By Michele Lerner

Since Hong Kong established its REIT rules in August 2003, Hong Kong REITs have hit the market running and are generating excitement for investors and property owners. There are now four REITs in Hong Kong with a total market capitalization of $6.2 billion, as of May 2006. Hong Kong market watchers anticipate further expansion of the country's REIT market, with demand remaining high and developers introducing new REITs in the future.

In the fourth quarter of 2005, three REITs were launched in Hong Kong with a combined total market capitalization of $3.56 billion. Link REIT, the world's largest REIT IPO to date at $2.8 billion, consists of Hong Kong retail properties and car parks, along with formerly government-owned housing. Prosperity REIT, with an IPO of $346 million, owns Hong Kong commercial property, while Guangzhou Investment Co. (GZI REIT), established by a Chinese development company, is the world's first China property trust investing in office buildings, with an IPO of $394 million.

A fourth REIT, Champion REIT, was launched in the second quarter of 2006, with an IPO of $808 million. This Hong Kong REIT is the first to have a single prime office building in the central business district.

"When the first three REITs in Hong Kong were listed, the response from investors was very good," says Clara Lau, senior vice president, Corporate Finance Group, Moody's Asia Pacific, Ltd. "Investors have developed a pretty strong appetite for REITs in Asia. Six more REITs are rumored or confirmed to be in the pipeline to be listed later this year."

Lachlan Gyde, executive officer of the Asian Public Real Estate Association (APREA), shares this optimistic outlook on REITs in Hong Kong.

"My feeling is, given that the GZI REIT was so heavily oversubscribed, a large appetite for REIT products exists with retail investors. Institutional investors also are keen to see the Asian REIT market grow and mature and they will support REIT IPOs where the fundamentals are sound," Gyde says.

Chris Reilly, CFA, director of property in Asia for Henderson Global Investors Limited and president of APREA, thinks investors in Hong Kong will continue to demand the low-risk, high-yield characteristics of REITs.

"Recent IPOs suggest demand remains strong, and there is likely to be more issuance in the Hong Kong REIT market in the quarters ahead, as domestic property developers issue REITs from their investment portfolios," Reilly says.

Making an Impact

Link REIT's impact has been particularly impressive. Lau says its success has increased local knowledge of REITs and proven their viability in Hong Kong. Link REIT includes car parks and retail locations that were previously owned by the Hong Kong Housing Authority. The introduction of Link REIT was delayed initially by a lawsuit from tenants in government housing who challenged the legality of the government selling assets. The lawsuit was resolved in favor of Link REIT and the IPO was able to continue.

"The Link REIT, because of its size and strong performance, has demonstrated to issuers and investors alike that REITs in Hong Kong are a profitable real estate alternative. It has also set a pricing and yield benchmark to some extent," Reilly says. "The Link REIT was a very big issue (approximately $2.8 billion) and it has performed extremely well, currently up around 70 percent in price terms in a relatively short period of time."

While Link REIT's launch was inspiring, GZI REIT's entrance into the market as the first REIT to own property in mainland China also had a significant impact. According to Reilly, GZI REIT was 74-times oversubscribed by institutional investors and nearly 500-times oversubscribed by the Hong Kong public, in other words, the demand for the IPO appreciably exceeded the number of shares issued.

"The investors were extremely receptive to GZI as both retail and institutional traunches were substantially oversubscribed," Gyde says. "It's hard to predict the future, but, given experiences globally and regionally, the future should be positive for GZI provided the REIT can perform to investors' expectations and grow through yield accretive acquisitions."

