Another Tar Baby for Hong Kong’s Investors

Hong Kong’s property barons never seem to lack for new ways of squeezing the local public and other investors. In most markets outside places like Russia and the Philippines it would be regarded as bizarre to invest in a so-called trust – a vehicle supposed to be run by independent trustees acting on behalf of the investors not the vendors. Hong Kong has long been notorious for allowing minorities to be ripped off in related-party transactions so why stop now that Real Estate Investment Trusts have arrived?

Such is the grip that Hong Kong companies have on the pockets and imaginations of Hong Kong financial institutions and the government bureaucracy that the dominance of the local REIT market by the untrustworthy offspring of the property cartel goes almost without notice. But investors seem to have been betting wiser.

Excluding the Link REIT, which is a stepchild of the government’s own public housing body, and the Guangdong-oriented GZI REIT, local investors now have a choice of three cartel-related REITs and will soon have more.

The latest to show its face is the Henderson Land offshoot, the inappropriately named Sunlight REIT, which is to be listed Dec. 21. Let the sun shine in on this creation and you immediately see that it is designed to extract maximum value for the vendor at the cost to the REIT buyer. To puff up its supposed attractions, Sunlight’s HK$2.72 billion IPO offered the seemingly mouth-watering dividend yield of 8.5 percent. Was Henderson giving away office and retail properties at a price and yield double that of the Link REIT? Of course, shareholders in Henderson would be naturally and rightly upset at that thought.

No, the answer is that financial engineering in the form of interest rate swaps, dividend waivers and gearing have raised the available short term return from buildings that actually yield around 3 percent. This manipulation is justified by the fact that rentals lag capital values and the properties can expect to see enhanced rental yields when existing leases expire. But if the rents fail to rise as projected, the dividend yield will fall.

A similar device was used by the Champion REIT when the Great Eagle group launched its in May 2006. Fortunately investors have seen through this particular bit of financial engineering and Champion now trades at a big discount over its IPO price — HK$3.90 against $5.10 — and an even bigger discount to its book net asset value of HK$5.94 even though its assets are parts of a single, high quality office building. Its dividend yield is a massive 7 percent.

Prosperity REIT, an offshoot of the Li Ka-shing empire, launched a year ago and has not fared much better. It is now selling at a 20 percent a discount to its IPO price and more to its net asset value; it also yields around 7 percent

Despite these apparent investment flops, the big players still want to offer REITs. Sun Hung Kai Properties is reportedly keen to revive a REIT it shelved at the time of the market correction earlier this year, and Regal Hotels has plans to dump some hotel properties into one before growth in tourism takes a knock.

REITs would seem a good place to dump second and third grade properties with scant redevelopment potential or parts of existing properties which may or may not be those best placed for rental increases. Otherwise, why part with them at all? Or why not sell them on the open market rather than to a captive so-called “trust”. And if the companies themselves want to raise cash, why not issue more shares themselves rather than go through the REIT route?

There is a huge conflict of interest at work here. Instead of being in the hands of fund manager who can pick and choose properties on behalf of investors, REITs are in practice saddled with whatever the insiders care to dish out to the REIT and its captive trustees and subject to whatever leverage the sponsors want in order to put attractive yields on what may well be geared, sub-prime assets. In addition, there are plenty of perks in the way of management and other fees are extracted.

There is in fact little real need for REITs in Hong Kong given the lack of tax advantages and the wide range of property investment and development companies available. But if Hong Kong is to have REITs, they at least should be managed in the interests of investors not the vendors of the properties.

Fortunately, investors are betting wiser. The languishing share prices of existing REITs and the rather modest over-subscription of Sunlight suggest that skepticism has set in. What remains stunning, however, is that no investment bank or fund manager has stepped forward to offer Hong Kong investors a genuinely independent REIT run by professional managers not linked to the existing cartel. One can only surmise that they are afraid of the commercial consequences for themselves if they take on the cartel, which has long had government in its pocket and the big banks as its allies in gouging the small guy.