It has been a tepid start for China's commercial REITs (C-REITs). Only four have listed since the country announced that it would support IPO of REITs backed by commercial properties in March 2023--including shopping malls, department stores, and farmers' markets.

S&P Global Ratings still believes China's C-REIT sector has the potential to become one of the world's largest, with possible underlying assets of over US$5 trillion.

Seemingly in response to the market's slow start, regulators in mid-July took steps to bolster C-REIT issuance. They likely acted to address concerns among investors and originators, such as a lack of diversity and scale in C-REITs' underlying assets, and the restrictions on the use of issuance proceeds.

Investors commonly ask us about the hurdles that stymie this market. Here we address their most frequent queries about C-REITs and explain why this market remains promising.

Frequently Asked Questions

What changes have China regulators made to their rules governing C-REITs, and what are the implications of these changes?

Regulators have made three major revisions:

• Originators can now use 15% of net cash that they collect from REIT issuance to supplement their working capital (increased from 10%);
• C-REITs can now include offices and hotels that are owned by the same originator and physically inseparable with the consumer-related infrastructure (e.g. shopping malls); the gross floor area of such offices and hotels is capped at 30% of the total of the underlying assets (or up to 50% in extreme case); and
• Regulators have ended the qualification requirement for a minimum distribution yield for the REIT's first three years of trading, of 3.8%. The minimum distribution yield is the net projected annual distributable cash flow divided by targeted funds to be raised based on the net asset valuation.

We believe these changes increase originators' incentives to issue C-REITs, particularly the increased flexibility on the use of funds. The revisions also allow for greater asset diversity in C-REITs, which should attract more investors to the instrument. The removal of the minimum yield likewise adds flexibility, making the instrument more market oriented. We view the revision as a concession to the prevailing low interest rates in China.

Are commercial property owners sufficiently incentivized to use C-REITs?

Not really. Even with the recent rules easing, the instrument remains just moderately useful to investors and issuers, in our view.

REITs present an exit route for owners seeking to sell assets. However, REIT issuance is a complicated process. At IPO, originators can typically only sell a few assets, if China's limited C-REIT record is a guide.

Moreover, regulators restrict the use of funds. No more than 15% of net cash from REIT issuance can be used to supplement the originator's liquidity or to pay out minority shareholders in the underlying assets. This percentage is after repaying existing debt, paying taxes and fees, and excluding the originator's own purchase of units.

Furthermore, the originators, which are usually also property developers, are prohibited from using the fund for residential development. As such, REIT issuance cannot help them to raise liquidity for their capital-intensive property development business.

For example, China Jinmao Holdings Group Ltd. (BBB-/Stable/--) collected Chinese renminbi (RMB) 267 million from the issuance of Huaxia Jinmao Commercial REIT, which raised RMB1.07 billion in March 2024. China Jinmao earmarked the funds for investment in other commercial projects.

Meanwhile, originators are gaining access to other funding options. In January 2024, China relaxed its rules on how property developers can use proceeds from commercial-property loans. The maximum loan-to-value ratio was also loosened to 70% (see "China Rules Easing Gives Developers A Shot Of Liquidity," Jan. 31, 2024).

This easing gives developers a new option for monetizing commercial properties, with loans from banks that are backed by asset pledges generally available at long tenors and low interest rates. A bank loan is moreover a much simpler, quicker, and easier source of funds than a REIT issuance. More importantly, developers can use such funds for debt repayment amid the industry downturn.

Table 1

If the credit profile of the originator is weak, will that weaken the standing of the C-REIT?

Yes. In our view, the originator's credit profile will affect investor appetite for REIT units at IPO and in follow-on offerings, and will also affect the REIT's ability to borrow.

As we noticed from the existing C-REITs, the originators and their related parties remain significant shareholders in REITs after listing. Moreover, the originators typically continue to act as the property manager of the REIT assets.

This could influence how the banks and investors assess the credit risk of the underlying assets and the REIT, in our view. Such parties would scrutinize the operational sustainability and growth prospect of the assets. We believe the originators have a big influence on the operations and asset growth.

According to regulations, the originator's post-float shareholding in the REIT should be no less than 20% for five years at least. In actuality, the shareholding of originators in China's existing C-REITs has remained far above this threshold, ranging 33.86%-62.8%. The levels include the stakes held by parties related to the originator after the IPO (see table 2).

Ownership has its privileges. In all existing C-REITs, the originators (or their affiliates) act as property managers, giving them an important source of fees. As the originators typically retain a significant stake in the REIT, we assume they will continue to use their voting rights to ensure they remain as managers.

As a result, investors care about the governance and financial strength of the originator. Negative news on the originator, such as liquidity stress or weak management and governance, could influence the credit standing of the C-REIT.

In this early stage, we believe investors have favored investing in C-REITs backed by state-owned entities. This has broadly been the trend during China's recent property market downturn: investors have preferred to put their money with state-backed firms, which could have less chance of failing.

Among the seven originators backing China's current C-REITs (four that are listed, and three that are in the pipeline), only Wumart Stores Inc. is purely privately owned. To attract investors and seemingly to compensate for its non-state-owned profile, it is also the only originator that has guaranteed a set dividend on its REIT over the next five years. If the guaranteed dividend were to fall short, Wumart has promised to cut the property management fee or its claim on REIT dividends, to restore the dividend distributable to non-group investors.

Table 2

Is the business risk profile of China's C-REITs on par with that of regional peers?

