A Comparative Analysis of Apartment Reits in US and China: an Examination of Challenges and Opportunities

A comparative analysis of apartment REITs in US and China: an examination of challenges and opportunities

Zixiao Yin Bachelor of Architecture Master of Urban Planning Tsinghua University (2016)

Submitted to the Department of Urban Studies and Planning in partial fulfillment of the requirements for the degree of

Master in City Planning

at the

MASSACHUSETTS INSTITUTE OF TECHNOLOGY

February 2019

The author here by grants to MIT the permission to reproduce and to distribute publicly paper and electronic copies of the thesis document in whole or in part in any medium now known or hereafter created.

Author______Department of Urban Studies and Planning January 15,2019 Certified by ______Professor David Geltner Department of Urban Studies and Planning Thesis Supervisor Accepted by______Associate Professor P. Christopher Zegras Chair, MCP Committee Department of Urban Studies and Planning

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A comparative analysis of apartment REITs in US and China: an examination of challenges and opportunities

Zixiao Yin

Submitted to the Department of Urban Studies and Planning On January 15, 2019, in partial fulfillment of the requirements for the degree of Master in City Planning At the Massachusetts Institute of Technology

ABSTRACT

During the past 2 years, Real Estate Investment Trusts (REITs) and the push to develop more rental housing in China have drawn lots of attention. REITs are expected to provide multiple capital channels for the development of rental apartments without continuously leveraging up the real estate industry, as traditional financing methods did. The mechanism of equity REIT can help cultivate and accelerate the formation of a sustainable rental housing market in China.

This thesis explores the opportunities and obstacles for REITs to work in the rental housing market in China by exploring the reasons for introducing REITs in the Chinese real estate market from a macro and historical perspective; by examining some cases of the newly issued REIT-like companies in China; and by reviewing the framework and system of REITs in US markets so as to draw lessons for China from a comparative perspective.

This thesis finds that equity REITs are still very immature and are not widely accepted by mass investors in China. The thesis puts forward three suggestions for apartment REITs in China: to streamline the REIT structure and avoid excessive complexity and opacity; to promote information transparency and regulated disclosure mechanism; to encourage and protect equity REIT investors by constraining REITs from taking on too much debt. Finally, the thesis concludes that REITs, as shown by US experience, should be regarded as a great opportunity to cultivate Chinese investors’ confidence in the stock market with its very simple and plain-vanilla structure. With the Chinese government’s strong ambition to increase housing affordability and to deleverage the economy, we foresee continuous legislative breakthroughs and more systematic improvements in the REIT field.

Thesis Supervisor: David Geltner Title: Professor of Real Estate Finance 3

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ACKNOWLEDGEMENTS

The pursue of my graduate study at MIT is driven by my deep desire of expanding my view of the world. My sincere thanks go out to Dr. Yu-hung Hong and Prof. Lei Shao, without their encouragement, I would not have the chance to have these eye-opening and rewarding time at MIT. While studying at MIT, the REIT concept attracted me a lot as an interesting investment vehicle that fits the emerging rental housing section of China’s real estate sector. My working experience and the current heated discussions on the transformation of Chinese real estate market make REIT topic become a natural selection for my Master thesis research.

In addition, my thesis aims to examine an investment vehicle that is still at its very early stage in China. The US REIT experience, both theoretical and practical, is of great reference value for China. In the process of unraveling US REIT experience, I would like to thank my thesis advisor, Professor David Geltner, for his unreserved knowledge sharing, guidance and patience. Also, without his generous reference, it would be impossible for me to talk to the senior REIT practitioners to see the whole picture of the industry.

I am grateful for the encouragement, guidance and generosity of Mr. Paul Adornato who spent many hours to speak and meet with me during my research. The thesis talk was just a great start of many. My related project GeoREIT would have been simply inconceivable without Paul’s unreserved help along the way. I would also like to thank the following people wholeheartedly.

Prof. Siqi Zheng, MIT Center of Real Estate Mr. Saurabh Jalori (STAG Industrial) Mr. Hong Fan (Morgan Stanley) Mr. Jim Wang (Bohai Huijin Securities Asset Management) Mr. Benchong Zhang (Bohai Huijin Securities Asset Management)

Finally, my deepest appreciation and love go to my family for their continuous support, care and encouragement during my 2006-2009 academic years at MIT.

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CONTENT

ABSTRACT ...... 3 ACKNOWLEDGEMENTS ...... 5 LIST OF FIGURES ...... 9 LIST OF TABLES ...... 10 Chapter1. Introduction ...... 11 1.1 Research question and my motivation ...... 11 1.2 Methodology ...... 12 1.2.1 Case studies ...... 12 1.2.2 Literature Review...... 13 1.2.3 Interviews ...... 14 1.2.4 Comparative Analysis ...... 15 1.3 Research Structure ...... 16 Chapter 2. How can REIT support rental housing theoretically and mechanically? ... 18 2.1 What is a REIT? ...... 18 2.1.1 Portfolios of income-producing properties ...... 18 2.1.2 Define the type of REIT focused on in this paper...... 19 2.2 REIT valuation ...... 20 2.3 REITs in the US real estate investment industry ...... 21 2.4 The mechanisms through which REITs serve the rental housing market...... 23 2.4.1 Requirement of Income-producing ...... 23 2.4.2 Liquidity and Accessibility ...... 24 2.4.3 Professional management ...... 26 Chapter 3. The opportunities for rental apartment and REITs in China from a macro background perspective ...... 28 3.1 The motivations to promote the rental housing market ...... 28 3.1.1. The circular relationship among land leasing, real estate construction and the economy ...... 29 3.1.2. The obstacles of the development of rental housing...... 30 3.1.3. The current requirements to develop rental apartments...... 31 3.2 The policy preferences for rental apartment and REITs ...... 33 3.2.1 Increase the land supply for rental apartment ...... 33 3.2.2 Explore multiple financing vehicles for rental apartment...... 35 Chapter 4. The current landscape of institutional rental apartments in China and its implication for REITs ...... 37 4.1 The business models and the comparative advantages of varied operators ... 37 4.2 The financing toolkit ...... 42 4.2.1 Rental Income Asset-Backed Securities (ABS) ...... 43 4.2.2 Commercial mortgage-backed securities (CMBS) ...... 45 4.2.3 Asset-Backed Note (ABN) ...... 46 Chapter 5. Case studies for Apartment “REITs” in China ...... 47 5.1 The Xinpai Apartment “REITs” ...... 47 5.1.1 The company profile ...... 47

5.1.2 The particularity of the assets...... 48 5.1.3 The design of the deal structure ...... 50 5.1.4 The preparations for going public in the future ...... 52 5.2 The Poly Rental Apartment REITs...... 53 5.2.1The company profile ...... 53 5.2.2The particularity of the assets ...... 53 5.2.3 The design of deal structure ...... 55 5.2.4 Preparation for growing package and going public ...... 57 5.3 Observations ...... 58 Chapter 6. Apartment REITs in the U.S...... 59 6.1 The evolution of REITs in the U.S...... 59 6.1.1. REITs in the 1960-80s ...... 60 6.1.2 The 1990s REIT boom ...... 62 6.1.3 1997-2008: Consolidation, specialization and the collapse ...... 64 6.1.4 The development of REIT post 2008 ...... 66 6.2 Case study- Equity Residential ...... 68 6.2.1 The brief introduction and the development history ...... 69 6.2.2 Corporate Management ...... 71 6.2.3 Reporting and Disclosure ...... 74 Chapter 7. Conclusion and final thoughts ...... 78 7.1 Streamline the REIT structure and avoid excessive complexity and opacity ...... 78 7.2 Increase the reliability of REIT valuation by promoting information transparency ...... 79 7.3 Reducing the investment risks of equity REITs by constraining REITs from taking on too much debt ...... 80 Bibliography ...... 82 Appendix 1 Relevant policies to promote rental housing and apartment REITs in China (2015/1 to 2018/5)...... 84 Appendix 2. A Timeline of Sam Zell’s Career ...... 87 Appendix 3 Websites of Equity Residential ...... 88

LIST OF FIGURES

Figure 1 Real estate investment system in US...... 22 Figure 2 Average housing price in Beijing, Shanghai, Shenzhen (2010-2016) ...... 32 Figure 3 Comparative advantages of different groups of rental apartments operators .. 41 Figure 4 The deal structure of rental income ABS issued by Mofang Apartment...... 44 Figure 5 The deal structure of apartment CMBS issued by Zhaoshang Shekou ...... 46 Figure 6 A comparison of the building of 2013 and of today ...... 49 Figure 7 Deal structure of Xinpai Apartment REIT scheme...... 50 Figure 8 Deal Structure of Poly REIT scheme ...... 56 Figure 9 Market capitalization of Equity REITs and Mortgage REITs (1971 to 2017). 60 Figure 10 Market Capitalization and Number of Equity REITS 1971-2017 ...... 64 Figure 11 Percentage of total shares held by institutional investors by year and asset type ...... 65 Figure 12 Supply growth by year and property sector...... 68 Figure 13 Equity Market Capitalization of Equity Residential ...... 70 Figure 14 Geographic distribution of Equity Residential portfolio 2017 ...... 71 Figure 15 Equity Residential’s and the Operating Partnership’s corporate structure .. 72 Figure 16 Median Household Income vs. Median Home Price in US 2017 ...... 73 Figure 17 A snapshot of EQR’s properties’ book value disclosure ...... 76 Figure 18 Equity Residential’s web interface for investors ...... 88 Figure 19 Equity Residential’s property’s website interface ...... 88 Figure 20 Equity Residential’s resident account web interface ...... 89

LIST OF TABLES

Table 1 Typical concerns and constraints that investors have...... 21 Table 2 Typical concerns and constraints that investors face...... 23 Table 3 Business modes of different types of rental apartment companies ...... 37 Table 4 Financing schemes issued by rental apartment companies (2017/01-2018/02) . 42 Table 5 Underlying assets information of Xinpai Apartment REIT scheme ...... 48 Table 6 Tranche information of Xinpai Apartment REIT scheme...... 52 Table 7 Underlying assets information of Poly REIT scheme ...... 54 Table 8 Tranche information of Poly REIT scheme ...... 57 Table 9 Market capitalization of public apartment REITs in US in 2018 ...... 69

Chapter1. Introduction

The present chapter points out the research question and describes the general background of the issue. Methodologies and the research structure are described here.

1.1 Research question and my motivation

As early as 2008, an official report published by the People’s Bank of China (PBC) titled “China's Financial Market Development Report” (2007) introduced the concept of Real Estate Investment Trust (REIT) publicly in China for the first time. It was also the first time the government in China called for "the initiation of REIT products at the appropriate time" in official publications.

However, what happened after 2008 was not what many scholars and financial experts expected. In the nearly 10 years from 2007 to 2016, barely any successful REIT have been issued or traded, nor were any detailed and developed policies guiding REITs published by the authorities.

In June 2016, the General Office of the State Council issued "Several Opinions on Accelerating the Cultivation and Development of the Rental Housing Market." The "Opinions" sent the signal that the government in China, for the first time in the past decades, switched its focus from building housing for sale and rapid urbanization to the cultivation and development of the rental housing market.

Subsequently, a series of favorable policies and documents supporting the development of rental housing were issued by the central and each level of government. These policies have provided strong political support to the rental housing sector from two aspects: by increasing the accessibility of land for rental apartments and by tapping a broader source of capital for the development of rental apartments. During the past 2 years, REITs, together with the advocacy for the development of rental housing in China, have drawn lots of attention.

One important reason that REITs have been mentioned frequently in official documents and conferences in the past 2 years are their distinctive trait as equity investments. REITs are expected to provide multiple capital channels and sources for the development of rental apartments without continuously leveraging up the real estate industry as the traditional financing methods did. Theoretically, the mechanism of REIT can help cultivate and accelerate the formation of a sustainable rental housing market in China.

In China, so far there is not a specific law for REITs, nor have any publicly listed REITs been successfully issued. Though a specific law is absent, many real estate companies and operators have started their own explorations to build REIT-style schemes within 11 legal limits.

Can REIT in China live up to these expectations? What are the critical factors that incentivize the Chinese government to promote the rental housing sector now? If REITs do help to finance the sector, what were the government’s concerns that led them not to promote or promulgate REITs since 2008 when they first floated the idea? This paper will answer these questions and explore both the opportunities and obstacles for REITs to really work in the rental housing market in China by:  Exploring the reasons for introducing REITs recently as socio-technical innovations in the current Chinese real estate market from a macro and historical perspective;  Examining some cases of the newly issued REIT-like companies in China.  Reviewing the framework and system of REITs in US markets so as to draw lessons for China from a comparative perspective.

1.2 Methodology

This thesis employs four types of research methods: literature review (including internet based investigation), interviews, case studies, and comparative analysis (which itself is based on literature review, interviews and case studies).

1.2.1 Case studies

Although no REITs are publicly traded in the Chinese stock market, the recent discussions seem to unanimously agree that the several financing schemes of apartment buildings in 2017 have strong potential to be transformed into public-listed REIT in the future, based on the design of the deal structure, the management of the schemes and the investment characteristics of the products.

In most discussions and articles currently, these projects are cited as “REIT Similar” because they have similar characteristics to public listed REITs, such as pooling together capital of relatively small shares, investing in equity, providing professional management.

But still, these schemes are cited as “REIT Similar” because so far no REIT is publicly listed or traded in mainland China. All the existing “REIT Similar” projects in China, without being directly traded in public stock market, are just trying to mock the deal structure and the mechanisms through which US public apartment REITs finance rental apartments. In this thesis, I refer to all "REIT Similar" projects in the Chinese context simply as “REITs.” REITs in the US context are referred to as publicly listed REITs.

During my 8-month work (from June 2017 to February 2018) in Shanghai, Beijing, and

Washington DC, I gained ground-level knowledge and experience with REITs. One of the teams the author worked with undertook underwriting of the Xinpai apartment REIT, widely regarded as the first equity REIT in mainland China. The case is analyzed in this paper to illustrate the factors that support the successful issuance of Xinpai apartment REIT as well as the implications of the obstacles and opportunities faced by the other rental apartment operators in China.

Another Chinese “REIT Similar” case that is analyzed in this paper is the one issued by Poly Real Estate Development, a state-owned development company. The scheme represents the first shelf-registered apartment REIT, and is also the first REIT case issued by a state-owned enterprise (SOE). The case shows well how the “visible hand” of the government is actively supporting the issuance of apartment REITs and the importance of political support in the process of the formation of REITs in China currently.

1.2.2 Literature Review

The “Real Estate Finance” course at MIT taught by Professor David Geltner enabled me to frame the functioning mechanisms of the real estate finance world. Besides the knowledge of the financing structure of individual physical asset, the course is helpful to understand the interactive relationship between the asset market and the capital market. The textbook Commercial Real Estate Analysis & Investment1 presents the essential concepts, principles, and tools for the analysis of commercial real estate both at the level of individual assets and the level of macro industry and secondary market. The book also illustrates a brief history of commercial real estate investment history in the Unites States, which provides important guidance for the 6th chapter of this paper.

Ralph L. Block depicts in his book2 the development history of REITs in the United States with a focus on REITs’ performance as investment products. He analyzes the returns of REITs by comparing them with other types of investment vehicles and provides a step-by-step guidance for building a REIT portfolio and risk management. The book explains the pros and cons of REIT as an investment product and offers technical guidance for REIT investors.

Su Han Chan’s book3 contributes to this paper with its detailed description of the origins and evolution of REITs in the U.S. before 2000s. It also discusses in depth the

1 David M. Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment. 2nd Edition., 2006. 2 Block, Ralph L. Investing in REITs: Real Estate Investment Trusts. Third Edition., 2006. 3 Chan, Su Han, John Erickson, and Ko Wang. Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities. Financial Management Association Survey and Synthesis Series. Oxford; New York: Oxford University Press, 2003., 2003. 13 reasons behind the historical ups and downs of REITs in the U.S. and their correlation with the real estate market fundamentals as well as the capital market. From these discussions many comparative lessons could be drawn for China where the potential impact of the introduction of public REIT on real estate market needs much scrutiny.

