RESEARCH OF THE INNOVATIVE DEVELOPMENT PATTERN OF REITS IN CHINA

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1 RESEARCH OF THE INNOVATIVE DEVELOPMENT PATTERN OF REITS IN CHINA Yan Chun ZHANG 1, Meng Jun WANG 2, Ping CHEN 3 1. Civil and Architecture College, Central South Univ., Changsha, Hunan, China. 2. Civil and Architecture College, Central South Univ., Changsha, Hunan, China. 3. China Merchandise Securities, Shenzhen, China Abstract: Through the analysis of characteristic of REITs and contrasting the selective development patterns in China, combining the minimum legal system obstacle and possible operation, an innovative development pattern that chooses the investment bank s special purpose asset management scheme as the development pattern of REITs in China is brought forward. It is the pattern with possible operation and without legal system obstacle in the present circumstance. In addition, the paper designs key implementations and relative policy suggestions for the investment bank s special purpose asset management scheme of REITs. Keywords: REITs; real estate finance; investment bank s special purpose asset management scheme; contract industrial fund 1 Introduction Along with fast development of the modernize construction and civilization progress in our country, the real estate industry is expanding fast with average growth rate of 37.8% per year, and it is expected to keep the pace in the following years. In present, about 70 real estate funds come from the support of bank s loans. The simplex financing channel accumulates so many real estate loan risks that affects our country s safety of the finance system greatly. How to open up the financing channel and choose appropriate finance portfolios to change the situation of bank risk in present risk sharing mechanism is an important issue today. As a mature real estate securitization product in the international markets, Real Estate Investment Trusts (REITs) has been developed for more than forty years in America, and popularized in several countries as well. REITs not only can provide the financing channel besides banks, but also can reduce the risk due to the high proportion on real estate loans. In addition, they can help the development of low risk security products, making the product structure more rational in the financial market. The development trend of Chinese real estate and development experience of REITs in the mature markets provide favorable conditions for the development of REITs in China. Therefore, researching the innovative development patterns of REITs in our country has a significant academic and realistic meaning. There are lots of research and discuss of REITs by internal experts, but most of them are concentrating on the concept, introduction of operational patterns in the mature markets and the feasibility of REITs in China(Li 2005; Song 2005; Li et al 2006). In addition, although few experts also do some research about the development patterns of REITs in China(Ding et al 2006; Zhuang et al 2005; Mao 2004), the development paths based on their patterns still have some legal and system obstacles, and require the supervise department to set legislation, so it is difficult to operate. This paper, based on the analysis of characteristics of REITs, through contrasting the selective development patterns, and combining the minimum legal system obstacles and possible operation, brings forward that choosing the investment bank s special purpose asset management scheme is the possible development pattern of REITs in China. It is the only pattern with possible operation and without the legal system obstacle in the present circumstance. In addition, the paper designs the key implementation and relative policy suggestions for the investment bank s special purpose asset management scheme of REITs. 2 Analysis of Possible Development Patterns of REITs in China From a long view, the development of REITs should base on the support of government legislation. While, in a short time period, because of the obstacle of legislation, we need make some innovation in the pattern.