Somewhat, but China's C-REITs lack diversification. All the assets underlying C-REITs are located in upper-tier cities with stronger underlying fundamentals and long operating records of 5.5-21 years. The most updated occupancy rate for underlying shopping malls of three listed C-REITs were all above 98%. Singapore-listed CapitaLand China Trust's (CLCT) occupancy rate for its retail malls in China was 98.2% as of end-2023. The retail occupancy in China for Hong Kong-listed Link Real Estate Investment Trust (A/Stable/--) was 96.6% as at March 31, 2024.

China's four listed C-REITs will yield 4.92%-7.03% in 2024, by their estimates, based on their initial offering prices. Their regional peers--CLCT, Link REIT and Hong Kong-listed Hui Xian REIT--meanwhile yielded 3.97%-7.94% over 2020-2023, based on their unit prices as at year-end.

However, China's C-REITs lack diversification both in terms of geography and asset type. Five of China's seven C-REITs each claim just a single asset: a shopping mall.

This presents concentration risk--the operating performance of a single asset can be volatile. For example, the occupancy rate of the Shanghai Bailian Festival Walk, the underlying asset of Huaan Bailian Consumer REIT, has fluctuated widely over the past five years, after the pandemic and strict mobility controls in Shanghai hit consumption. The mall's occupancy dropped from 100% in 2018-2020 to 88.12% as at end-June 2023. It has since recovered to 92.14% (as at end-2023).

Mature overseas-listed REITs are generally more diversified in both geographic exposure and asset type. For example, CLCT owns nine shopping malls, five business parks, and four logistic parks across 12 cities in China. Link REIT owns retail, offices, logistics parks and car parks in Hong Kong, mainland China, Australia, Singapore, and the U.K. Hong Kong-listed Hui Xian REIT owns shopping malls, offices, serviced apartments and hotels across four upper-tier cities in China.

Greater asset diversification generally makes the operating performance of REITs less volatile and, therefore, less risky.

C-REITs have been limited by regulation to buy assets of the same type. However, the recent rules relaxation allows C-REITs to include offices and hotels that are physically inseparable with consumer-related commercial properties. Standalone offices or hotels are still not in the scope of REIT issuance. We expect the policy may be further relaxed, enhancing the diversification of REITs.

Do listed C-REITs have the potential to expand beyond their existing portfolio?

The policy encourages C-REITs with a stable operating and investment record to buy assets using external borrowings and new-share offerings. That said, C-REITs have no record of expansion yet, given the first batch of C-REITs were only listed in March and April this year.

For reference, four listed industrial park REITs and logistics REITs in China have a record of asset acquisitions. The purchases were funded through issuance of new shares, and were completed two years since listing.

That two-year timeframe could act as guidance for making purchases. Three affordable-housing REITs in China that have applied to expand their portfolio also have an operating record of 1.5 to two years. We believe it will take some time for C-REITs to widen their portfolio, because fund managers and property managers need to establish a solid operational record before taking this step.

Among China's four listed C-REITs, two have obtained secured commercial property loans at the project-company level, with tenors of 10 and 15 years. The initial market capitalization of the REIT and secured bank loans basically are equal to the value of the underlying assets. This indicates that the value of assets that REITs pledge still acts as a cap on external borrowings.

The financing model is very different for overseas-listed REITs with longer operational records and more established relationships with lenders. Hui Xian REIT had total borrowings of RMB6.6 billion without pledging any assets. Link REIT's secured borrowings backed by investment properties accounted for 16% of its total reported borrowings. CLCT's secured borrowings accounted for 12% of total reported borrowings.

All the three REITs could leverage their brand names and operating performance to obtain unsecured bank loans, or to issue bonds. This would give them more capacity to make acquisitions. We believe high-quality C-REITs in China could also move toward such a credit model.

Where is China's C-REIT market heading? What role will it serve?

China's C-REIT market is in its infancy. Investors want to see a more established record among fund managers and property managers before handing them a mandate to build and manage a larger and more diverse portfolio.

We expect C-REITs to expand their portfolios by acquiring assets. This will be an important step in the evolution of the instrument. We believe further that the acquisitions will start from assets under the same originator, then extend to external parties.

Entities will likely fund these purchases through the issuance of new shares, at least in the beginning. This equity focus will partly stem from the requirement that borrowings for acquisitions should be no higher than 20% of the C-REIT's net asset value.

Once the C-REITs have grown larger, with a more substantial record of operation and investment, they could borrow more from financial institutions, and use the money for acquisitions.

Most broadly, we believe that as China's C-REITs mature and the market develops, issuers will pursue acquisitions. The asset diversification will make their incomes more stable and predictable, which will bolster their business-risk profiles, helping them attract a wider range of investors.

The promotion of REIT issuance could help asset owners that focus on development by establishing an exit channel. Entities can thus pursue an invest/finance/build/manage/exit process, and use the funds recovered through REIT issuance for investment.

For property operators, they could deepen their expertise through an asset-light management model, with recurrent fee income and minimized capital investment. For investors and other financial institutions, the public-offered REITs and its strict requirement on financial reporting and disclosure could help improve the transparency of the property industry and provide more valuable information for risk management.

China has a vast base of commercial property assets, which speaks to the potential of C-REITs. We believe the evolution of this instrument would help establish a healthier property market, with parties playing more specialized roles.

Writer: Jasper Moiseiwitsch

Digital Designer: Evy Cheung

Related Research

• China Rules Easing Gives Developers A Shot Of Liquidity, Jan. 31, 2024
• China Commercial REITs: Small First Step, Large Potential, May 14, 2023