Dave Levy’s paper1 revisits the fundamental reasons behind the tax schemes of modern REITs in the U.S. by reviewing the initial introduction of the corporate tax and the historical development of REITs. Though the paper is more focused on the tax policy debate of REITs, the background knowledge about the early days of REITs, such as why the REITs needed the tax legislation in 1960s and how REITs were perceived differently from C corporations are very helpful to understand the structural difference between REITs and other types of companies.

Jim Clayton, Michael Giliberto, Youguo Liang, and Frank J. Fabozzi’s works2 depict the shifting real estate fundamentals and the capital market landscapes over the evolution of REITs. Their works provide empirical observations about the interaction between the real estate cycles and the trends of capital flows. Their works also examine the links between real estate, REIT and capital market from an empirical aspect.

Much REIT research looks at the historical performance of REITs by comparing REITs with other traditional and alternative investments. They help to connect REITs’ performances with a broader range of factors such as interest rates, global capital flows, mortgage supply and fundamental real estate cycles. These combinations are very enlightening to understand the development of REIT within a big picture. Specifically, Richard Waldron’s research3 provides insights of how REIT as a type of financial innovation has been formed and how history, politics and geography have influenced their development. Though Waldron’s research is set up in the Irish post- crisis context, his observations are very compelling to China where the leverage level of the real estate sector is perceived to be very high, and one of the goals that REITs are expected to achieve is to provide a sustainable capital source for the rental apartment sector while deleveraging the overall Chinese real estate market.

1.2.3 Interviews

The main interviewee of this paper is Mr. Paul Adornato, who has built his successful career in REIT industry over the past 20 years. He witnessed and participated in the

1 Dave Levy, Nick Giano, and Kevin Jones. “Modern REITs and the Corporate Tax: Thoughts on the Scope of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles.” University of Chicago, 2015. 2 See Bibliography. 3 Waldron, Richard. 2018. "Capitalizing on the State: The political economy of Real Estate Investment Trusts and the ‘Resolution’ of the crisis." Geoforum 90, 206. Supplemental Index, EBSCOhost 14 underwriting of US REIT IPO (Initial Public Offerings) boom in 1990s and has shared with the author many front-tier stories of the era.

The interviews are very instrumental for us to document the development history of modern REITs in US. Specifically, Mr. Adornato’s narrative provides a valuable source for Chapter 6, the nuts and bolts of US REIT experience.

1.2.4 Comparative Analysis

Comparative analysis plays a very important role in this paper. There are at least two comparisons that are needed here. First, the vertical comparison, which is the comparison within a country across different times. We will focus on China and the US: What changes have taken place in its housing rental market before and after the introduction of REITs? Second is the horizontal comparison across countries: Has either country derived rental housing development from REITs? The answer to both questions is “no.” That is, REITs may not appear to have a major impact on rental housing development. But through the explorations of these questions, we may gain some insight about the possibilities.

The development history of the REIT industry in the U.S. is examined in this paper to make comparisons with the development of REITs in China. As the country that "invented" the REIT, the U.S. can provide valuable reference both from the aspect of academic studies and from practical experience. Most research is built on the basis of the relatively mature and efficient capital and real estate markets in the U.S., while both are relatively underdeveloped in China. Although the conclusions about how REIT interacts with the rental asset market and capital market may not be applied directly to China, the empirical observations and methodologies are instrumental and enlightening to explain some of the emerging phenomena in China.

The affluent historical experience of the U.S. makes it a good reference. To make the comparisons more systematic and well structured, the observations of the interaction between U.S. REITs and rental housing sector help us gain insights from the interactive process between the asset market and capital market, and they are also the important questions that Chinese REIT schemes need to focus on. Investment and management expertise is also a critical factor to build a regulated and organized rental apartment market. In China, institutional apartment operators are relatively scarce and the REIT industry is still at its early stage, the expertise to operate and manage rental apartments and REITs is noteworthy to address and research in advance.

1.3 Research Structure

With the combination of the methods above, the paper is structured in a way that starts from developing the claim that REIT can support the rental housing market by examining the theoretical mechanisms. The paper than tests the assumption through empirical data analysis and specific case studies. Finally, by examining the US historical experience and current practical experience of apartment REIT operation, the paper points out several suggestions for the REIT development in China. To draw the conclusions in an organized, comprehensive and evolutionary fashion, the paper is divided into 7 chapters.

The present chapter points out the research question and describes the general background of the issue. Methodologies and the research structure are described here.

The second chapter envelopes and establishes the links between REITs and the rental apartment sector from the theoretical perspective. By explaining the fundamental structure and evolution of REITs, readers can understand the mechanisms that enable REITs to support the rental market not only by tapping a broader capital source but also by adjusting the business model of real estate industry. The chapter also explains the specialty of REIT by putting it into the US real estate investment system. The concepts and descriptions that are examined in this chapter are summarized mainly through a review of the literature.

The third chapter describes the macro environment of real estate development in China currently and how this macro factor influences the development of REITs as well as rental apartment sector. The chapter tries to build a two-sided observation about the macro environment on the current stage.

The first side is about the motivations. What are the driving forces that stimulate the Chinese government’s promotions on rental apartment development as well as the advocacy of REITs? As mentioned before, it is not the first time that REITs came into the attention of the government's decision-making level. In the midst of the current wave of REITs advocacy, it is necessary to reflect on how REITs, promoted together with the rental housing sector, fit into the current stage of the real estate market. The chapter gathers data and relevant reports from 2008-2018 to examine the evolution of attitudes and reactions of the government and markets towards the rental apartment sector as well as REITs. Besides, the chapter also pictures the dynamic relationships of developers, buyers and tenants and real estate investors in the same period.

The other side is about the favorable policies, driven by the motivations above, that have been published and implemented so far. The section further discusses the sub-level mechanisms that transform these political support into straightforward driving forces

16 for the growth of rental apartment sector and the development of REITs in China.

The fourth chapter examines how the rental apartment sector has responded to these changes of the macro environment, which including the advancement of political support and the evolutional fundamentals of real estate market. Specifically, the chapter summarizes the emerging types of rental apartment operators in China and the financial toolkits that are accessible to them, such as rental income asset based securities (Rental Income ABS), commercial mortgage based securities (CMBS), and asset based notes (ABN). Through examining these vehicles and the cases they were applied, the specialties of REITs—both advantages and limitations—can be drawn from a comparative view.

Building on the previous macro-level analysis, the fifth chapter dives down to the micro-level to look into two domestic Chinese REIT cases. By comparatively reviewing the case of Xinpai Apartment REIT and Poly Real Estate Development REIT, the chapter illustrates the representative deal structure of current REITs in China, how REITs are utilized in practice and how they are expected and planned to serve the rental apartment sector in the future. Besides, through the scrutiny of the underlying assets and the scheme terms, the specialty and advantage of issuing REIT instead of other products such as CMBS, rental income ABS will be discussed. Finally, the issuers of the two cases have varied characteristics. One is issued by a small-size private company and the other is by a large scale state-owned company. This comparison provides an interesting view on how their strategies of REITs issuance are differentiated and adjusted according to the varied resources they possess. Generally, the chapter illustrates how the political willingness and the visible hand of the government are actively promoting the formation of apartment REITs and the influence in practice.

The sixth chapter focuses on the U.S. experiences. The chapter examines the interaction between REITs, the U.S. fundamental real estate market and capital market from a historical and evolutional view. It is described in this chapter about the macro-economic background and real estate market environment when REIT was initiated in the US. Besides, the chapter tracks how the regulations and structures of REITs have been adjusted to the changing macro environments over the time. Specifically, the chapter looks into the case of Equity Residential, one of the largest apartment REITs in US, to illustrate the nuts and bolts of US apartment REITs.

The final chapter draws conclusion for the paper. The chapter summarizes three aspects that Chinese REIT policy makers need to pay special attention to. Besides, I also conclude with some thoughts on the future development of public REITs in China.

Chapter 2. How can REIT support rental housing theoretically and mechanically?

To establish the links between REITs and rental apartment sector, this chapter defines REITs and explores the mechanisms that REITs support rental housing from the theoretical perspective.

2.1 What is a REIT?

Let us begin by considering the essence of what a REIT is, and by describing the various different types of REITs that exist at the broad-brush level.

2.1.1 Portfolios of income-producing properties

REITs, or Real Estate Investment Trusts, are companies that own or finance income- producing real estate in a range of property sectors. Similar to mutual funds, REITs provide all investors the chance to own valuable real estate, present the opportunity to access dividend-based income and total returns, and potentially help communities grow, thrive and revitalize.

By definition, an equity REIT is a company that, as its principal business, buys, manages, renovates, maintains, and occasionally sells real properties. Many are also able to develop new properties when the economic conditions are favorable. A mortgage REIT is a REIT that makes and holds loans and other bond-like obligations that are secured by real estate collateral. Hybrid REITs own both properties and mortgages.

In the US, all the above three types of REITs exist, but in practice, even mortgage REITs typically behave like equity rather than debt. This is in part because mortgage REITs tend to be highly leveraged, so the debt on the liability side of their balance sheets largely offsets the debt-like characteristics on the asset side. This is the reason why Geltner says that ‘in essence, REITs are equity products1’. In the sixth chapter of this paper, which mainly focuses on experience of the U.S., the REITs referred to, if not explained specifically, are publicly-listed equity REITs.

REITs possess portfolios of income-producing properties of various categories, ranging from ofﬁce, retail facilities, apartment buildings, industrial parks to health facilities, and etc. All of these types have specific advantages, risks, idiosyncrasies, and cycles that set them apart from the others. But the basic working mechanisms are the same

1 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 2nd Edition, P131. 18 across varied underlying property types: capital pooled from multiple investors is used to finance real estate development or acquisition, daily operation, value adding and other real estate investment activities. The future cash flows generated by the underlying assets are then paid back to the investors through dividends.

In the US, a qualified REIT needs to meet the following criteria to ensure that it has enough liquidity and qualifies for corporate tax exemption： • Invest at least 75 percent of its total assets in real estate • Derive at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate • Pay at least 90 percent of its taxable income in the form of shareholder dividends each year • Be an entity that is taxable as a corporation • Be managed by a board of directors or trustees • Have a minimum of 100 shareholders • Have no more than 50 percent of its shares held by five or fewer individuals, also known as ‘50/5’ or ‘five-or-fewer’ rule

2.1.2 Define the type of REIT focused on in this paper

Technically and legally, a REIT in the US does not need to be publically traded, though it requires “broad ownership”. A REIT must have at least 100 equity investors (owners) and comply with the “five-or-fewer” rule.1 Whether or not a REIT is publicly traded, it can be otherwise classified using many criteria, including investment style, asset class, and shareholder-level characteristics.

Although many of the issues discussed in this article are applicable to all types of REITs, this paper focuses primarily on publicly traded equity REITs for two reasons. First, this type of REIT has been at the epicenter of the policy discussions and practical explorations in China addressed in this paper. Second, publicly traded equity REITs account for more than 94% of the total public REIT market capitalization. Mortgage REITs are excluded because they account for a very small fraction of the industry and cannot well represent the equity essence and the other investment characteristics of REITs.

The reasons for the attention to publicly listed REITs in China are multiple. Not only because they can facilitate liquidity, information efficiency and transparency for the rental apartment sector, but also because publicly listed REITs can create a high degree of accessibility for small-scale investors by the instrument of stock market. In China, the public trust and confidence in the stock market is historically lower than that of

1 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 2nd Edition, P587.

19 direct real estate investment. Building a robust public REIT system may not only benefit the real estate sector but also cultivate public trust in the stock market.

In summary, all the REITs-related concepts and descriptions in the rest of this paper, if not explained specifically, refer to publicly listed REITs.

2.2 REIT valuation

The valuation of REITs could be analyzed from two perspectives: REITs as collections of assets or REITs as streams of cash flows.

Viewed as a stream of future cash flows, the valuation of a REIT is not so different compared to the valuation of other types of stocks. However, due to the dividend payout requirement of REITs, shareholders of REIT companies care more about the future dividends amount than those of non-REIT companies that have huge corporate-retained earnings and small payout ratios. The formula for the cash flows valuation is below, where E represent the current value of the firm’s equity, DIVt refers to the annual dividends expected to be distributed by the REIT in year t, and r refers to the stock market’s required long-run total return expectation for investments in the REIT shares.

Alternatively, REITs can be uniquely treated as collections of physical capital. Given a well-functioning primary real estate market, the value of a REIT can be estimated by the value of property assets that it holds. Notice that the value of the total properties includes both the equity and debt components. It is thus necessary to subtract the value of the REIT’s current liabilities and adjust for any non-asset-based value the REIT might have, such as property management services, to reach the net asset value (NAV) of the REIT.

By either method, the valuation of a REIT fundamentally reflects the income generating capacity of the properties it holds as well as the property management capacity of the REIT company. But the valuation methodology or philosophy has to be adjusted within different geographical and cultural contexts. For example, the house ownership rate in China is higher than that in US, which research has explained as due to cultural differences. The cap rates in some tier one cities in mainland China, Hong Kong and Singapore are generally lower than US and European cities. These indicators need to be adjusted before investors look into REITs in foreign countries and make judgements about whether a REIT is over or undervalued.

2.3 REITs in the US real estate investment industry

The US has the longest history of the development of publicly traded equity REITs, and probably has the most mature REIT sector in the stock market of any country. By looking at the role of REITs in the US real estate investment industry, one can get a brief view of REITs’ characteristics as investment vehicles.

The word ‘industry’ refers to purposeful work and diligence, and in economics, the term is used to refer to a branch of economic activity or trade. Investors in the real estate investment industry need to decide not only the prices at which they are willing to trade for the real estate assets, but also their preferences for risk-taking. Geltner has summarized in his book a list of investment elements to show the major constraints and concerns that affect most investors, particularly investors in the real estate markets:

Table 1 Typical concerns and constraints that investors have. Risk The possibility that future investment performance may vary over time in a manner that is not entirely predictable at the time when the investment is made. Liquidity The ability to sell and buy investment assets quickly without significantly affecting the price of the assets. Time Horizon The future time over which the investor’s objectives, constraints, and concerns are relevant. Investor Expertise How much knowledge, ability, and desire the investor has to and Management manage the investment process and the investment assets. Burden Investor Size How “big” the investor is in terms of the amount of capital in need of investment Capital Constraint Whether the investor faces an absolute constraint on the amount of capital he or she has available to invest, or can obtain additional capital relatively easily if good investment opportunities are available. Source: David M. Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 3rd Edition, P126

Investors are heterogeneous in terms of different investment objectives and constraints, which lays the foundation for a market in investment products. The investment industry matches heterogeneous investors with heterogeneous productive assets.

In contrast to other industries, the major traditional market for trading real estate equity is the property market in which the underlying physical assets are directly traded. Although the property market is a private market, this is a highly developed and well- functioning asset market. In private markets, other investment products exist besides the direct trading of real estate. Equity investment products include Limited

Partnerships, Private REITs, etc. Commercial Mortgages have long been well known and they provide investors with a finite-lived, contractually fixed cash flow stream. In the 1990s, the ‘securitization revolution’ of commercial real estate saw a tremendous development of a second-level of investment products in the US: the REITs and CMBS. REITs are essentially equity products, whereas CMBSs are characterized by debts. By the early 2000s, REITs had grown to represent important shares of the major commercial investment property market sectors with particular dominance in the regional shopping mall sector and significant exposure in major US cities. In his book, Geltner provides a chart that summarizes the real estate investment system in US.

Figure 1 Real estate investment system in US.

Source: David M. Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 3rd Edition, P131

REITs, in the same manner as the other investment products or vehicles, add value by matching and connecting sources and uses of capital. They enable small investors to participate in commercial property investment by offering small shares. Additionally, being publicly traded fulfills the investors’ appetite for liquidity. Finally, unless the investor purchases a large proportion of all the REIT shares, the investor will have little management burden because REITs are typically managed actively by the company’s professional management teams. The table below depicts how the characteristics of REITs speak to varied concerns and constraints of real estate investors.