2 Whatever the kind of the pattern is, the basic characters of REITs as a product must be kept(dong 2005; HKSFC 2005) and then the pattern of minimum obstacles of legislation, possible operation and maintaining the management characters of REITs is chosen. 2.1 Analysis of possible development patterns Based on the relative legislation of our country s real estate industry and securities industry, there are four possible ways to develop REITs presently Pattern of investment trust scheme Considering the structure demand, REITs is a product of mutual fund investment scheme. So the investment trust scheme can satisfy this kind of demand. It can establish the trustee and asset management function respect to the structure. The investment trust scheme can insure the implement of the investment and profit distribution strategy of REITs. At the same time, it can effectively protect the holders benefits. However, due to the restriction of relative legislation, eg. the single investment trust scheme can not exceed 200 fiduciary s fund trust contracts, and the minimum sum in one contract should be RMB50000yuan, it is hard to solve the problem such as small size of the scheme, difficulty in collection, limits on liquidity, and short term of the scheme. So it is hard to develop for REITs market Pattern of corporate type fund The REITs of the real estate corporation is based on the Company Law and Security Law to establish the legislation of REITs, and making the regulation of company structure, management range, asset requirements, debt proportion to definite the REITs company s investment object (maintain and manage real estate) and earning distribution (gross earning distribution proportion) requirement. But this kind of companies requires the legislation of REITs by the government so that they can operate Pattern of contract type fund The REITs of contract type fund is similar with the mutual fund in our country, except that REITs is a type of industry fund. This kind of development pattern is very hard to implement because of our country s law is not integrated for its expansion. In present, the relative law of investment fund is the Mutual Fund Act, and it is in allusion to the type of mutual fund, not the type of industry fund. Therefore, although the structure and operation of REITs which based on the real estate investments are similar with the mutual fund, the Mutual Fund Act is not appropriate for the development of REITs products Pattern of investment bank s special purpose asset management scheme It is the first time in China that this kind of pattern of REITs is proposed by the authors of this paper. The investment bank s special purpose asset management scheme is the same with the investment trust in the structure of law and the operational mode. The difference is that the latter is issued by the trust company which acts as a invest management institution, while the former is issued by the investment bank which acts as a invest management institution. Under the pattern of investment bank s special purpose asset management scheme, the problems of small size of the scheme, difficulty in collection, limits on liquidity, and short term of the scheme with the investment trust scheme can be eluded. In addition, it can maintain the management characters more properly. Comparing the four kinds of patterns mentioned above, the investment trust is according with the demand of REITs product s structure. However, in the existing law system, it has to break through considerable restriction (fund size, liquidation, and deposit term) which brings lots of difficulties. Corporate type REITs and contract type industry fund have the advantage in operational management, and they can make the best of

3 especial service of professional real estate management companies to enhance the asset management capability. Furthermore, it is also difficult to implement because of the absence of relative industry fund laws. Therefore, the investment bank s special purpose asset management scheme has the lowest restriction of the law, and it is the only pattern which can form a minimum cost and highest possibility considering the international market s experience and Chinese realistic situation. 2.2 Feasibility of the pattern of investment bank s special purpose asset management scheme It accords with the laws and regulations In 28th, December, 2003, Chinese Securities Regulatory Commission promulgated the Temporary Act of Investment Bank Client Asset Management Business, the 11th rule in this Act has definitude prescribed that investment banks can engage the special purpose asset management scheme for their clients. According to the explanation of Chinese Securities Regulatory Commission, the business of the special purpose asset management scheme is quite extensive so that we can use the special purpose asset management scheme as the possible operational pattern for REITs. The investment range is specified by the contract of the special purpose asset management scheme which can only be invested in real estate. The scheme must issue in terms of the Temporary Act. In this way, the REITs products not only can avoid the obstacle of law in existence, but also can save the cost and time of the product innovation. Furthermore, the REITs products can solve the problem that most asset management schemes in the capital market are invested to stocks or bonds and create different investment style with the mutual fund It accords with REITs property The investment bank s special purpose asset management scheme is actually based on the relationship of the trust law. It is a special kind of trust. From the tropism of its intrinsic value, the special purpose asset management scheme is utilized by the idea of the third party management. It follows the rules of preference of efficiency, fairness and assembling capital, through the specialized management, and portfolio investment to reduce the risk and make the highest profit for the investor as possible. Therefore, from the property of law, the investment bank s special purpose asset management scheme provides the genius property of REITs It accords with the product characters of REITs It can be prescribed in the asset management contract for the product characters of REITs to accord with the product rules of REITs worldwide, such as the structure of operation, the policy of investment, the rule of income distribution, and the policy of information disclosure. Comparing with the pattern of investment trust scheme, the investment bank s special purpose asset management scheme is not restricted by the regulation of no more than 200 contracts in the investment trust law. Therefore, the investment bank s special purpose asset management scheme can avoid the problem which is a limitation in the investment trust It can be traded in the exchange center After the issue of the Temporary Act of Investment Bank Client Asset Management Business, Shanghai Stock Exchange and China SD&C both make a progress of rules of the trading register, and settlement for the issue of the special purpose asset management schemes. Therefore, considering utilizing the present exchange condition, stinting the cost of trading, enhancing the liquidity of products, and following the trend of REITs in the international financial markets where REITs product are mainly traded in the exchange center, the special purpose asset management schemes for REITs can be traded in the exchange center.

