Hong Kong’s REITS and Wrongs

Another example has just surfaced of the ability of Hong’s real estate developers to find new ways of exploiting investor sentiment, positive or negative.

Two years ago the Great Eagle group became one of the first Hong Kong property companies to launch a real estate investment trust (REIT). Hitherto the territory had been considered infertile ground for REITs because there were none of the tax advantages which favor them in other jurisdictions. Anyway Hong Kong had such a range of and mix of developers and property investment companies that individual and institutional investors alike already had plenty of choice for acquiring easily tradable assets in the sector.

However, it then occurred to some of the big names, egged on by investment banks, that REITs offered an opportunity to unload some of their assets at favorable prices without having to lose control of them. So Great Eagle set up Champion REIT and injected a major office property, Citibank Plaza, into it, selling 51 percent of the units to outside investors – including the Government of Singapore Investment Corporation, which took 9 percent -- while retaining 48.7 percent on Great Eagle’s own books.

In most other jurisdictions REITs are independently-operated trusts that select properties from the market. But in the case of ever-incestuous Hong Kong this was deemed unnecessary. REITs were to be created first and foremost for the benefit of the underlying property companies, which would inject their own assets, not the creation of independent fund managers.

Unfortunately for them, Hong Kong’s investors, even though sometimes insufficiently skeptical of the motives of the big players, were reluctant to take the bait. Launched at HK$5.10, a modest discount to the appraised value of the trust’s property, Champion’s price immediately went to a substantial discount. Despite generally firm property prices since then, the Champion price has never again reached its initial offering price, fluctuating between $3.70 and HK$4.60.

Investment trusts usually trade at discounts to their net asset value (NAV) but a 10-15 percent discount is the norm, not the 30-50 percent one experienced by Champion, a reflection both of its structure, involving a complex interest swap arrangement, and its captive ownership. The fact is that however honest the trustees and the valuers who determine the NAV, even Hong Kong’s investors are prone to skepticism when buyer and seller are in effect controlled by the same company.

With Champion – and other Hong Kong REITs -- going to such big discounts, one might have thought that there was no opportunity left for the big developers to repeat the exercise. But Great Eagle has just managed to do so, doubling the size of the Champion portfolio by injecting Langham Place, an office and retail complex in Kowloon’s Mongkok district, for HK$12.5 billion. In addition to the new units to Great Eagle, Champion has placed HK$2.96 billion worth of new units with outside investors and another $4.68 billion in convertible bonds.

Under the circumstances it’s no surprise that Great Eagle would be happy to unload a big chunk of property at a discount of only 13 percent. But why would anyone want to buy the new units? The Langham Place property is being bought at a discount of 13 percent to appraised NAV and the new units at a discount of 6.85 percent to the pre-suspension closing price of $3.85. But those combined discounts fall well short of that at which the existing units were then trading -- a 44 percent discount to the end-2007 appraised value of HK$6.98.

However, the subtext is that the new investors do relatively well compared with the existing ones – which explains why the Champion price has fallen further, to around $3.68, close to its all-time low. The reason is simple. Add the new properties to the old ones and the overall discount to appraised NAV falls sharply. So in effect the buyers of the new units are getting access to part of the discount on the old ones without having to drive up the price.

Meanwhile the old holders are seeing their discount being reduced. Potential gains for them will also be diluted by conversion of the bonds. The conversion price is 16.9 percent above the pre-suspension price but still a 35 percent premium to the end 2007 NAV. Conversion is possible any time after one year until 2013.

Thus it is that old investors’ woes get worse to the advantage of Great Eagle and the new investors. And one of those losers looks to be the GSIC, whose stake will initially fall to 5.7 percent and assuming conversion of the bonds, to 4.5 percent. Once again, Hong Kong takes advantage of Singapore.