Table 2 Typical concerns and constraints that investors face. Risk REITs are typically actively managed firms that may engage in buying and selling of properties as well as property management. Thus, the risk of the REIT reflects the risk of the REIT’s management, including the stock market’s perception of their abilities and future opportunities, as well as the nature of their existing portfolio of properties. Liquidity Publicly traded REITs provide investors with high liquidity. Time Horizon Perpetual ownership vehicle. Investor Expertise Publicly traded REITs typically specialize in investing in, and and Management often actively developing and managing portfolios of commercial Burden property equity. These activities are conducted by the REIT’s professional management, thus relieving management burden for investors, except those who own a large proportion of all the REIT shares. Investor Size and REITs shares are small, enabling small individual investors to Capital Constraint participate in commercial property investment. Source: The author.

2.4 The mechanisms through which REITs serve the rental housing market.

To understand how REITs can potentially support the rental market, we need to first trace back to the basic mechanisms of REITs from a theoretical perspective. The following chapters provide practical cases and empirical evidence to further testify these mechanisms and assumptions. Here, we introduce three fundamental factors. First, REITs need to generate on-going income, and rental apartments do that. Second, public REITs provide liquidity for their investors, and are accessible to a broad group of investors including small investors, hence, can attract capital for building rental apartment properties. Third, REITs need to, and have the scale and specialization to enable them to, provide skilled professional operational management of rental properties. We elaborate on these three points below.

2.4.1 Requirement of Income-producing

The set-up of REITs’ underlying properties needs to be income-producing, as do ‘commercial properties’ in the US context. The opposite of commercial property is owner-occupied home. By this definition, the commercial residential properties in China are very scarce.

The reasons are twofold. First, the business mode of Chinese developers in the

23 residential sector has been particularly unified in the past decades. Almost all of them are merchant builders who sell or pre-sell the residential units to individual buyers. Even though an individual property owner may not be the ‘occupier’ of the unit later on because she will possibly lease it out to collect rental income from a tenant, this is the owner’s individual choice and the property is still essentially a merchant unit. There’s no existing data source to measure the percentage of owner-occupied and tenant-occupied units within a residential building. The heterogeneous status of different units in the same building, and the blurred boundary between ‘owner occupation’ and ‘income-producing’ in China make it hard to classify these residential units as owner-occupied or commercial properties.

Second, there are indeed rent-only buildings for residential use in China, but it is not accurate to classify these buildings as ‘commercial’ because the owners of these buildings are mostly not-for-profit or state-like institutions, such as universities, government, or state-owned enterprises. The residential buildings owned by these institutions are ‘leased’ to their students or employees at a highly discounted rate compared to market average level or even free. Apparently, these properties serve as a type of “pay-in-kind’ benefit to a target group of people rather than a commercial investment.

The above two reasons show the scarcity of commercial properties in the residential sector in China. The developers of these residential buildings get their profit by once- off capital gain rather than rental income. Obviously, apartment REITs do not have a solid and board fundamental in China given this landscape of residential sector. It also explains why REITs naturally come into public attention when the national government supports rental housing. For those entrepreneurs and investors who bet on the prosperity of rental housing in China, REITs provide them with a well-tailored financing channel.

2.4.2 Liquidity and Accessibility

Besides REITs, there are a number of ways investors can choose to hold or invest in real estate, such as direct individual ownership, private partnership, and holding shares of traditional property companies which develop and operate real estate. But let’s consider how these other ways compare to REITs in terms of liquidity and accessibility (of the investment to a broad range of investors).

Investors like liquidity, real estate investors are no different in this. However, liquidity has been a major constraint or concern in traditional real estate investment due to the high transaction cost. Property assets may need a long time to sell at a less discounted value, compared to publicly traded stocks and bonds. The process of selling a single piece of real property may be very time-consuming and risky for individual property owners. For example, in a traditional individual ownership of a residential unit, the owner needs to spend a lot time negotiating with the intermediaries, advertising or showing her property to potential buyers. Brokers provide these services on behalf of 24 the property owners but charge fees. Some online platforms both in US and China are trying to build the direct connection between buyers and sellers, and charge less for intermediary services. But the counterparty risks and other concerns still largely exist and keep transaction costs high.

The issue of transaction cost is manifested in other forms of ownership, too. In private partnership, for example, although the partnership terms may make it theoretically possible for one partner to transfer her shares to another partner without the underlying property being sold, in practice it often doesn’t proceed smoothly because of the unmatched demands of selling and buying among the several partners. Similarly, in private REITs, the shares of the sponsors are not traded in public markets, thus the shares cannot be quickly sold at the shareholder’s will.

Compared to others, public REITs stand out by their high liquidity and low transaction cost through public trading in the stock market.

Furthermore, the requirements of REITs embody the concerns of REITs’ accessibility to small investors. The rules of ‘Having no more than 50 percent of its shares held by five or fewer individuals’ and ‘Having a minimum of 100 shareholders’ (together known as 5/50+100 rule) were designed to make sure that a REIT is widely held in order to encourage its accessibility to small investors. In the Section 6.1.2, we describe how the rules were modified later on to allow pension fund investment in the 1990s. The original founding idea for REITs reflects the emphasis on accessibility of REITs for small investors.

Besides the initial founding ideas, publicly listed REITs make investing in real estate possible for a broader range of investors who has access to stock markets. The securitization process gathers properties into a package and divides the REIT shares into a small size which enables small individual investors to participate in commercial property investment. This process greatly increases the accessibility of investing in real property and gives investors the liquidity to move capital in and out of the investment so that they can respond to news and perceived opportunities.

The fact that REITs stand out by their high liquidity and accessibility through trading publicly in the stock market builds a distinctive channel between capital markets and the income yielding property market. The rental apartment, as a type of income producing property, naturally fits with the criteria required by being the underlying asset of a REIT. In this case, rental properties, by making use of REITs, have advantages in tapping into broader capital sources pooled by individual investors compared to merchant property builders1. Thus, the liquidity and accessibility of apartment REITs serve specifically to the group of rental housing investors and operators, and contributes to the development of rental housing sector.

1 Merchant developers are those who build only to sell the buildings, not holding them as investments for income. 25

2.4.3 Professional management

Former managing partner of Ernst & Young's Real Estate Group, Stan Ross, defined REITs by saying: "They are really operating companies that lease, renovate, manage, tear down, rebuild and develop from scratch." This explanation points out another important element of a REIT - a sophisticated, skilled management team who has the ability to manage and grow the REIT's cash flows.

In this sense, when investors buy stocks of a REIT, they are not only buying the company’s underlying real estate assets, they are also investing in a business. The REIT company’s role is more than to exchange the large block of real estate assets into accessible stock. They also contribute their expertise in managing and operating real estate, as well as creating value and taking advantage of new opportunities in the market.

Some research 1 has demonstrated the value of such expertise quantitatively with historical performance data. REIT management teams have typically grown the REIT’s cash flows by 4-6 percent annually—and sometimes much more. Adding a 5 percent dividend yield to capital appreciation of 4-6 percent, resulting from a 4-6 percent annual increase in operating cash flow, provides for total return prospects of 9-11 percent.

In China, a clear legal and administrative guidance for governing residential tenancy has long been absent. This absence undermines the quality of rental housing services significantly and thus creates market opportunities for the institutional apartment operators to capture value by competing for more professional and reliable apartment services.

The importance of management expertise is amplified by REITs. Because of the fact that REIT investors are actually buying a bundle of underlying assets and management expertise, competition for efficient property management will naturally motivate the operators to provide better services to attract tenants and build up tenants’ loyalty. Accordingly, it’s fair to predict that the overall rental housing market can be cultivated in a more customer-friendly and regulated way.

Furthermore, REIT as an equity product requires stable and sustainable income generation to pay back investors, thus it is not designed to serve the “merchant developers”. Thus the introduction and promotion of REITs is exclusively beneficial to the investors and companies who pursue profitable opportunities from holding properties. The REITs companies will stay highly vigilant to the factors such as the real estate market’s cap rates, housing price movement, the cost of their capital, the market landscape of investment return, etc. These factors are constantly monitored by REITs

1 Investing in REITs. Ralph L. Block page9. 26 to help the investors capture potential investment opportunities, and evaluate the specific options to sell, buy or hold.

In summary, REIT management teams not only contribute property management expertise but also sophisticated financial skills. This attribute effectively links and coordinates the asset market and the capital market. Presumable results accordingly are that REITs can help to tap a very large capital market which can flow into the rental apartment sector. Besides, with financial support and sophisticated management teams, REITs can help make better use of existing assets with a better management capacity.

Chapter 3. The opportunities for rental apartment and REITs in China from a macro background perspective

As early as 2003, Hong Kong, the Asian financial hub and the special administrative region of the People’s Republic of China, enacted its REIT code. The first H-REIT, “The Link REIT”, came to the market in 2005 with asset types of Retail and Car Park. As, the first H-REIT, The Link was sponsored by the Hong Kong Housing Authority, securitizing the 151 shopping centers and 79,000 parking spaces that were owned and managed by the government. It was a major push from the government to initiate the H-REIT market.

Despite the fact that mainland China has borrowed experience of developing the real estate market and land leasehold system mostly from Hong Kong, the mainland did not push forwards the formation of REIT until 2008. After years of market anticipation, on April 10th 2008, the People’s Bank of China (PBC) published its policy blueprint for the Chinese Financial Industry, titled “China’s Financial Market Development Report (2007)”. It is in this white paper that, for the first time, the PBC called for ‘the initiation of REIT products at the appropriate time’.

In 2016 to 2018, seen from the frequently issued polices with regard to REITs, it seems that the “appropriate time”, at least from the government perspective, may have arrived. It has been almost a decade since REIT was introduced in 2008. This chapter analyzes the recent changes of the macro Chinese real estate market and examines the reasons behind the series of favorable policies published for rental housing, as well as the reasons for the current promotion of REITs. A summary of all the relevant polices and important conferences in China during 2016-2018 is attached in Appendix 1.

3.1 The motivations to promote the rental housing market

In the past decades, real estate construction in China has been rapidly growing under the strong wave of urbanization. Meanwhile, the development of the rental apartment sector has been relatively stagnant. While the reasons for the country’s rapid urbanization are complex, as drivers such as economic structure, policy emphasis, demographic change are mingled, this section mainly focuses on how the real estate sector has been one of the most important driving forces of the urbanization process. Finally, the obstacles faced by the rental apartment sector compared to the more successful merchant properties sector are explained.

3.1.1. The circular relationship among land leasing, real estate construction and the economy

To understand why the real estate sector can play an important role in stimulating the local economy and the government’s motivation to promote real estate construction activities, the perception of the model of “land finance” is very critical.

Not every piece of land in China is privately owned. While the land in the rural areas are collectively owned by the “Rural Collectivity”, the land in urban areas is “state- owned” and can be leased out to the private sector, represented by the local government, for a specific time as regulated by constitutional law. The terms for different land use vary, and 70 years is the duration for a residential land lease.

Leasing out land to developers provides the local government an important, if not fundamental, channel of fiscal revenue. Meanwhile, with the state-wide advocacy for urbanization, the developers benefited significantly from the highly accessible development and construction loans from banks. The merchant builders get cheap loans from banks with the almost riskless collaterals of the land lease, as well as the merchant properties that will be built in the future.

Under the “land finance” model, the capital flow is such that it starts from individual savings in banks, and is then borrowed by the developers to finance the land lease and construction. Part of the capital then flows to the government’s public account to fund further infrastructure projects and improve the urban environment. In essence, it’s the build-and-sell model that largely accelerates the capital circulation. This is because developers are generally using high leverage to finance construction and the only source for them to pay down the debts is the revenue from selling the properties to individuals, which is collected much faster than rental income.

The government’s income through land leasing is used to fund infrastructure projects and to prepare more land for leasing, thus fulfilling the circulation to stimulate the expansion of the urban areas. What’s more, the expansion also coincides well with the willingness of the government. In China, a fast growing “concrete forest” is generally perceived as a straightforward and conspicuous means of demonstrating the local government’s achievement.

From the state level, real estate construction is a special type of economic activity for its extensive industrial and financial links. In 2011, real estate investment accounted for a quarter of total fixed asset investment (FAI) in China.1 The real-estate-dependent

1 Ahuja, Ashvin, Alla Myrvoda, and Department International Monetary Fund. Asia and Pacific. 2012. The spillover effects of a downturn in China's real estate investment. [electronic resource]. n.p.: Washington, D.C.: International Monetary Fund, Asia and Pacific Dept., 2012., 2012. MIT 29 construction industry accounts for 7% of GDP by itself, and it also creates significant final demand in other domestic sectors; it has among the highest degrees of backward linkages, particularly to mining, manufacturing of construction material, metal and mineral products, machinery and equipment and consumer goods, as well as real estate services. All of these factors strengthen the macro-level motivation to develop the real estate sector and construction industry.

3.1.2. The obstacles of the development of rental housing.

Then why does the rental apartment sector lag behind merchant housing construction?

To illustrate this, we need to trace back to the role that rental apartments play in the urbanization process and see how it functions differently compared to the merchant properties.

The functioning of the land finance model, which is explained above, relies heavily on the support of the banks which provide development and construction loans. The banks evaluate the risk of the loans and price the loans using the quality of the collaterals as the primary source. In an economic environment where the demand for buying an apartment is constantly strong, driven by the large population inflow from rural areas, the banks have enough reasons to justify the loans borrowed by the real estate development sector.

Fundamentally, the demand for buying apartments in urban areas is the critical factor that supports the land finance model. As urban industries grow, a large number of laborers are attracted and they normally have a strong desire to settle in the city. This preference may be based on some unique conditions in China. As the gap between rural and urban areas is becoming more apparent regarding social welfare, wage level, infrastructure quality and many other aspects, the meaning of ‘living in cities’ is becoming a symbol of better quality of life and even higher social status in China.

In comparison to the strong demand of owning an apartment in cities, rental apartments can only fulfill the basic demand for accommodation but cannot provide the other economic, investment and social effects that house ownership offers.

From the economic perspective, as explained before, both local and central governments have the intention to leverage the economic development and urbanization process with construction activities. One can argue that rental apartments can also stimulate construction activities. But the competitive advantage of rental apartments is very limited for two reasons. On one hand, the longer investment duration of rental apartments and lower return rates make them less attractive for banks that have the alternative to issue construction and development loans for merchant builders. On the other hand, the government, with its desire of further expansion of cities, has few 30 reasons to favor rental housing instead of merchant property construction when the latter can immediately help to collect the fiscal income that is needed for infrastructure development from lump sum apartment purchases.

From the investment perspective, owning a residential unit has long been an investment option that is widely accepted by Chinese families. This is not to argue that buying houses in China is a preferable investment everywhere. Actually, an over supply of residential units has been observed in some less developed cities in China. There is significant literature on Chinese “ghost cities” resulting from a vulnerable industrial structure, inadequate population growth, limited job opportunities, overinvestment in the real estate sector, etc. A report by the IMF1 summarizes the reasons for the potential overinvestment in the real estate sector in China as follows: “in the underlying structural features of the economy, namely low real interest rates in a high growth environment, the under-developed financial system (offering few alternative assets) and a closed capital account, foster the enthusiasm in real estate investment.” Indeed, with the few alternative assets for investment, merchant properties provide the investment value that rental apartments do not possess.

Finally, from the social perspective, in many cities, owning an apartment within the city gives rural migrants a higher chance to transform their ‘Hukou’ into an urban ‘Hukou’, which helps the migrants get better social welfare and gives them the sense of being a homeowner rather than a rural migrant. These social and psychological factors are also the reasons behind the booming of merchant property construction and cannot be achieved by rental apartments.

3.1.3. The current requirements to develop rental apartments.

As illustrated before, geographical factors matter a lot when studying the Chinese real estate market. This section mainly focuses on first-tier cities where most of the recent successfully issued rental apartment REITs have exposure.

Both the real estate market fundamentals and the policy preferences bring about the opportunities and requirements for the development of rental apartments.