4 2.2.5 It can use the outstanding operational experience of investment banks After the issue of the Temporary Act of Investment Bank Client Asset Management Business, indicated by the China Unicom CDMA Network Lease Fee Income Scheme which was designed by the China International Capital Corporation Limited, many investment banks in China have issued large number of special purpose asset management schemes which can be traded in the exchange center also. It is estimated that the size of the investment bank special purpose asset management schemes will reach 30 billion Yuan by the end of Therefore, the successful experience of special purpose asset management scheme provides a useful reference for REITs and brings up many specialized professionals. Furthermore, the abundant and outstanding client groups also serve as a base of clients for the issue of REITs. 3 Main Design Points of REITs Using the overseas design experience of REITs product for reference, combined with operational requirements of investment bank s special purpose asset management scheme in China, points of REITs product under the pattern of investment bank s special purpose asset management scheme have been designed. 3.1 Operational patterns According to relative law and regulations, the investment bank s special purpose asset management scheme adopts contract type structure. In addition, as the cycle of real estate investment scheme is generally longer, and stronger financial stability is required, and considering the complexity of the frequent assets value assessments in REITs,s period of validity, closed-end funds suits it more than open-end model in terms of its development. Therefore, contract type, closed-end funds of operation are to be adopted for REITs. 3.2 Organization structure Referring to the experience of REITs development in Asian countries and regions, organization structure takes investment bank as principle part of issuance and management, emphasizing the role of the trust bank meanwhile. The relationship among investors, management institution(investment bank) and trustee (trust bank) is cleared through contract: investment bank issues and manages REITs; trust Bank supervises the operating of the investment bank so as to ensure the interests of investors, and keeps assets in the name of REITs; investors perform the highest decision-making power by the general assembly of holders. General Assembly of Holders Major Decisions Return on Investment Supervision Expense Trust Expense Entrusted Management Investment Bank Consulting Expense Management Duties Ownership REITs Revenue Trust Assets Trust Bank Property Companies Property Figure 1 Organization Structure of REITs in Pattern of Investment Bank s Special Purpose Asset Management

5 Scheme From the perspective of risk control and professional business, investment bank can outsource its property management functions to property management company with adequate resources, professional technical knowledge and good reputation. At the same time, monitoring mechanisms should be established so as to monitor the activities of outsourcing business continuously, and make the property management company bear ultimate responsibility for the management of REITs. The organization structure is illustrated in Figure Scale and deposit term The infancy of using the pattern of investment bank s special purpose asset management scheme to develop REITs is mainly tryout. The scale should not be too large, an appropriate size is around one billion yuan. At the same time, considering investment properties of real estate schemes and through the experience from closed-end funds, most suitable term should be five to ten years. 3.4 Investment policy Considering the elements that determine the characteristics of REITs products, definition of core investment policy of REITs is the key factor to the success of REITs. Using the successful experience of other countries and regions for reference and considering present situation in China, core investment policies for REITs are designed as follows: (1) In light of the reality that the domestic real estate industry is not yet regulated, the scheme shall only invest in real estate that have been developed and put into use at home and have a stable source of return, rather than those that are under construction or the completed ones without revenue guarantee. (2) Investment ratio in real estate: at least 75% of assets must be invested in real estate and assets that are related to real estate. (3) Income ratio from real estate: the ratio of return of investments in real estate to the total should be higher than 75%. 3.5 Property valuation The investment bank s special purpose asset management scheme for REITs shall appoint professional property assessment agencies to value the real estate of the scheme fairly, timely and independently. Then the valuation reports shall be published regularly, which contributes to forming reasonable market pricing of REITs and is also the basis of the transactions prices of REITs in exchanges. Valuation methods could be combined with funds from operations methods (FFO) and the fair market value methods (FMV). Assessment agencies must be independent of trustees, managers and property management companies of REITs. 3.6 Costs and earning distribution In light of the relatively stability of REITs in terms of return on investment it can be required in the contract that 90% of net income of REITs be allocated to investors as dividends. 3.7 Information disclosure To strengthen the supervision and protect the interests of investors, regular and irregular information disclosure shall be taken in the investment bank s special purpose asset management scheme for REITs. Information disclosure documents shall include recruitment brochures, annual reports, interim reports, provisional notice etc.