Comparison of Key Regulatory Requirements in Singapore, Hong Kong and U.S.
Regulatory requirements	Singapore	Hong Kong	United States
Manager	External	External	External
Manager licensing agreements	To be introduced	Yes	Yes
Overseas investment allowed	Yes	Yes	Yes
Partial ownership of properties allowed	Yes (through SVPs)	Yes	Yes (No more than 50% value)
REITs allowed to develop Invest in property developments	Yes (10% including development activities within REIT)	Yes (10%)	Yes
REIT allowed to participate in Development activities	For properties to be held by REIT	No	No
Investment outside real estate allowed	Yes	No	Yes
Leverage restrictions (includes deferred payments in Singapore)	Yes 35% (60% if rated)	Yes (45%)	No
Pass-Through Entity and Trust Withholding Tax	Yes	Profits/property tax at REIT level (but N/A to overseas property)	Yes
Mandatory distribution requirements	No (but 90% required for tax pass-through)	Yes	Yes
Unit holder notification requirements	Yes	No	No
Takeover regulation applicable	No	No	No
Performance fees permitted	Yes	Yes	No

China's Potential

Lau mentions that the investment return for GZI has been on the low side, but that it is perceived as a growth mechanism for people who are bullish on investing in China. In June 2005, the Hong Kong Securities and Futures Commission (SFC) removed earlier restrictions on REIT investments overseas, allowing for the introduction of GZI in the market. Future REITs are expected to hold properties overseas and in Hong Kong.

"China is a huge source of potential REIT product and the stock of office, retail and industrial/logistic premises in Hong Kong is significant. Practitioners from other markets in Asia which have no REIT legislation may also seek a Hong Kong listing. However, most other Asian markets now have the regulatory framework in place for REITs. China is the obvious exception," Reilly says.

The SFC REIT code changes adopted in June 2005 also raised the maximum borrowing ratio from 35 percent to 45 percent of the total gross asset value of each REIT, which may have an impact on REIT growth in Hong Kong.

"Moody's view is that it should be market forces which determine the maximum debt ratio, not the government," Lau says. "In Australia and the U.S., there is no maximum. In the medium term, these restrictions will slow property acquisitions and the growth of assets, but in the long term, there won't be as much of an impact because REITs can increase their revenue with renovations and rental increases."

Gyde says that well-managed debt allows for growth and better returns to unit holders.

"As the REIT market matures in the region, the market will decide what level of borrowings they are comfortable with," he says. "The decision to raise the ratio is positive but the gearing controls are still greater than in competing REIT centers."

Media speculation about the future of REITs in Hong Kong has focused on the creation of REITs as spin-offs from parent companies.

"REIT spin-offs theoretically shouldn't be any different than any other REIT, but it depends on the type of properties companies choose to place in the REIT portfolio," Lau says. "There's been some suggestion that some companies might choose to put their second-class assets in a REIT, but it's unlikely that they would be able to attract many investors that way."

Reilly agrees, "These REITs ought to be no different from existing REITs. Rising asset prices means yields are low in Hong Kong, so there has been some speculation that they will need to be structured in order to offer sufficiently attractive yields."

In the SFC's March 2006 "Dr. Wise" column, the Hong Kong government advised investors to be cautious about investing in REITs because of the intense speculation about future REITs creating market volatility.

"At one point, it seemed that a listed property company need only announce the intention to spin off a REIT for its stock price to benefit. There was a little concern over this issue by regulators," Reilly says. "Frenzied interest in IPOs is a common phenomenon in Hong Kong for well-anticipated deals."

The success of the Link REIT has raised investors' expectations for other REIT issues, Reilly says. "We would point out that the REIT vehicle itself is no guarantee of success, and encourage investors to be selective and to judge each offering on the quality of the management, the assets, the price, and, ultimately, the likely distribution growth."

Reilly and Henderson Global Investors anticipate continued strength in the REIT market in Hong Kong.

"At Henderson Global Investors, we see both cyclical and structural changes supporting REITs in Asia," Reilly says. "The ongoing recovery of the property market in both China and Hong Kong will continue to attract investors both in terms of returns and diversification. Furthermore, we anticipate an increase in allocation towards real estate by institutional investors driven by, among other things, aging populations and the impact this will have on the pension industry. In this environment, REITs are likely to be increasingly in demand by investors seeking capital protection and a decent income return."