Seen from real estate market fundamentals, the boom of the real estate sector in the past decades has been significantly supported by aggressive borrowing both by home buyers and by housing enterprises. Some research2 has shown the different influence that the

1 Ahuja, Ashvin, Alla Myrvoda, and Department International Monetary Fund. Asia and Pacific. 2012. The spillover effects of a downturn in China's real estate investment. [electronic resource]. n.p.: Washington, D.C.: International Monetary Fund, Asia and Pacific Dept., 2012., 2012. MIT Barton Catalog, EBSCOhost 2 Guo, Ye, Wenbin Xu, and Zhiyuan Zhang. "Leverage, Consumer Finance, and Housing Prices in China." Emerging Markets Finance & Trade 52, no. 2 (March 2016): 461-474. 31 leverage level has had on different groups of cities. It is observed that the leverage level has the strongest influence in the first-tier cities where the housing price has been increasing dramatically in the past decade. According to data from CREIS, the average price/m2 in Beijing, Shanghai and Shenzhen, from June 2010 to June 2016, has increased by 65%, 59%, 136% respectively.

Figure 2 Average housing price in Beijing, Shanghai, Shenzhen (2010-2016)

Source: CREIS database.

In a typical real estate cycle, rents and property values begin to rise as the economy and demand for space expands; at a certain point, new building accelerates to take advantage of the higher values; the market becomes overbuilt, but new construction continues to come online because of the time lag in construction; values fall due to oversupply. However, in the first-tier cities of China, a sharp fall of housing prices in these cities could hardly be expected. It is widely acknowledged that the housing demand has not been fulfilled and will be continuously robust due to the stable population inflow to these cities. These cities have strong attractiveness to the migrants all across the country because of their mature and comprehensive economic structure.

Tier one cities like Beijing, Shanghai and Shenzhen have developed into a stage where knowledge-intensive and technology-intensive industries play more important roles in supporting fiscal income compared to land finance. With limited land resource, the new wave of competition among these cities is to retain and attract sophisticated labor who have skills and techniques that support knowledge intensive industries. Human capital is the most valuable resource to the sustainable development of an economy. Accordingly, one priority issue that needs to be solved is the accommodation of these talents.

Responding to the fevered housing purchase, some policies, such as increasing the down payment level or raising mortgage interest rates, are published subsequently. These policies aim to control the leverage level of real estate sector. These new policies limit the accessibility of construction loans, increase the down payment level and decrease the total scale of housing loans to prevent the housing sector from over leveraging. 32

Besides the regulations on the leverage level, restrictive policies have been published simultaneously to limit the supply of traditional residential land while providing a separate channel for rental housing land supply. The goal is to suppress home purchases as well as stimulate demand for rental housing via the cross-elasticity of demand.

3.2 The policy preferences for rental apartment and REITs

In the past several years, the instructive direction of the government has diverged from the promotion of merchant housing construction with high leverage level that has posed risks to market sustainability and financial stability. Meanwhile, the central government has issued a series important documents and policies to cultivate and promote the development of rental sector. This session examines the policies that have been subsequently issued in the past two years favoring rental apartment sector as well as REITs.

In general, the polices and documents have provided support to the rental housing sector from two aspects: increasing the accessibility of land for rental apartments and tapping a broader source of capital, i.e. financial support, for the development of rental apartments. The financial support category is where REIT is put forward and is regarded as an important vehicle that should be largely developed.

3.2.1 Increase the land supply for rental apartment

The land resource in China is usually regarded as an important vehicle to help fulfill the country’s macro-level strategy and help implement relevant policies. This is also the case in the current wave of promoting rental apartment.

3.2.1.1 The rural collective land

As described previously, land in China is either owned by the state or by rural collectives. Theoretically, only the state-owned land, i.e. urban land is subjected to the zoning guidelines whereas the functions of rural land are decided by the rural collectives, which are formed by the local rural people. In practice, this duality of land creates some difficulties in regulating land uses and real estate market functioning. For example, though forbidden by law, many collective-owned land in the edge of urban areas are used to build the so-called “Small Property Rights Housing” (SPRH), which are usually sold to non-indigenous buyers at discounted prices compared to those merchant apartments nearby which are built on the state-owned land and are fully certificated.

The conflict between the rising value of the collective-owned land and the lack of legitimacy to develop it and sell the units into the market is becoming more obvious, especially in the big Chinese cities where formal housing prices are constantly rising and increasingly unaffordable for many urban residents. Recently, as the emphasis on the rental apartment growing, the government has explored ways to increase the land supply for rental apartment as well as to provide legitimate channels for collective land owners to capture the increasing value of collective-owned land.

On August 28, 2017, “Pilot Program of Building Residential Houses on Collectively- owned Construction Land for Rental Purpose” was published by Ministry of Housing and Urban-Rural Development (MOHURD) and Ministry of Land of China. The program launched 13 pilot cities to build rental apartments on rural collective land. At the city level, each city has issued more detailed policies that fit the local contexts.

Take Beijing as an example. On November 16, 2017, Beijing issued “Opinions on Further Strengthening the use of the collective land and rental housing construction work”, which makes it clear that five types of institutions are allowed to participate in the development of rental apartments built on collective land : rural collectives, town- owned enterprises, joint ventures of town-owned enterprises and state-owned enterprises (with town-owned shares take at least 51%), institutional rental apartment operators and financial institutions. With the clarity about the allowable operators, Beijing plans to supply 1000 hectares of land for rental housing in the next 5 years.

In summary, the accessibility of rural collective land for rental apartment largely cuts the land cost of rental apartment thus also help to maintain the rental to an affordable level for tenants. It also helps to make better use of the existing assets on the collective land and provides new profit channels for rural collectives.

So far, seen from the local policies among the pilot cities, the main type of institution that achieve the permission to construct, operate and manage the rental apartments on collective-owned land is state-owned enterprises(SOE).

3.2.1.2 State-owned land

Besides the accessibility of collective-owned land, several cities have explored to lease out state-owned residential land for building rental apartments. At the end of 2017, there were 180 pieces of land in total leased as rental housing land in Beijing, Shanghai, Hangzhou, Foshan, Tianjin, Guangzhou, which are estimated to offer about 6 million square meters of rental apartments.

Though the rental housing land is usually priced lower than the traditional residential land for merchant housing, the current cap rate in the first tier cities makes the profitability still questionable for the developers who bade the rental apartment land.

Because given the prevailing market rent level and cap rates, which are usually around 3% in core areas of first tier cities, it might take the developers who hold the properties more than 30 years to collect back the initial investments. So far, most bidders for this type of land are either state-owned developers or the big-name developers who can afford the short-term loss for a strategic exploration. In fact, most developers see buying rental apartment land in the first tier cities as a strategic move which lays the foundation for potential profitable opportunity if managed effectively and if the rental apartment market becomes more mature and developed in China.

3.2.2 Explore multiple financing vehicles for rental apartment

In a less developed rental apartment market like China, it is very hard for rental apartment operators, especially the small-to-medium size companies to get access to affordable financing sources to start the rental apartment business.

With regard to this, preferential policies have been issued to expand the financial sources for rental housing, including but not limited to “Notice on accelerating the development of the housing rental market in large and medium-sized cities with a net inflow of population” co-published by 9 ministries on July 20, 2017; the Central Economic Work Conference held in Beijing from December 18th to 20th in 2017. The appendix of this paper summarizes all the related policies to promote rental apartment as well as apartment REITs in China from January 2015 to May 2018.

As explained in Chapter two, the several key factors of a typical REIT: requirement for long-term and constant dividends; effective asset management; sophisticated financial skills of the management team as well as equity investment, make REIT a favorable choice to promote the development of rental apartment in a high-levered macro environment. In other words, REIT is expected to tap a broader capital source for developing rental market without continuously leveraging up the real estate sector like what construction and development bank loans did.

It is further described in the next chapter that the recent “breakthroughs” in REITs in China are largely credit to the political support and relevant preferential policies. Meanwhile, the rental apartment operators also benefit from the accessibility of other financial vehicles such as rental income asset based securitization (ABS), asset based notes (ABN) and commercial mortgage based securitization (CMBS). These financial vehicles have been recently introduced in China. Actually both ABS and CMBS were frequently issued but previously the underlying assets normally were limited to consumer mortgages, infrastructure projects, shopping malls, office buildings and so forth. It is the current boost of rental apartment that enables the rental apartments to be used as underlying assets to issue ABS, ABN and CMBS.

Most recently, on April 25, 2018, “Notice on promoting rental housing asset securitization” was published by MOHURD and China Securities Regulatory Commission. The Notice states clearly that the governments support rental housing companies to issue equity-based asset securitization products using their holding properties as underlying assets. Specifically, the Notice announced that pilot REITs projects will be issued in mainland China in a short period.

Chapter 4. The current landscape of institutional rental apartments in China and its implication for REITs

2017 has been commented as “the first year of the era of rental apartment” of China. The policy preferences have attracted multiple types of investors into the field of rental apartment. This chapter pictures the changes of the landscape of rental apartment industry in China from two aspects: by examining the new types of operators emerging in the current rental apartment sector and by looking into the financial sources they could tap according to their business model and the characteristics of the assets they possess.

4.1 The business models and the comparative advantages of varied operators

Encouraging the establishment of more professional rental house corporations is emphasized in the preferential policies for rental apartment. Meanwhile, the underdeveloped rental housing market in China sheds light on market opportunities for varied types of corporations. Operators enter into the rental apartment field with different backgrounds and business models to pursue market share.

The emerging rental apartment operators are selectively exploring varied business models. The table below summarizes the main four types of business model in the current market and aims to comparatively illustrate the competitive advantages of different operators, and to lay the foundation to examine the varied financial vehicles and sources they are able to pursue.

Table 3 Business modes of different types of rental apartment companies Model 1 Develop/Acquire-Own-Operate Sources of assets Representative Companies • Bid for raw land and develop. As the land • Private Developers: supply for rental apartment increases, Vanke, Longhu; enterprises who have the capacity to develop • SOEs: raw land can develop leasing business through Zhaoshang Shekou. bidding and auction. Profit Model • Stock assets. Enterprises can make use of their • The owner of the apartment sets up interior own assets and transform the strategy from operation teams to manage stock properties build-and-sell to build-and-hold. or newly built properties

• The owner provides tenants with leasing • Acquisition. Many enterprises choose to and value-added services strategically acquire core areas of first-tier and • The owner obtains asset appreciation and hot second-tier cities and those which have the rent income. potential to become core locations, and then hold and operate. Their plans are to rely on the growth potential of the city in the future, and to obtain higher rental returns and appreciation premiums of land and properties. Advantages Disadvantages • These companies can make use of the large • Few experience in marketing for quantity of inventory. leasing. • They have accumulated relatively • Weakness in perceiving tenant needs for abundant financing sources and have easier long-term rental apartments. access to lower cost capital. • They have advantage in new construction and retrofit projects with regard to cost management and experience.

Model 2 Develop-Own-Entrust management Sources of assets Profit Model • The same as Model 1 • The owner entrusts outside teams or Representative Companies companies to operate. • Private Developers: • The owner obtains asset appreciation and Lvcheng, Yangguangcheng; rent income and pays management fees to • SOEs: operation teams. Poly Real Estate Group Co., Ltd. • The owner undertakes maintenance costs and decoration costs Advantages Disadvantages • With the help of the operator's branding and • The operation of rental apartments is operating experience, the market can be handed over to outsiders, which is not quickly opened up and the short-term benefits conducive to the growth of the company’s can be better guaranteed. own operation capacity.

Model 3 Contract to operate Sources of assets Profit Model • Do not own asset. • Sign the operation contract with the owner Representative Companies of the property • Hotel operators • Standardize the decoration of the house • Brokers and broker platforms • In charge of the operation and maintenance • Start-up apartment brands. of the rental period Mofang Apartment, Ziru Apartment • Pay fixed rents to the owner of the house to earn the rent difference and service fees Advantages Disadvantages

• Expand market share through providing • Cannot directly benefit from asset professional operation skills. appreciation • Increase brand influence with light capital. • Less borrowing capacity without collateral . asset and solid operation history.

Model 4 Contract to build and operate Sources of assets Profit Model • Do not own asset • Development enterprises are entrusted by Representative Companies landowners/users to provide land planning, • Private developers construction and operation services Xuhui • Developers pay fixed rents to owners, collect rent and service fees from tenants, then earn rental differences and service fees • Landowners need to pay for construction costs, earn asset appreciation and fixed rental income Advantages Disadvantages • Developers can enter the leasing market more • The agent-builder cannot directly benefit quickly and more conveniently without from asset appreciation. bidding for land lease. • The agent-builder’s decisions should follow • Provide a bunch of services of land planning, the land owner. apartment construction, and leasing • Developers do not have advantages in management, etc., which lays the foundation operating rental apartments compared to for realizing the whole industry chain of rental professional apartment operators. apartment business. • Usually the developer can intervene at a very early state to determine whether the lot is suitable for building rental apartment. • Tenants needs are considered since the design and construction phase, which does not require later transformation or retrofit work. Source: The author.

The emerging operators, according to the ownership structure and primary business, can be classified into five categories: State-owned Enterprises (SOEs), private real estate developers, hotel operators, brokers and broker platforms, start-up apartment brands. Their competitive advantages can be analyzed from five aspects:

1. Development capacity for a whole new building

Though developing a whole new building is not a necessary condition to operate rental apartments, with the accessibility of rural collective land and the new classification of rental housing land, corporations who have accumulated experience in developing raw land and whole buildings have competitive

advantages from the cost management perspective by taking advantage of increased land supply.

SOEs who have real estate sector and private developers have apparent advantages with regard to this. Hotel operators come second because most hotel brands lack the development capacity of raw land, meanwhile most have accumulated experience in retrofitting the whole building both interior and outside. Finally, brokers and start-ups barely have the capital or capacity to develop the whole building from scratch.

2. Development capacity for interiors of units

Tenants, compared to home buyers, are the consumers rather than investors. Thus, unlike merchant properties, whether the leasing properties have ready-to-use interiors is a very important factor for rental apartment competition.

Hotel operators and start-up apartment brands are stronger at managing the interiors of the units with their brand image implanted in the unified design style. Some private developers and SOEs have produced decorated units for their merchant apartment business before, the experience can be transported to the rental apartment business. Brokers barely have experience in development.

3. Market positioning and attracting tenants

The capacity to properly position the products and target tenants is fundamental for generating cash flow. This capacity is closely connected to the understanding of the local market which includes accumulated data of local demographic, judgement of both macro-level and local economic trends and up-to-date information about real estate deals.

Brokers and broker platforms have first-hand information of the local demands for rental units, thus their market positioning capacity is the strongest. Actually, the first-hand information about local rental market is the most valuable source for brokers and broker platforms. Start-ups and hotel operators usually have a clear strategy about their target tenants and tend to focus on some specific market segments that enable them to maintain the low vacancy rates. Private developers and SOEs have accumulated knowledge about local merchant housing market and the experience can only be partly transported to position the potential tenants.

4. Management of operation

The quality of management is a very comprehensive benchmark to evaluate the competitive power of varied types of operators.

In the current early stage of rental apartment industry of China, it is fair to say that all the domestic operators are novice to the field. Evaluating their management capacity requires more empirical data of a longer observation period. However, hotel operators and start-up apartment brands have accumulated relatively more professional experience of providing standardized room service and property management. They have the advantage of “first starter” because their value proposition is to offer operation services.

5. Funding capacity

The capacity of the borrower to obtain funding should be tightly linked to the risk that is imposed to the lender. The risk is then adjusted by the price of the capital. In equity investment market, the investment value is determined by the investment target incorporating its risks and growth potential.

This is mostly true in the current Chinese market. The development subsidiaries of SOEs, even with similar underlying assets and credit history, have apparent advantages of raising money by the easier access to land leases and their strong parent companies. Then comes the group of big private developers who can raise capital by pledging the properties they owned. Some high-end hotel brands also own some of the properties they operate, and their credit history also help to raise fund. The main capital sources of start-ups and brokers are venture capital. It’s usually harder for them to raise cheaper capital due to the lack of collaterals.

The chart below illustrates the five aspects to review the competitive advantages of different types of operators. The more filled-in in the circles means stronger comparative advantages.

Figure 3 Comparative advantages of different groups of rental apartments operators

Source: The author.

4.2 The financing toolkit

As summarized previously, the government mainly promotes renting from two aspects: land supply and financial support. Among the series of preferential policies for rental apartment industry, many policies have stated to set up financial vehicles that can better serve the rental apartment companies.