6 3.8 Liquidity arrangements Currently, according to the provisions of the relevant regulations, bulk transactions of the investment bank s special purpose asset management scheme can be carried out in exchanges. Therefore, in light of the use of the existing trading platform, transaction cost savings, and the increase of product mobility, as well as the mainstream that REITs products in global market usually go public in the exchanges, investment bank s special purpose asset management scheme for REITs can be traded in Shanghai Stock Exchange. 3.9 Product supervision In view of the whole world, REITs products developed on the basis of real estate trust generally must accept the supervision of the securities regulatory bodies, and follow the general regulatory principles of the stock market. Given the situation that investment bank is the main body in issuance under the pattern of investment bank s special purpose asset management scheme for REITs and the products shall be transacted at exchanges, we propose of a uniform regulation by the Securities and Futures Commission(SFC) and a assistant supervision by the corresponding stock exchange according to the legal nature of REITs and the identity of the transactions in stock markets. 4 Proposals on relevant policy In order to start up and popularize the investment bank s special purpose asset management scheme for REITs, corresponding policies to support the scheme are given from the following aspects. 4.1 Develop preferential tax policies To ensure a sound development of REITs under the pattern of investment bank s special purpose asset management scheme, corresponding systems should be perfected, including the property registration system, financial accounting system and the tax system especially the tax system consistent with REITs. According to the experience from the USA, preferential tax policies can greatly stimulate the enthusiasm of investors and stimulate the development of REITs. Currently, there is still no clear tax provisions related to special purpose asset management scheme. So we suggest developing tax relief policies specifically for the REITs under the pattern of investment bank s special purpose asset management scheme according to the U.S. tax code, to create a good tax environment for the development of REITs. 4.2 Creating conditions to foster institutional investors In the United States, a large part of the funding source of REITs comes from institutional investors. Funds from institutional investors such as insurance funds, pension funds, open-end funds and others are of large quantity and quite rational, and is able to provide a stable source of funding for REITs. Currently, in China, insurance funds, pension funds and open-end funds haven t yet been liberalized to investment bank s special purpose asset management scheme, which is very unfavorable for the development of REITs. Therefore, efforts should be made to liberalize policy restriction as soon as possible, allowing these institutional investors investing the investment bank s special purpose asset management scheme for REITs, as well as to speed up fostering such institutional investors. 4.3 Speeding up the training of REITs professionals The operation of REITs involves a number of markets and many areas like real estate, funds, securities, legal, auditing, asset evaluation and so on, so it requires a team that is professional, high-level and high-quality, and human resources will also be an issue requiring immediate solution in the development of REITs in China. Efforts must be made to train and form a team composed by a group of professional, versatile and high-quality

7 talents that are proficient in the fund business and familiar with the real estate market and financial market to meet the demand of the market and all investor parties. And at the same time, we must actively promote the building of service-type talents like lawyers, accountants, auditors, evaluators that is indispensable to the REITs business. 4.4 Revision of mobile institution arrangements Currently the biggest problem of special purpose asset management scheme in liquidity arrangements in the secondary market is that as a result of bulk transactions, the product transaction is limited to institutional investors, while ordinary investors could not participate. Therefore, reviving relevant regulations, enhancing the mobility of REITs special purpose asset management scheme and expanding the scope of investors participation is the essential elements in promoting REITs development under the investment bank s special purpose asset management scheme. References Ding X.Y., et al. (2005). The international comparison on product design of REITS and experience to China. Reform, 2005(12): Dong C.S., (2005). Analysis on product superiority of real estate investment trust funds. Chinese Real Estate, 2005(5): Hong Kong Securities and Futures Commission (HKSFC) (2005). Code on real estate investment trusts. June 2005: Li J.F., (2005). Research on real estate trust funds in the United States and inspiration for China. Study of International Finance, 2005(1): Li R., et al. (2006). The state of development of the US real estate investment trust fund and its inspiration for China. Finance and Economy, 2006(4): Mao Z.R., (2004). Listed real estate fund development study. Report of Study on Shenzhen Stock Exchange, Sep. 20, 2004: Song L., (2005). The state of development of the US real estate investment trust fund and its reference meanings. Chinese Real Estate, 2005(3): Zhuang W., et al. (2005). The research of workable REIT pattern of China. Northern Economy and Trade, 2005(3):