEs such as COLI have access to cheaper offshore bonds or syndicated loans. Meanwhile, those bond covenants may restrict their commercial properties being used as collateral.

So far, majority of CMBS are issued by private developers. SOHO China, Shimao, Red Star, and Golden Eagle have issued CMBS/CBMN. A-share SOE developers like Financial Street and Poly CN have also issued CMBS.

CMBS could be more beneficial to private developers that have premium investment properties but lack a high credit rating.

Diagram 48. Return/yield of pre-REITs/CMBS vs benchmark rates

Source: Bloomberg Financial L.P., DBS Bank

Appendix


49

Taxes related to asset transfers in different countries

Country Transfer tax Stamp duty Deed tax Sales tax LAT Trade tax Income tax

China Tax base Transaction price

Transaction price

Transaction price

Depending on price and cost

Capital gain

Tax rate 0.05% 3% 5% 30-60% 25%

Applicable to REITs

nil nil nil nil Nil

Hong Kong

Tax base Transaction price

Capital gain

Tax rate 0.2%/3.75% for acquiring

equity stakes /properties

17%

Applicable to REITs

Nil Exempted

Singapore Tax base Transaction price

Capital gain

Tax rate 3.00% 18%

Applicable to REITs

Exempted Exempted

Japan Tax base Transaction price

Transaction price

Transaction price

Transaction price

Capital gain

Tax rate 4% 0.011-0.15% 5% 5% 20%/39% if held >5

years/<5 years

Applicable to REITs

1% Nil 2% Nil Nil

Australia Tax base Transaction price

Capital gain

Tax rate <=6.75% 45%

Applicable to REITs

Nil Capital gain distributed /

not distributed is fully/50%

tax exempted

US Tax base Transaction price

Capital gain

Tax rate 15-30%

Applicable to REITs

Nil Capital gain distributed is

exempted


UK Tax base Transaction price

Capital gain

Tax rate 1-4% 30%

Applicable to REITs

Nil Self-developed properties

holding <3 years is

subject to tax; otherwise tax

exempted

Germany Tax base Transaction price

Capital gain Capital gain

Tax rate 5% 9.1-19.7% 25%

Applicable to REITs

Nil Nil Exempted

France Tax base Transaction price

Capital gain

Tax rate 5% 33%

Applicable to REITs

Nil Capital gain distributed is

exempted

Country Transfer tax Stamp duty Deed tax Sales tax LAT Trade tax Income tax

Taxes related to asset transfers in different countries cont.

Source:“ Tax of Real Estate Investment Trusts” by Su Jiang & Huang Zhigang, DBS Bank


51

Taxes related to commercial property operations in different countries

Country Property tax Sales tax Land use tax Value-add tax Trade tax Income tax Income tax

China Tax base Original cost / rental income

Was 5.65% on revenue, but no more after

VAT reform

Revenue - deductible

items

Profit before tax

Capital gain

Tax rate 0.84% / 12% 6% for hotel and 11% for

other IPs

25% 25%

Applicable to REITs

Nil Nil Nil Nil

Hong Kong

Tax base Profit before tax

Capital gain

Tax rate 16.5% 17%

Applicable to REITs

Exempted Exempted

Singapore Tax base Profit before tax

Capital gain

Tax rate 18% 18%

Applicable to REITs

Profit distributed is

exempted

Exempted

Japan Tax base Property value Rental income Property value Profit before tax

Capital gain

Tax rate 1.4% 5.0% 0.3% 42% 20%/39% if held >5

years/<5 years

Applicable to REITs

Nil Nil Nil Profit distributed is

exempted

Nil

Australia Tax base Profit before tax

Tax rate 45%

Applicable to REITs

Profit distributed is

exempted

US Tax base Property value Profit before tax

Tax rate 1-3% 15-35%

Applicable to REITs

Nil Rental income

distributed is exempted


UK Tax base Profit before tax

Tax rate 30%

Applicable to REITs

Exempted

Germany Tax base Property value Profit before tax

Profit before tax

Tax rate 1-1.5% 9.1-19.7% 25%

Applicable to REITs

Nil Nil Exempted

France Tax base Property value Profit before tax

Tax rate 3% 33.33%

Applicable to REITs

Nil Profit distributed is

exempted

Country Property tax Sales tax Land use tax Value-add tax Trade tax Income tax Income tax

Taxes related to commercial property operations in different countries cont.

Source:“Tax of Real Estate Investment Trusts” by Su Jiang & Huang Zhigang, DBS Bank


53


55

Disclaimers and Important Notices

The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee.

The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof.

The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.

The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.


55

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