In 2017, the < Notice of accelerating the development of housing rental market in large and medium-sized cities with net population inflow> ([2017] No.153) issued by MOHURD announced to “enhance financial support for apartment leasing companies, expand direct financing channels, support the issuance of corporate bonds and asset- backed securities, and develop the financial tools that are specifically designed for apartment leasing business. Specifically, the Notice stated to “actively support and promote the development of real estate investment trusts (REITs)”. Policy preferences have given rise to financial innovation in the leasing market.

Accordingly, rental apartment companies in China have made full use of these preferential financing policies in diversified ways. The table below summarizes all the rental apartment companies’ financing schemes from January 2017 to February 2018. The table classifies these schemes into four categories which are separately analyzed in this session: (i) rental income asset based securitization (ABS), (ii)asset based notes (ABN) (iii) commercial mortgage based securitization (CMBS), and (iv)real estate investment trust (REIT), which is referred to as “REITs Similar”1 in China.

By February 2018, there are 8 financing schemes been successfully issued by rental apartment companies in total. The following sessions will discuss the differences of these financial tools.

Table 4 Financing schemes issued by rental apartment companies (2017/01-2018/02)

Issuance Notes Number Type Issuer Time The first rental income 1 Rental Mofang Apartment 2017.01 ABS scheme in China. Income 2 ABS Ziru Apartment 2017.08 The first case of shelf- Zhaoshang Shekou 3 CMBS 2017.12 offering rental apartment Development CMBS in China .

1 The reason why Chinese people call this type of financing schemes as “REITs Similar” is because so far no REIT is publicly traded in the stock market in China and there isn’t any legislation with regard to public REITs yet. All the existing “REIT Similar” schemes in China are just trying to mock the deal structure and to mock the mechanisms through which US public REITs finance the rental apartment companies. This was also explained in Session 1.2.1. 42

Zhaoshang Shekou The first rental apartment 4 ABN Development/ China 2017.12 ABN issued in China Construction Bank Interbank Bond Market. 2017.10 The first apartment REIT in 5 Xinpai Apartment China. Baoli Real Estate The first shelf-offering 6 2017.10 Development apartment REIT in China. REITs The first apartment REIT Xuhui Lingyu 7 2017.12 issued by private developer Apartment in China. Biguiyuan The first apartment REIT 8 2018.2 Development exceeding 10 billion RMB.

4.2.1 Rental Income Asset-Backed Securities (ABS)

The financial nature of Rental Income Asset-Backed Security (ABS) is “debt-like” rather than “equity-like”. The ABS is structured in a way that the issuer borrows money from investors and pay back the debt according to the contracted schedule. The source of the debt payments is the apartments’ rental income which is backed by a pool of underlying assets generating cash flow, i.e., the apartments that are packaged in the ABS scheme.

The newly issued (ABS Regulation) requires that the underlying asset backing the securities should be specific property rights or assets that meet the requirements of “compliance with laws and regulations, clear ownership, and the ability to generate independent, predictable cash flows”.

In practice, the apartment companies issuing Rental Income ABS, most of the time, do not own the apartments by themselves. Instead, their business model is to rent the existing properties from the owners and then sublease the units to individual tenants or to the companies who use these units as their employee dormitories. The apartment companies only have the “receivable rights” to claim future rental income, which cannot meet the requirement of being sufficiently “predictable” because the tenants usually sign a short term lease contract, ranging from 6 months to 1 year, while the duration of ABS scheme usually ranges from 3 to 5 years or even longer. This duration mismatch is one of the most important risk factors that is evaluated by the securities regulatory authorities.

Fundamentally, ABS, as a debt product, needs to guarantee the creditors or investors contractually fixed returns during the horizon structured in the ABS scheme. The predictability issue prevents the rental apartment operators from issuing ABS directly.

Thus in the current practices in China, a “2 SPVs deal structure” 1is adopted widely. The idea is to provide an extra layer of guarantee for the cash flow return promised to the ABS investors and to transform the “unpredictable rental income” to a type of trust beneficiary right which “generates independent, predictable cash flows” as required by the ABS Regulation.

The following diagram shows the deal structure of rental income ABS scheme issued by Mofang Apartment.

Figure 4 The deal structure of rental income ABS issued by Mofang Apartment.

In summary, the rental income ABS is adopted mainly by the apartment companies who don’t own the apartments. The product is “debt-like”, which transforms the receivable rights on the “unpredictable future rental income” to guaranteed creditor’s rights. For the “light capital” apartment companies who are perceived as riskier business due to the lack of real estate collateral, the rental income ABS help them raise capital to build up their brand image and to acquire more market share in the fast growing field of rental apartment.

1 The SPV1 (Special Purpose Vehicle) is a subsidiary company which is 100% owned by the initial issuer. In Mofang’s case, SPV1 is a trust to which the initial issuer transfers the rental receivable rights of the underlying apartments. This transaction is regarded as a “real sale” from legal aspect. This step aims at 2 goals: the rent receivable right is transferred to SPV1；SPV1 has achieved bankruptcy remoteness of the initial issuer.

SPV2 is the ABS scheme set up by the scheme underwriter, the so-called scheme manager which is the financial institution who works to sets up the scheme. SPV2 gets the underlying asset from SPV1, namely the rent receivable right, packages the right into a trust and then issues ABS in capital market.

4.2.2 Commercial mortgage-backed securities (CMBS)

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security that is secured by mortgages on commercial properties.

Similar to rental income ABS, CMBS is also “debt-like”. CMBS is to set up a trust scheme using the beneficial rights of the trust as the basic assets. However, the companies issuing CMBS own the apartments which are used as the collateral for them to borrow debts. In contrast, the companies issuing rental income ABS do not own the apartments and they only profit from the rental difference between their contract rent with the asset owners and the rent generated by the sub-leases.

Zhaoshang Shekou rental apartment CMBS is the first rental apartment CMBS case in China. It is also the first shelf offering rental apartment CMBS.

In U.S, shelf offering or shelf registration is a special type of public offering where certain issuers are authorized by the U.S. Securities and Exchange Commission to offer and sell securities to the public without the issue of further prospectus. Instead, there is a single prospectus for multiple, undefined future offerings. The prospectus (often as part of a registration statement) may be used to issue securities for up to several years after its publication.

Shelf offering is usually available to companies that are regarded as deemed reliable by the securities regulation authority in the relevant country.

Currently, China is exploring to adopt this concept and has authorized Zhaoshang Shekou, Poly Group, which are both state-owned enterprises(SOEs), to issue shelf offering CMBS and REITs. The authorization of shelf offering saves the further filing work for the SOEs to issue similar financial products. It also helps the SOEs to acquire more market share of the rental apartment sector with more available capital source.

The followed diagram shows the deal structure of apartment CMBS using Zhaoshang Shekou as an example.

Figure 5 The deal structure of apartment CMBS issued by Zhaoshang Shekou

In summary, the main difference between CMBS and rental income ABS is that he former requires the issuer owns the apartments whereas the issuer of rental income ABS is more like a middle man between apartment owners and the terminal individual tenants. Both products are “debt-like” through which the investors get contracted fixed rate returns.

4.2.3 Asset-Backed Note (ABN)

Asset-backed Note(ABN)is another type of debt financing instrument, backed by underlying assets, that allows the issuer to raise fund and obtain capital from investors. In China, ABN is traded in the China Interbank Bond Market, which was founded in 1997 when all the commercial banks in China were required to move their repo and bond to the interbank market.

The most important differences between ABN and ABS are the trading place and the requirement of SPV. ABN is traded in the China Interbank Bond Market whereas ABS is traded in the Stock Exchange Market. Besides, ABS is required to set up the SPV in the deal structure to accomplish the bankruptcy remoteness which is not required in the deal structure of ABN.

Chapter 5. Case studies for Apartment “REITs” in China

By February 2018, there are four “REITs Similar” schemes issued in China. Not only the state-owned enterprises, but also some privately owned companies have joined this wave of financial innovation in the apartment field.

This chapter will focus on two cases: Xinpai Apartment REIT and Poly rental apartment REIT issued by Poly Real Estate Development. The two cases are very representative and also very different. Xinpai is the first equity apartment REIT in China and Poly REIT is the first case of shelf offering apartment REIT. The issuers of the two cases can represent start-up apartment companies and state-owned enterprises separately. This chapter will analyze these two representative REIT cases comparatively about the underlying assets, the deal structures, the issuers’ characteristics and so forth.

5.1 The Xinpai Apartment “REITs”

Regarded as the first case of equity REIT in China, the Xinpai Apartment is special, if not unique, in many aspects. Although it is offered privately, it has acquired the approval of Security Exchange Committee of China and it has laid good foundation for further transformation to public issuance. Under the supportive environment for rental apartment, Xinpai finally achieved its original goal, which according to the interview of its founder Wang Gehong, is to be the first explorer in the field of equity REITs in China.

5.1.1 The company profile

The founder of the Xinpai Apartment Wang Gehong has oversea real estate industrial experience which is not commonly seen among Chinese developers. When he decided to go back to China to start a new business, he had established the JW Stone Commercial Real Estate Investment Trust (REITs) in the United States in 2006 as a founding partner and president. After he came back to China, he got his first position as the CEO of Shengshi Shenzhou Real Estate Investment Fund Management (Beijing) Co., Ltd. His experiences and background make him an expert in the field of real estate management and operation besides the skills that the traditional Chinese merchant builders have.

Wang’s company, Xinpai Apartment was founded in 2012 invested by SAIF Fund. Wang and the SAIF fund co-founded a real estate fund called SAIF Properties Fund.

The first investment of the fund was to buy a whole building in the CBD area of Beijing, The brand’s English name “China Young Professionals Apartment” (CYPA) suggests its target tenant as young and high-income work force in tier 1 cities.

Now the company is operating three apartment buildings, which are in Beijing, Shanghai, Shenzhen separately. Among the 3 properties only the Beijing CBD branch is used as the underlying asset of their REIT scheme. Compared to other competitors in the field, the business mode of CYPA is to buy the whole-building properties, operate integrally by retrofitting the building, standardized service and provide control of interior design and efficient management.

The company, by its own operating history, is still at the level at start-up, it does not have strong financing capacity due to its limited credit records. The successful issuance of their REIT scheme is largely credit to the uniqueness of the underlying asset rather than the guarantee function in the deal structure.

5.1.2 The particularity of the assets.

Table 5 Underlying assets information of Xinpai Apartment REIT scheme Project Name The Equity Land The years left Total floor Holder Classification of the current area(m2) land lease Xinpai Apartment Tongdafu Asset Residential 47 6,094 CBD Branch management Floor number No. of Average rental per Occupation Book value of apartments unit(RMB/month) rate the property(thousa nd RMB) -3 to 12 101 8490 99% 78,000

The above table shows some basic information about the underlying assets. There are some particularities that need to be further explained.

Ownership of the apartments

Currently, not many apartment operators own the properties. The reason is straightforward if a simple calculation from financial aspect is done. When SAIF Properties Fund bought the Xinpai building, it was a real bargain with a floor price of 20,000 RMB/m2. The housing price, especially in the CBD of Beijing, has skyrocketed in the past 4 years. At the end of year 2017, the surrounding apartment buildings’ floor price ranges between 80,000 to 100,000 RMB /m2. The dramatic climbing up of housing price in the past several years is commonly seen in tier 1 cities. This situation has attracted lots of speculators into the real estate investment field and has also shaped

48 the landscape of “buy-sell” instead of “buy-hold” of the real estate industry. In the past decade, almost any investment in the residential properties in Beijing’s CBD area could gain incredibly high capital gains once the property is resold.

On the other hand, the rental level is very low using the average cap rate of metropolitans around the world is used as the benchmark. In this sense, the Xinpai Apartment is really special in terms of pursuing long-term growth and building up its own brand instead of short-term payback.

The ownership of the underlying asset laid the most important foundation for the company to issue equity REIT.

Figure 6 A comparison of the building of 2013 and of today

Source: http://www.cypalife.com/about.html

Whole-building management

The second element that qualifies the apartment building to be packaged into the REIT scheme is the standardized management of a whole building, which is perceived as a more efficient and manageable operating mode which provides higher quality services compared to the dispersed apartments in multiple areas and buildings. Indeed, the project maintains a vacancy rate of 1% and the rental 121 yuan/ month* m2 is 30%- 50%1 higher than the surrounding subleased units by individuals.

The clarity of the land use

In the past, there was no specific correspondent land use to rental apartment in China. Some operators rent the commercial space such as office and transform them into

1 ABS industry observation, 2017.10.9. 49 apartments, some others convert hotels directly into apartments, some apartments are even built on industrial land and are actually converted from previous industrial warehouse. There’s a huge value gap between the residential land and non-residential land in China. On one hand, some cities lease out the industrial land at a very low price, if not for free, to attract the companies that can boost the local economy. On the other hand, the price of residential land, especially in tier 1 cities, is bid to an extremely high level due to the limited land supply.

Though some developers have already explored to build rental apartments on residential land as a response to the intensive policies to promote the rental sector as well as a strategic move, Xinpai Apartment is indeed the first institutional explorer that choose to hold the asset in CBD areas in tier 1 cities. The uniqueness of the ownership of the whole building contributes to the success of its REITs issuance.

5.1.3 The design of the deal structure

The conservative valuation of the assets

According to the valuation report issued by Cushman & Wakefield on March 16th 2017, the Xinpai Apartment is valued at 55,000 RMB/ m2 with the method of discounted future cash flow and at 62,705 RMB/ m2 with the method of comparative analysis. The report finally values the apartment at the level of 57,252 RMB/ m2, which is a very conservative valuation if considering the surrounding residential properties’ price.

In the end, the book value that is assigned to the equity shares in the REIT implies that the price of the apartment is only 55,151 RMB/ m2 which is a very conservative valuation. By the issuance date of the REITs scheme, the average surrounding housing price of second-hand apartments is 95,000 RMB/ m2. The valuation of the building sends out a signal that the asset has strong appreciation potential thus to some extent, offset the risk of the equity investors.

The consistency of managements’ and investors’ interest

As the first equity REIT, the design of the deal structure carefully aligns the interest of investors and the managements, i.e. Qing Nian Le Property Management (QNL), by some innovative mechanisms. QNL is also a company owned and directed by Xinpai Apartment. So the REIT can be regarded as internally managed.

Figure 7 Deal structure of Xinpai Apartment REIT scheme 50

There are two aspects that help to attract investments:

First is through the interior management and proper incentive mechanisms. the REIT scheme sets up a performance benchmark for the cash flows of operation from the underlying assets: 8 million RMB/year in every operating year. QNL is a property management company 100% owned by Xinpai Apartment. According to the terms of the deal, QNL is responsible to pay the difference between the actual operating cash flow generated and the committed 8 million. At the same time, QNL is charging the SPV a fixed amount of management fee every year and gain bonus of 5% of excess income. This mechanism aligns the interest of QNL, the operating company, and the interest of investors and promotes the management team to achieve the highest service quality. Meanwhile, the fact that QNL is owned by Xinpai Apartment, which is the biggest equity shareholder of the REIT, prevents QNL from skimping on necessary operating expenses and capital improvements for the property, causing the property to decline in value to the detriment of the equity stockholders.

Second, SAIF Property fund, in this case, purchases the equity shares of 10 million RMB by themselves. The final private equity fund is structured as 2 tranches with the priority tranche takes 130 million and the equity tranche takes 140 million (Table below). Thus the SAIF’s 10 million worth of shares takes up 3.7% of the total 270 million worth of REIT to send out the signal to the market of its confidence in the REIT scheme. SAIF’s (equity) tranche is subordinated (junior) to the external (priority) tranche, so the shares hold by SAIF actually build up another protective layer for the other investors.

Table 6 Tranche information of Xinpai Apartment REIT scheme Interest Duration Size(million Interest Principle Tranche Rating payment (years) RMB) Type Payment frequency Fixed At the end of Priority 3+2 130 AAA Every year interest duration At the end of Equity 3+2 140 N/A No Interest None duration

The mechanism of reserve account

To better guarantee the interest of investors, SAIF pay another 5 million for the REIT scheme to set up a separate reserve account, which will be used to guarantee the return of the priority tranche is the tranche’s contracted return is not fulfilled.

Specifically, the distributable fund under the scheme is allocated according to the following priority arrangements:

(1) The scheme manager pay taxes1 related to the REIT scheme according to Chinese laws (2) To pay the related fees for listing, registration, fund transfer, etc. to the registered institution; (3) To pay the management fee for the scheme manager, the custodian fee for the custodian bank, audit fee, follow-up rating fee, follow-up evaluation fee and other fees; (4) To pay back the corresponding interest to the priority tranche. (5) To transfer the corresponding amount to the reserve fund account until the funds under the reserve fund account reach RMB 500 million; (6) If there is any remaining fund, it will be allocated to the equity shareholders.

Seen from the above sequence, the reserve account is kept at the level of 500 million as long as the priority tranche’s return is satisfied. The reserve account, in this case, is serving similar as a mezzanine fund to protect the priority tranche.

5.1.4 The preparations for going public in the future

Another important term in the Xinpai REIT scheme is about the exit mechanism. The term states that when the duration ends and the investors exit, 20% of the asset appreciation will be distributed to SAIF and the 80% left will be distributed to the equity tranche shareholders. SAIF will benefit from the asset appreciation themselves,

1 Currently, REIT does not have tax exemption characteristic like it does in US. 52 which motivates QNL, the company owned and directed by SAIF to carefully maintain the building condition and provide good qualify management. Besides, it will truly make the equity holders benefit from the appreciation of the assets when public-trading REITs is set up in China in the future because the equity holders can either liquidate their shares by trading them in the public REITs market or hold the “original shares” of the REITs which price is very likely to jump up after IPO.

5.2 The Poly Rental Apartment REITs

5.2.1The company profile

Founded in 1992, China Poly Group is a state-owned enterprise (SOE) under direct management of State-owned Assets Supervision and Administration Commission of the State Council. Its business covers many significant industries such as real estate, arms and ammunition, international trade and etc.

As a subsidiary company of China Poly Group, the Poly Real Estate Group Co., Ltd.(PRE) was founded in 1992 with a registered capital of 11.8 billion RMB, which is a huge size level that merely any private owned company can compare with. Like every SOE in China, the leader of the Poly Real Estate Group is also an official of the government.

5.2.2The particularity of the assets

The underlying properties that are packaged into the Poly REIT scheme are 10 apartment buildings that Poly now owns in 9 different cities in China, among them only two, if not one, is in tier 1 cities. (Beijing and Guangzhou). The following table shows the basic information of the properties.

Table 7 Underlying assets information of Poly REIT scheme Building City Total No. of Market Unit Name floor apartments Value price(Yuan area (Yuan) /m2) (m2) Xishanlinyu Dalian 4457 96 48,000,000 10,700 International Changsha 5329 96 66,610,000 12.374 Square Yuelulinyu Changsha 6018 152 43,440,000 7,200 Linyuxi Chongqing 3186 93 25,510,000 8,005 Xishanlinyu Beijing 22384 200 496,000,000 20,953 Lafeigongguan Chengdu 4835 35 34,660,000 7,168 Jinxiangbin Xi’an 5536 116 40,350,000 7,289 Xihulinyu Shenyang 7293 134 35,000,000 4,799 Daduhui Tianjin 884 15 32,000,000 36,216 Tianyue Guangzhou 19,942 150 857,000,000 42,974

Geographical dispersion in tier 2 cities

A glance on the underlying apartments give us the impression of geographical dispersion, which generally regards as a positive condition for risk diversification. Indeed, as one of the biggest SOE, Poly owns a large amount of land stock and property stock in a majority cities of China. It’s not surprising that the company can choose 10 of them that are dispersed in varied cities. However, a further look into the packaged properties demonstrate that most of them are in tier 2 cities who are faced the problem of housing over supply. In this case, the scheme is also actively responding to the advocacy of central government to digest the property stock to avoid systematic financial risk and huge volatility of real estate market. What’s more, this geographic characteristic in tier 2 cities raises the doubt that whether the underlying assets have the capacity to generate stable rental cash flow and to keep a low vacancy rate in the future.

Non-residential land property

As explained before, due to the conflict between extremely high price level of residential land and the strong demand for buying housing units, which is regarded as a reliable investment object in the past, many developers have tried to play the game in the grey area. One method that is widely adopted is to build apartments or mixed –

54 used properties (commercial and residential) on the non-residential land.

In the past, even these properties built on non-residential land are sold to individuals at a price level much higher than real office or commercial units and lower than the formal residential units. What the Poly’s REITs scheme does is to put light into the grey area and treat these hybrids, i.e. residential units on non-residential land, as rental apartments that are legally operated as commercial properties which generate future cash flow.

Not occupying the whole building or the whole project

Another concern is that the packaged residential units usually do not occupy the whole building or the whole development projects. In some cases, the packaged units occupy several floors of the building, for example, the apartments in Tianjin are just 15 units locate within a commercial building. Besides, most of the packaged units locate within the only-one commercial building surrounded by a group of true residential buildings developed all by Poly.

The reason behind this is that the developers usually purchase residential land leases from the government with detailed zoning requirements such as allocating a small proportion of land for public use or community service. Some developers will also voluntarily choose to use some land to build community service infrastructure to improve the quality and attractiveness of the project as a whole.

Based on the above background of these commercial properties which are packaged in the Poly REIT scheme, the underlying assets themselves bear higher investment risk for some reasons: most of them locate in tier 2 cities, the legal risk brought by the fact that they are built on non-residential land, the lack of whole building management.

5.2.3 The design of deal structure

Given the above risks of the underlying assets, unlike the Xinpai Apartment equity REITs, the successful issuance of the Poly Apartment REITs is largely attributed to the guarantee of the parent SEO: Poly Group.

Figure 8 Deal Structure of Poly REIT scheme

The design of the deal structure has made fully use of the advantage of the parent company’s strong capacity. The REIT fund is split as 9:1 between the priority tranche and inferior tranche, i.e. the equity tranche (see the table below). The priority tranche investor’s interest is well protected by the credit capacity of Poly Group. First, Poly Group is responsible for managing the reserve account which fund is used to make up the priority tranche if there’s any unpaid contracted returns. Second, during the duration of the scheme, once the underlying assets’ rating goes down to AA+ or below, Poly Group is obligated to pay all the undistributed principle and the contracted returns for the priority tranche. Finally, the Poly Group promises to pay the difference between committed and actual payment to the priority investors.

Table 8 Tranche information of Poly REIT scheme Interest Size(billion Interest Principle Tranche Duration(years) Rating payment RMB) Type Payment frequency Fixed At the end of Priority 18 1.5 AAA Every year interest duration At the end of Inferior 18 0.176 N/A N/A None duration

Similar to the Xinpai Case, the Poly REIT is also internally managed. The properties will be managed by Poly’s own asset management teams who have the incentives to maximize the rental income by improving their service quality and management efficiency.

5.2.4 Preparation for growing package and going public

The Poly Apartment REIT is the first case of shelf-issued Apartment REIT in mainland China. The shelf issuing system is a refinancing system that needs to be approved once and can issue new shares several times. For this case, the approval size of the scheme is 5 billion RMB, the first issuance described above was just 1.676 billion. According to the published terms of the deal, the left quota of issuing new shares has an open window of 2 years.

This arrangement indicates the strong potential of the REIT fund to grow. With this shelf-issued system, Poly has the decision right to include more qualified assets into the underlying asset package without pursuing further approval as long as the whole REIT value is within 5 billion RMB. Theoretically, the more geographically diversified asset package and more investors involvement will increase the liquidity of the REIT shares thus lays a good foundation for the scheme to become public REIT.

The terms of the scheme also make arrangements for potential scenario of going public in the future, which is a signal that developing public REIT in China has really gained support from the government.

The terms state that if the scheme or the private REIT fund goes public, there’s a lock- in period when the regulatory institutions may prevent the original shares holders from transferring the REITs shares. In this case, the shareholders may face the risk of decreasing shares value. The terms make it clear that the potential loss of the original shareholders when going public should also be compensated by the protective mechanisms such as funding in the reserve account. The difference between promised payment and actual received payment for shareholders will also be compensated by the guarantee, i.e. the Poly Group.

5.3 Observations

In general, equity REITs in China does not have solid foundation due to the immature rental housing market. The qualified underlying assets for equity REITs are scarce. The two cases analyzed in this chapter, Xinpai REIT and Poly REIT can be regarded as a hybrid REIT and a mortgage REIT respectively.

Most REITs rely heavily on credit guarantees, just like the Poly case. The key factor that pushes the successful issuance of Poly Apartment REIT is that the investment risk is fundamentally transferred back to the Poly Group, the parent company of Poly Real Estate Development. Without the support of the government and a state-owned company, such a REIT would be hard for the market to accept due to the large unpredictability of the underlying assets. In contrast, the Xinpai apartment REIT did not set up a credit guarantee institution and has a larger share of equity versus debt. The investors are willing to invest because of the better quality of the underlying assets and the company’s management. This is also the reason that Xinpai apartment REIT was able to be the first equity apartment REIT in China.

As a result, Chinese REITs are mostly treated as an alternative debt-financing tool by apartment operators instead of an equity investment channel for investors.

Chapter 6. Apartment REITs in the U.S.

In this chapter of this thesis, we will take a brief detour out of China to review the history of REIT in the USA.

The US experience may be relevant for China for several reasons. First, US has the longest history of the development of publicly-traded equity REITs, and probably is the most mature and fully developed REIT sector in the stock market of any country. Second, as of end of 2017, the total market capitalization of equity REITs in US has reached one trillion dollars, which is larger than that of any other country. Specifically, the total market capitalization of the 15 publicly traded apartment REITs excesses 113 billion dollars, taking up more than 10% of the total equity REIT universe. Finally, the US is a large diverse country like China, with highly-developed and high-density metropolitan areas along the coastlines and massive inland areas. Though a direct comparison of economic and demographic data between the two countries, especially between the inland areas, seems not instrumental, the fact that most underlying properties of US REITs locate in the metropolitan areas are very relevant for China to understand and project the development path of REITs in China from a geographical aspect.

6.1 The evolution of REITs in the U.S.

In essence, REITs are equity products. 1 There are some REITs in US specialize in investing in mortgages, which are known as mortgage REITs. However, these mortgage REITs tend to be highly leveraged, so the debt on the liability side of their balance sheets largely offsets the debt-like characteristics on the asset side of their balance sheets. Besides, as the owner of the bottom classes of CMBS may have a high chance to end up owning the properties collateralizing the mortgages via the default and foreclosure process, these classes of CMBS may have more characteristics of real estate equity than debt.

In summary, even mortgage REITs typically behave like equity rather than debt in the U.S. The historical examination in this session focuses on the equity REITs in US.

1 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 2nd Edition, P131 59

Figure 9 Market capitalization of Equity REITs and Mortgage REITs (1971 to 2017)

1200000

1000000

800000

600000

400000

200000

Market Capitalization MarketCapitalization (million $) 0

Year

Equitiy REIT Market Cap Mortgage REIT Market Cap

Data source: The National Association of Real Estate Investment Trusts (NAREIT)

6.1.1. REITs in the 1960-80s

By the mid-1950s in US, syndicated limited real estate partnerships were the main form that passive1 individual investors can participate in the income-producing real estate investments. Because C corporations2 could not hold real estate in a way that made economic sense for common stockholders (due to double-taxation), small passive investors (aka “retail investors”) were locked out of the commercial real estate sector altogether. One result was that the syndicated limited partnership capital market was not capable of providing real estate developers and sponsors with the amount of capital that they needed.

In 1960, The REIT investment vehicle was created by Congress through legislation called the Real Estate Investment Trust Act (1960 Act), which authorized a real estate ownership structure with tax treatment similar to that of mutual funds: a pass-through entity that distributes most of its earnings and realized capital gains.3The perception of

1 “Passive” here refers to investors who want to put money into real estate as an investment, but who don’t want to or can’t manage and operate real estate properties (and they may lack specialized knowledge about real estate or specific properties). As distinct from the “entrepreneurial” investors (who also may be individuals) who develop and manage properties and sponsor the syndications or funds or act as a general partner (managing partner) in the limited partnership. 2 A C corporation, under “United States federal income tax law”, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. Most major companies (and many smaller companies) are treated as C corporations for U.S. federal income tax purposes. C corporations and S corporations both enjoy limited liability, but only C corporations are subject to corporate income taxation. 3 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate 60 a REIT as a “conduit” entity saves it from the concerns around retained earnings, which formulated the primary arguments for the legislation of corporate taxes.1

In the income tax structure of the United States (particularly at that time, when tax rates were higher than today), it was important to avoid double taxation, whereby an entity’s profits are taxed at the corporate level, and then its earnings paid out to equity investors as dividends are also subject to income taxation at the personal level. Pass-through entities such as limited partnerships achieve this purpose, but the idea of REITs is to achieve the same purpose using a corporate structure that would be appropriate for public trading of small-denomination equity shares on the stock exchange, facilitating investment by small investors. The idea is to closely mimic the “pass-though” taxation structure of limited partnerships or mutual funds, whereby the entity is not subject to taxation but must pass through all or almost all of its annual taxable income to investors who would then pay taxes on those investment earnings, that is, one, but only one, layer of income taxation.

Although the REIT entity is not subject to taxation by mimicking the “pass-though” taxation structure of mutual funds, following the same logic, REITs were rigidly required to be “externally managed” at that time, which significantly limited the strategic and tactical management capability and effectiveness, which in the case of real estate was more of a problem than it is for stock mutual funds.

However, in the case of mutual funds, there’s no need for the mutual fund to manage the companies because they are already buying the stocks of large, publicly-traded professionally managed corporations. But in the case of REITs, the properties that they are buying need to be managed professionally at the individual level. Also, portfolio level management is also very necessary. In this sense, the requirement for external management set up a structure that was susceptible to conflict of interest between the external manager and the REIT stockholders.2

In these early years, mortgage REITs had experienced some ups and downs due to the prevailing high interests in 1968-1970 and the recession in 1973. Equity REITs, although entitled to tax exemption at the entity level, played only a limit role in real estate investment due to the rigid requirement of “external management” during their first three decades of existence.

Analysis & Investment, 2nd Edition, P586 1 Levy, Dave, Nick Giano, and Kevin Jones. “Modern REITs and the Corporate Tax: Thoughts on the Scope of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles.” University of Chicago, 2015. 2 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 3rd Edition, Appendix 23. 61

6.1.2 The 1990s REIT boom

The equity REIT market experienced tremendous growth in the 1990s. Both the number of publically traded REITs and overall equity market capitalization grew explosively over the 1992-1997 period.

The reasons for the REITs explosion in the 1990s can be analyzed from legislative aspect, and space and asset market aspect.

Legislative change of REIT

A number of legislative changes increased the popularity of REITs. One important impetus was the Tax Reform Act of 1986 (TRA86), which effectively eliminated the tax advantages that had underpinned most real estate limited partnerships (RELPs) and master limited partnerships (MLPs).

The Omnibus Budget Reconciliation Act of 1993 (OBRA) changed REIT shareholder ownership requirements as they applied to pension funds. The 1993 act modified the ‘5/50+100’ rule1. As explained in Section 2.3.2, the founding idea for the ‘5/50+100 rule’ was to make sure that REITs were widely held, with many investors, to encourage accessibility to small individual (“retail”) investors. The modification in 1993 allowed pension funds to count all of their own investors in the fund as individuals for REIT investment purposes and thus avoid violating the 5/50 rule as long as the REIT had at least 100 shareholders. This change in legal requirements helped spur pension investment in REITs, which contributed to the growth of REIT capitalization.

More importantly, the REIT Modernization Act of 1999 (RMA) not only reduced the required income distribution from 95% to 90% of taxable income but also provided REITs with increased managerial flexibility which allowed REITs to provide certain customary services to tenants without using independent contractors. The significance of this change was that REITs were given greater managerial control over their properties and could make substantial investment decisions internally rather than externally.

During this period, a structural innovation of the umbrella partnership REIT (UPREIT) contributed to REIT growth. An UPREIT consists of two entities: the REIT and an operating partnership (OP). In an UPREIT structure, the REIT owns its properties indirectly through the OP. OP unit holders have the right to convert their units into the REIT’s shares, deferring capital gains taxes until such conversion. The UPREIT

1 5/50+100 rule refers to the rules of ‘Having no more than 50 percent of its shares held by five or fewer individuals’ and ‘Having a minimum of 100 shareholders’. 62 structure allows the operating partners to defer capital gains taxes until a time when the tax costs of such a conversion are the least, which motivates the owners of private real estate to move their properties into an UPREIT. In 1993 and 1994, 67% and 89%, respectively, of all new equity REIT capital was raised through IPOS that used the UPREIT vehicle.1

With all these changes, REITs transformed from passive real estate portfolios to actively managed corporations with increased access to investors’ capital.

Space and Asset Market.

Both the space market (rents, occupancy) and asset market (inverse of cap rates) started to collapse in the late 1980s. Then the Recession of 1990-91 hit. The recession had been characterized by over-building, leading to excess real estate supply in the space market, driven by abundant debt financing and notable property overvaluation.2 The recession further undercut the space market and caused a retrenching in the stock market and a crash of REIT share prices. But this then made both properties and REIT shares cheap. As a result of a large number of foreclosures of nonperforming loans, many foreclosed properties were put on the market at low prices and purchased by equity REITs.

As the economy recovered (the 1990-91 Recession was pretty mild and short), the space market began to recover, and REITs became attractive investments to stock market investors.

The flood-in of investment combined with the legislative and structural developments in the REIT industry set the stage for the “REIT Revolution” of 1992-97. Between the end of 1990 and the end of 1995, the REIT return index rose by 149%, and total equity REIT market capitalization rose from $8.5 billion to more than $56 billion.

1 Chan, Su Han, John Erickson, and Ko Wang. Real Estate Investment Trusts : Structure, Performance, and Investment Opportunities. Financial Management Association Survey and Synthesis Series. Oxford ; New York : Oxford University Press, 2003.

2 Clayton, Jim, S. Michael Giliberto, Jacques Gordon, Susan Hudson-Wilson, Frank J. Fabozzi, and Youguo Liang. “Real Estate’s Evolution as an Asset Class.” Journal of Portfolio Management 35, no. 5 (2009): 10–22.

Figure 10 Market Capitalization and Number of Equity REITS 1971-2017

1200000 200 180 1000000 160 140 800000 120 600000 100 80 400000

60 Number Number ofREITs 40 200000

Equity Equity Maket Cap million) ($ 20

0 0

1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

Equity Market capitalization # of equity REITs

Source: The National Association of Real Estate Investment Trusts (NAREIT)

6.1.3 1997-2008: Consolidation, specialization and the collapse

In this decade, there were some events and developments that may of great reference value for the Chinese perspective.

From 1997 to 1999, there was a REIT “crash”. By 1997, REIT issuance had reached a record $44 billion, and half way through 1998 issuance was on pace to beat the previous year. Competition between conduit lenders, however, had created unrealistic spreads by the last quarter of 1998, and the market went through a dislocation when incredibly thin spreads exploded in reaction to negative news in the Russian debt markets. Besides, the second half of 1990s was also marred by a series of crises including the 1997 Asian Financial Crisis and the 1999 Brazilian financial crisis. Equity REIT market capitalization shrunk from 127 billion to 118 billion.

Consolidation and specialization are two obvious features of the period. The historical data of this decade shows a major consolidation, during which the equity market capitalization increased three-fold from 127 billion to more than 400 billion whereas the number of Equity REITs decreased from 176 to 138. Larger firms were buying and taking over smaller firms, increasing the average size and scale of the REIT firms. The feature of specialization of REITs by property type became apparent during 1992 to 1997 and confirmed during 1997-2008. This promotes more skilled and effective management, as different yet focused expertise is the best for managing different types of properties. REITs became dominant in large shopping malls, and also became major players in some other sectors of the space markets, such as shopping centers, upscale apartments, international logistics warehouses, self-storage, healthcare.

The composition of the equity REIT universe is broken out by five major property sectors as defined by NAREIT. The chart below shows the increased institutional interest across property types. The institutional participation in each sector rises dramatically over the period of 2000 to 2008. Residential and office/industrial REITs have the greatest level of institutional ownership throughout the majority of the sample period, with office/industrial experiencing the most pronounced gains in institutional ownership, from 27% in 1999 to 80% in 2016.

Figure 11 Percentage of total shares1 held by institutional investors by year and asset type

Source: Feng, McKay, Sirmans (2011)2

During the subprime crisis in 2007, REITs experienced the most terrible crash, deeper than any previous crash in terms of percent of share price fall from peak. During 2005- 2007, it’s notable that property values run up but new construction did not rise dramatically. So drops in 2008-2009 were not caused by overbuilding in space market, but rather because of using excessive external debt to fund aggressive acquisitions and development activities.

One most important lesson from the crash in 2017 is the way REITs had used debt. Some researchers have argued that they crashed farther than they should have. Kawaguchi, Sa-Aadu and Shiling3 argued that the declining commercial-mortgage-10- year-Treasury yield spread during the Greenspan era (1994-2006) allowed REITs to

1 Shares owned by institutional investors / total shares outstanding 2 Feng Zhilan, Price S. McKay, and Sirmans C.F. “An Overview of Equity Real Estate Investment Trusts (REITs) : 1993–2009.” Journal of Real Estate Literature, no. 2 (2011): 307. 3 Kawaguchi, Yuichiro, Jarjisu Sa‐Aadu, and James D. Shilling. “REIT Stock Price Volatility and the Effects of Leverage.” Real Estate Economics 45, no. 2 (2017): 452.

65 take on far more risk than most people realized. Their empirical observations show that equity REITs have become excessively risky relative to the returns they generate in the years before 2017 crisis.

6.1.4 The development of REIT post 2008

Unlike the previous downturn in the 1980s, the real estate sector was not abandoned by institutional investors following the financial crisis of 2008-2009. Similar to the recovery in 1990 to 1991, the attractiveness of the undervalued properties after the collapse of the real estate market made REITs have the chance to acquire many properties at discounted prices. Besides, the quantitative easing environment which makes the asset class of real estate attractive with steady returns also contributed to the capital pouring into the real estate sector.

In the years following the financial crisis, the private real estate market in US has attracted significant capital inflow, which according to Clayton, Fabozzi, Giliberto, Gordon, Liang, Mackinnon and Mansour 1 , mainly come from the traditional institutional real estate investors and cross-border capital brought by globalization.

In additional to the overall growth of capital inflow to the real estate sector, Levy, Gianou, Jones2 pointed out two other reasons for the specific growth of the REIT industry: the development of capital markets and the trend to specialization.

The capital markets factor that contributes to the growth of REIT industry builds on the widely accepted idea by the capital markets that some businesses can operate most efficiently by renting rather than owning critical parts of their value chains. Besides, other businesses can function profitably by owning critical parts of value chains and charging rent for their use. Both of the ideas mean some companies will choose to rent the properties which creates opportunities for other investors to acquire that real estate. These ideas can explain many C-to-REIT conversions and REIT spin-offs.

The widely accepted belief about specialization of the firm and the separation of asset ownership and usage is an important aspect of the growth of REIT industry. Specialization refers to a process in which a business focus on a narrower field while functions at better quality. As specialization becomes more attractive, businesses that, in prior times, would have owned real estate are now encouraged to dispose of that real

1 Jim Clayton, Frank J. Fabozzi, S. Michael Giliberto, Jacques N. Gordon, Youguo Liang, Greg Mackinnon, and Asieh Mansour. “New Horizons and Familiar Landscapes: New Capital Sources Confront Shifting Real Estate Fundamentals.” Journal of Portfolio Management, 2015, 11–20.

2 Levy, Dave, Nick Giano, and Kevin Jones. “Modern REITs and the Corporate Tax: Thoughts on the Scope of the Corporate Tax and Rationalizing Our System of Taxing Collective Investment Vehicles.” University of Chicago, 2015.

66 estate and turn to third party owners to fulfill their real estate needs, which contributes directly to the growth activities of REIT spin-offs and to the growth of REIT industry. Investors tend to pay a premium for securities that pay a predictable yield, and the markets financial metrics tend to punish many non-real estate companies that own the real estate in which they conduct business. In this case, many C corporations are pressured to either dispose their real estate assets through a spin-off or sale-leaseback transaction, or convert to REIT status.

Besides the conscious of specialization, public REITs may have natural growth motivation due to the stock market’s preference for growth stocks than values or income stocks. The infusions of external capital into the firms, either debt or equity, have boosted the growth of REITs.

From the aspect of space market, as mentioned first in this section, the real estate fundamentals in this cycle has followed a different pattern compared to previous ones. In a typical real estate cycle, rents and property values begin to rise as the economy and demand for space expands; meantime, new construction accelerates to take advantage of this increasing trend; then over supply appears as a result of the time lag in construction, thus value falls. In the post 2008 era, it’s notable that the rate of new supply to the market remains relatively low. New construction activities rise in some years but not dramatically. (Figure 12) Some scholars 1 have attributed this phenomenon to greater informational efficiency in the real estate market which makes the cycles less severe than in the past. However, it is notable that the less severe cycles do not mean that the real estate fundamentals are not crucial for REITs any more.

1 Packer, Frank, Timothy Riddiough, and Jimmy Shek. “Securitization and the Supply Cycle: Evidence from the REIT Market.” Journal of Portfolio Management 39, no. 5 (2013): 134–43. 67

Figure 12 Supply growth1 by year and property sector.

Source: Cornerstone Real Estate Advisors, based on data and forecasts provided by CBRE Econometric Advisers.

6.2 Case study- Equity Residential

Equity Residential (EQR), incorporated on July 21, 1992, is one of the largest US public apartment REITs. According to NAREIT’s website2, by October 6th, 2018, there are 22 publicly traded residential REITs in US, including 15 Apartment REITs, 3 Manufactured Homes REITs and 4 Single Family Homes REITs. Among the 15 apartment REITs, Equity Residential has the largest Implied Market Capitalization3 of 25.01 billion as of August 2018 and ranks the second for Equity Market Capitalization4 with 24.092 billion, which is next to Avalonbay Communities by a difference of 350 million.

1 Annual completions as a percentage of beginning year stock, using square footage of space for office, industrial and retail and number of units for apartments. 2https://www.reit.com/investing/reit- directory?field_rtc_segment_tid_selective[]=531&field_rtc_listing_status_tid_selective[]=524&field_ address_country_selective[]=US&sort_by=field_stock_return_30_value 3 Implied Market Capitalization is calculated as common shares outstanding plus operating partnership units, multiplied by share price. 4 Equity Market Capitalization is calculated as common shares outstanding multiplied by share price. 68

Table 9 Market capitalization of public apartment REITs in US in 2018 Implied Equity Market Cap Apartment REIT name Equity Market Cap ($million) ($million) Equity Residential 24,092.20 25,010.00 Avalonbay Communities 24,442.20 24,443.60 Essex Prop Trust 15,880.80 16,427.50 Mid-America Apartment 11,467.90 11,885.30 Comm UDR 10,297.30 11,243.70 Camden Property 8,590.00 8,764.40 Apartment Inv 6,711.00 7,033.20 Management American Campus 5,634.80 5,677.40 Communities Education Realty Trust 3,135.60 3,145.90 Independence Realty 882.8 891.9 Trust Preferred Apartment 663.6 681.7 Communities NexPoint Residential 621.5 623.7 Trust Clipper Realty 189.5 469.5 Bluerock Residential 217.8 291 Growth REIT BRT Apartments 188.3 188.3 Source: Monthly Statistical Report of REITWatch, August 2018.

Equity Residential’s development history can be seen as a microcosm of US REIT industry. This session unfolds the management structure of the company as well as its reporting and disclosure mechanisms to public.

6.2.1 The brief introduction and the development history

Over the past two decades, EQR’s equity market cap has been continuously increasing except a collapse during the 2008 financial crisis by active acquisition, development and management (Figure 13).

Figure 13 Equity Market Capitalization of Equity Residential

Source: Factset Database

EQR is founded and still chaired by Sam Zell, who started his business of student apartment management as early as 1960s. He owned and managed student apartments while pursuing his bachelor degree in the University of Michigan.

EQR is not the only public company founded by the legendary businessman (Appendix 2 depicts the timeline of Sam Zell’s career). In 2001, Zell’s then public Equity Office Properties Trust became the first REIT added to the S&P 500, which is a tremendous milestone and validation for the REIT industry. The company was sold to the Blackstone Group for $39 billion in 2007, which marked the largest leveraged buyout deal to that point. History has shown Zell’s timing to be impeccable as the deal closed shortly before the financial crisis. Besides Equity Residential and Equity Office Properties, he also founded Equity LifeStyle Properties, the manufactured housing and resort REIT which went public in 1993. He has been chairing Equity Commonwealth from 2014 after shareholders won a takeover battle and effectively pared the company’s portfolio of disparate assets.

Zell’s achievement and contribution to the US REIT industry shines more brightly besides the tremendous success in his own business. In his interview with NAREIT, he described the achievements of himself and his team as “We’ve created liquid real estate, we’ve unmasked the mystery of real estate. We’ve created a much more disciplined industry, a much more transparent industry, and a much more relevant industry to the U.S. economy.” Indeed, Equity Residential’s growth experience largely reflects the ups and downs of US modern REITs.

Figure 14 Geographic distribution of Equity Residential portfolio 2017

Source: 2017 Equity Residential Annual Report

As of December 2017, EQR directly or indirectly through investments in title holding entities, owned all or a portion of 305 properties located in 10 states and the District of Columbia consisting of 78,611 apartment units. Equity Residential has whole ownership of 283 out of the 305 properties (93%). Their portfolio focuses on the coastal, gateway markets of Boston, New York, Washington, DC, Southern California, San Francisco and Seattle. Similar to the tier one cities in China, these markets are regarded as having the potential to grow and create well-paying jobs that attract large segments of the population opting for high-quality, well-located rental housing. And, as these cities have the highest cost of single family home ownership, there are growing populations of permanent renters that support high occupancy, low turnover and strong renewals in the rental housing markets.

6.2.2 Corporate Management

This section describes the corporate management of US modern REITs through the example of Equity Residential’s corporate structure, its property location strategy and property management system, and its financial strategy.

6.2.2.1 Corporate structure

The old REITs in US, before the 1990s, were confined largely to one phase of the process of the production of commercial property goods and services, namely, the ownership and operation of existing income-generating properties. Equity Residential

71 is a good representative of the vertical integration of US modern REITs.

Vertical integration refers to the concept of a single firm controlling several linked stages in the production process.1 Equity Residential is a good representative of the ‘vertical integration’ of REITs. Its business covers every phase of the commercial property production phases. It involves going ‘upstream’ in the production process to the construction and development of new buildings, and even the acquisition of land sites for future construction. It also involves going ‘downstream’ in the production and delivery process to include property management, leasing and other related services. Figure 15 Equity Residential’s and the Operating Partnership’s corporate structure

Source: Equity Residential Annual Report 2017

EQR is the general partner of, and as of December 31, 2017 owned an approximate 96.4% ownership interest in, ERPOP. The remaining 3.6% interest is owned by limited partners. As the sole general partner of ERPOP, EQR has exclusive control of ERPOP’s day-to-day management. Management operates the Company and the Operating Partnership as one business. The management of EQR consists of the same members as the management of ERPOP.2

1 David M.Geltner, Norman G. Miller, Jim Clayton, and Piet Eichholtz. Commercial Real Estate Analysis & Investment, 3rd Edition, P597 2 The Company is structured as an umbrella partnership REIT (“UPREIT”) and EQR contributes all net proceeds from its various equity offerings to ERPOP. In return for those contributions, EQR receives a number of OP Units in ERPOP equal to the number of Common Shares it has issued in the equity offering. The Company may acquire properties in transactions that include the issuance of OP Units as consideration for the acquired properties. Such transactions may, in certain circumstances, enable the sellers to defer in whole or in part, the recognition of taxable income or gain that might otherwise result from the sales. This is one of the reasons why the Company is structured in the UPREIT manner.

6.2.2.2 Location strategy and property management

As introduced before, EQR’s location strategy for their properties is focusing on the high-density, coastal areas, such as Boston, New York, Washington, DC, Southern California, San Francisco and Seattle. According to the analysis by the company’s annual report, the demand for rental housing in these cities is driven primarily by household formations from the Millennial segment of the US population, also known as the Echo Boom Generation.1 EQR is strategically located in markets with high cost of single family housing. It is noteworthy that the emerging geographic exposure of the apartment operators in China is also in the coastal metro areas, where the two factors of high cost of owning a house and higher portion of younger adults who are attracted to rental housing for the flexibility support the market demand for rental housing simultaneously.

Figure 16 Median Household Income vs. Median Home Price in US 2017

Source: American Community Survey; CoreLogic; National Association of Realtors, as of 2018 (1) PHADO represents Phoenix, Houston, Atlanta, Dallas and Orlando as a proxy for low barrier to entry markets.

The company classifies its properties into two types: the garden-style properties and mid-rise/high-rise properties. The garden-style properties are generally defined as properties with two and/or three story buildings while the mid-rise/high-rise are defined as properties with greater than three story buildings. Typically, these two types provide residents with amenities, such as rooftop decks and swimming pools, fitness centers and community rooms. In addition, many of their urban properties have parking garage and/or retail components.

1 2017 Equity Residential Annual Report, Page 3. 73

6.2.2.3 Financial stability

Financial stability is one of the keys to protect the interest of REIT shareholders. Yet financial flexibility is still necessary to support REIT companies through transformative events and operating cycles, and to provide REITs with the capacity to take advantage of opportunities.

Both REIT analysts and REIT investors are intensively tracking the borrowing activities of REIT companies to avoid taking the risks brought by over-aggressive financial decisions. Correspondingly, REIT companies maintain a healthy level of leverage to ensure the confidence of their investors and the stability of market sentiment.

The 2017 annual report of Equity Residential uses much narration about their effort to maintain the balance between keeping access to multiple sources of capital and locking in low interest rates. In February 2018, EQR issued a $500 million, 10-year unsecured bond at 3.5%, representing the lowest credit spread (80 basis points) of any 10-year REIT benchmark offering in history. At the same time, the reports carefully explained their proceeding to retire a $550 million, 6.08% mortgage loan, which significantly reduced their interest cost. In this way, EQR is sending out the message to the analysts and investors that the overall leverage and debt cost of the company is maintained stably and conservatively.

6.2.3 Reporting and Disclosure

It is required by U.S. Securities and Exchange Commission (SEC) that publicly listed companies need to submit annual report on Form 10-K and quarterly reports on Form 10-Q. Like most public companies, EQR’s SEC files reflect the company’s recent period performance in a very transparent and detailed manner. Using EQR’s reporting as an example, this session points out how the specialties of REIT companies are manifested in their annual reports and other disclosures. Some of the parameters and requirements may have reference value for Chinese policy makers to draft the legal guidance for public REITs in China.

6.2.3.1 Assets Value

As with many other investment questions, perhaps the most fundamental and important issue in analyzing REITs is valuation: How much is a given REIT worth? As pointed out before, in order to qualify as a REIT, one test that a company must 74 pass is ‘Asset Test’ that 75% or more of a REIT’s total assets must be real estate, mortgages, cash, or federal government securities, and 75% or more of the REIT’s yearly gross income must be derived directly or indirectly from real property. In this sense, REIT can be thought as a collection of real estate assets that are themselves directly valued in the private property market. In their SEC files, REITs companies are required publish the book value of their holding real estate and accumulated depreciation.

Figure 17 A snapshot of EQR’s properties’ book value disclosure

Source: Equity Residential Annual Report 2017

It is noteworthy that under the GAAP accounting rules, REITs in the United States are not required to mark their assets to market. Thus, REITs in US usually carry their assets on their books at their historical cost (less accumulated depreciation). This is in contrast with most other countries, where international accounting standards rely more on the principle of “fair value” than historical cost. Under fair value accounting, which the United States is gradually moving towards, REITs may engage more in their own (or their accountants’) estimates of the market values of their properties.

6.2.3.2 REIT earnings measures

Investors should be guaranteed the rights to grasp the streams of cash flows of a REIT. However, REIT GAAP net income (or earnings), however, is widely viewed as not being directly comparable to the earnings reported for most other types of publicly traded operating companies. This ties back to the fact that the depreciation expenses that are used to get the book value of the properties are often not matched by an actual loss in nominal value of the properties over time. As a result, the REIT industry in US has adopted a special measure of earnings, known as FFO (funds from operations, as a supplement to the traditional GAAP net income metric. The National Association of Real Estate Investment Trusts (“NAREIT”) defines funds from operations (“FFO”) (April 2002 White Paper) as net income excluding gains (or losses) from sales and impairment write-downs of depreciable operating properties, plus depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. Adjustments for unconsolidated partnerships and joint ventures will be calculated to reflect funds from operations on the same basis. It’s important to point out that though the FFO’s definition in US may seem complicated at the first sight, the most important reason that the measurement is widely adopted is that it helps to control the chunk of depreciation expenses and helps investors compare the actual rental income of REITs, both from a historical view into a specific REIT company and from a horizontal aspect to compare operational conditions of different REITs.

In essence, though the measurement of operational conditions may vary in different REIT schemes and different countries, the key idea here is to control out the possible factors that may mislead or opaque the investors and outsiders’ judgements on the REIT company’s actual performance. One important lesson that one can draw from US REIT system is that it effectively creates a parameter that not only captures the operational performance of a REIT, but also builds on the existing conventions of book value recording and the property taxation system.

In addition to the above reporting and disclosure items that are required by SEC for legal purpose, Equity Residential has additional publications that are more readable which include more detailed information that the investors may care about, such as company strategies and significant events. For example, it’s also noteworthy that EQR’s IT infrastructures, including the company’s main page, the hundreds of websites built individually for each property and the online-payment system, also improve the information transparency significantly(see Appendix 3).

Chapter 7. Conclusion and final thoughts

Starting with the theoretical mechanisms of how REITs can support the rental apartment sector, this thesis analyzes the current macro background of the opportunities for rental apartment REITs in China. We then summarize the current landscape of institutional rental apartments and the implications of REIT development. The thesis honestly records and the author’s first-hand experience and thoughts about two early- stage REIT cases in China. Through a review of the US experience and a description of the modern REIT in the US from a practical perspective, we hope this paper can provide reference value for policy makers and REIT practitioners in China to design, guide, and regulate Chinese REITs towards a type of well-functioning equity investment channel, and provide Chinese investors with more predictable and reliable investment options.

As the Chinese economy has taken on higher leverage, REITs are definitely one of the important options that China should study in depth due to the huge real estate market that REITs could directly impact. Under the current macro environment of high housing prices and high degree of leverage, REITs are worth exploring for their equity characteristic and the fact that public REITs can allow everyone to have equal access to the return of commercial real estates.

By comparatively examining REIT cases in China and the US, and by reviewing the US REIT development history, we conclude three aspects that we think Chinese policy makers and the practitioners in the REIT industry should watch.

7.1 Streamline the REIT structure and avoid excessive complexity and opacity

It’s understandable that REITs, as a very new financial concept in China, still need a long time for the mass investors to accept and acknowledge the stability and robustness of REIT investment. Accordingly, it’s noticeable that the current

Chinese REIT schemes have very complicated structures and components, such as third-party guarantees, a layer of Special Purpose Vehicles (SPV), regulatory banks and so forth. Though these different parties are taking on varied responsibilities and functioning differently in the Chinese REIT schemes, their existence also increases the cost of REIT operation, thus impeding the investors’ returns.

As illustrated in this paper, the public REITs in the US have a much simpler and more transparent structure. With the REIT qualification requirements, REITs in the US act more like pass-through vehicles and mutual funds that directly connect securitized real estate portfolios with investors.

More importantly, an over-complicated structure will naturally increase the investment risks and uncertainty due to the multiple layers through which capitals flow, thus dampening investment impetus. This complexity also makes the firm vulnerable to conflicts of interest between various stakeholders (so-called “agency cost” that can reduce the value of the firm). REIT companies should recognize that keeping the simplicity of the corporate structure is a more feasible long-term strategy.

7.2 Increase the reliability of REIT valuation by promoting information transparency

Fundamentally, the valuation of a REIT is based on the valuation of each individual property whose price is well reflected in the primary real estate market. However, the quality of the REIT’s governance and management, as well as the transparency and quality of information that the REIT provides to the public, will also influence the value of REIT.

Accordingly, the REIT companies in China should invest in information infrastructure and develop an accessible channel where not only the REIT investors but every individual can check the cash-flow situation of a REIT. Currently, concluded from the several apartment REIT pilot schemes in China, the rental income and other profitability features of the REIT are only known by the private investors of the REIT scheme. If China wants to lay a good foundation for REIT public offerings, policy guidance and legal regulations on a standardized-income reporting and disclosure mechanism are essential.

7.3 Reducing the investment risks of equity REITs by constraining REITs from taking on too much debt

Compared to the mature REIT schemes, the equity REIT market capitalization in China is very low compared to the total market value of the real estate industry. Most REITs issued so far are structured as debt financing tools with fixed return rates; only a small portion of the REIT schemes have equity characteristics.

Although the strong political clout and involvement of state-owned companies do play an important role in promoting the successful issuance of REIT projects, which in practice significantly stimulates the digestion of inventory properties and expands the rental apartment supply, these pilot projects failed to really build up Chinese people’s investment confidence in equity REITs. By contracting fixed return rates to REIT investors, the downside is that REITs have not really functioned as equity investment vehicles at all. The investment risks are transformed into default risk and are generally transferred to the state-owned enterprises when they act as the credit guarantees.

In other words, the current apartment operators are using REITs as debt-financing channels instead of real equity financing. As a result, the leverage level of the real estate sector may not really be decreased at all, but rather increased. With regard to this, the overall leverage level of the emerging apartment REIT companies should be a key factor that must be monitored to embody REIT as an equity investment vehicle.

Though a naturally born equity REIT market is hard to foresee in China in the short term, with the Chinese government’s recently announced support for rental apartments and the preferential policies for apartment REITs, the leverage level of the emerging apartment REIT companies should be a key factor that is necessary to be monitored to maintain REIT as an equity investment vehicle.

When discussing about the development of REITs in China, many people argue that the current poor market share of REITs in China can be explained by the fact that the cap rates in the tier 1 cities have not reached a level sufficient to support a ‘buy and hold’ strategy for institutional apartment companies. In other words, they are arguing that it may take too long for the rental apartment owners to recover their initial capital investment through rental income. However, this argument may not be solid enough to explain Chinese people’s lack of confidence in REITs.

The cap rates in the tier 1 cities reflect the prices investors are willing to pay to buy

80 and hold apartment properties directly. Given the strong demand for buying properties in tier 1 cities, it’s apparent that investors think these low cap rates are sufficient to justify this type of real estate investment. The continuous strong demand for buying properties may be due to a combination of several reasons: (i) Investors are expecting a lot of growth in the rents over the short, medium, and long-term; (ii) Investors view those apartment properties as having very little risk, that is, little chance that the rents will crash, vacancy will soar or cap rates will rise thereby depressing asset prices; and (iii) Maybe investors don’t care very much about risk and return, they just want a place to “park” their money that they view will be safe from economic collapse and inflation.

For any of the above reasons, the low cap rate should not by itself harm investors’ confidence in REITs. If direct ownership of apartment properties justifies their high prices and low cap rates by providing any of the above benefits, then apartment REITs, in theory, can also provide these benefits, assuming that the apartment REITs would hold nothing other than tier 1 apartment properties and would owe no debt. Consider the high leverage that Chinese investors are willing to take to buy properties in tier 1 cities, the debt issue must not be the fundamental reason that prevents Chinese investors from accepting equity REIT investments.

Fundamentally, the true reason that Chinese investors don’t yet have confidence in REITs is that the current structure of REITs available in China are too complex, difficult for investors to understand, and create possible conflicts of interest between stockholders and managers/sponsors. Additionally, even though in the short term, as stated by the government, the public REITs in China are possibly coming into place, it could still be difficult for the mass investors to build confidence in REITs in a short time. Generally, Chinese investors don’t trust the stock market like they do in the direct property market, and they may view the stock market as inherently risky.

Therefore, at the end of this paper, we want to conclude that the most important issue that needs to be addressed to develop public REITs in China is to cultivate the mass investors’ confidence in the stock market. REITs, as shown by US experience, should be a great opportunity to achieve this goal with their very simple structure. So far, we’ve already seen many state-owned enterprises, representing the policy preferences of the government, investing strategically in apartment REITs. With the Chinese government’s strong ambition to increase housing affordability and to deleverage the economy, we foresee continuous legislative breakthroughs and more systematic improvements in the REIT field.

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Appendix 1 Relevant policies to promote rental housing and apartment REITs in China (2015/1 to 2018/5)

Date Name of the institute/ Content conference/document/Report 01.06. 2015 [2015] No.4 document Build multiple channels to develop issued by MOHURD the housing rental market. 03.05.2015 2016 State Council Work Establish a concurrent housing Report system for rent and purchase 12.21.2015 The Central Economic Work Encourage individuals and Conference institutions to buy stocking houses. 04.15.2016 [2016] No.832 issued by Digest the inventory real estate by Development and Reform designing city-specific polices, Commission establish a concurrent housing system for rent and purchase 06.03.2016 “Opinions on Accelerating Support rental apartment the Cultivation and companies by reclassifying the Development of the Rental industry as life service industry Housing Market" issued by which can benefit from a bunch of the State Council favorable policies. Encourage the real estate development companies to initiate the business of apartment leasing, guide the development companies to corporate with the rental apartment companies to develop the rental market, encourage these

companies to lease their stock real estate. Regulate the real estate intermediary institutions. Support and regulate individually- operated rental units. 08.28.2016 “ Pilot Program of Building 13 cities to build rental homes on Residential Houses on rural collective land. Collectively-owned Land for Rental Purpose” issued by MOHURD and Ministry of Land 10.18.2016 "Report of the Nineteenth The president Xi Jinping stated that Congress" “The house should be used for living, not for speculating.”

12.16.2016 The Central Economic Work Accelerate the legislating work Conference related to the rental apartment industry. 03.05.2017 2017 State Council Work Establish a concurrent housing Report system for rent and purchase 04.01.2017 “Notice on Strengthening Enhance the price monitoring of the Management of Recent “pre-sale” housing units, regulate Residential Land Supply and the real estate development Regulating Related Work” companies to price reasonably. issued by MOHURD. Adapt multiple methods to increase the land supply for rental apartment. 05.20.2017 Residential Tenancy and Build regulations of rental level, Sales Management lease term, the rights of the tenants. Regulations (Draft) Mandate the governments at city and county level to build mechanisms for publishing the local rental level and to guide a reasonable rental level locally. 07.20.2017 “Notice on accelerating the Strengthen rental housing development of the housing management service and increase rental market in large and the supply of rental housing. medium-sized cities with a Expand the financial support of net inflow of population” rental housing. co-published by nine Establish a monitoring platform for ministries. housing rental level and provide convenient public services for rental housing tenants.

Specify the code of conduction for rental housing and protect the legal rights and interests of concerned parties. Strengthen the supervision of market participants and improve the level of rental housing service. 12.20.2017 The Central Economic Work Speed up the establishment of Conference multiple channels for rental apartment supply, build multi- aspect protection, and build the concurrent housing system of renting and buying. 04.25.2018 “Notice on promoting rental Support rental housing companies housing asset securitization” to issue equity-based asset published by MOHURD and securitization products with their China Securities Regulatory holding properties as underlying Commission. assets. Announces that pilot REITs projects will be issued in mainland China.

Appendix 2. A Timeline of Sam Zell’s Career

Source: NAREIT website1

1 https://www.reit.com/news/reit-magazine/may-june-2018/sam-zell-talks-about-evolution-reits 87

Appendix 3 Websites of Equity Residential

Figure 18 Equity Residential’s web interface for investors

Source: http://investors.equityapartments.com/CorporateProfile.aspx?iid=103054

Figure 19 Equity Residential’s property’s website interface

Source: https://www.equityapartments.com/boston/kendall-square/lofts-at-kendall-square- apartments#/

Figure 20 Equity Residential’s resident account web interface

Source: https://my1.equityapartments.com/Default.aspx