The Reit stuff

The advantages introduced by the Code on Real Estate Investment Trusts is likely to stir up a whole new market in Hong Kong. Tom Lennox reports on the new investment tool

The Hong Kong Securities and Futures Commission (SFC) has recently released its Code on Real Estate Investment Trusts (Reit). This is a very positive step for Hong Kong. The Reit code has the potential to stimulate demand for Hong Kong real estate and provide the opportunity for a wide range of people to share in the benefits of investments in a diversified and liquid real estate portfolio.

What is a Reit?

Reits have been common investment vehicles in places such as Australia and the US for a number of years. More recently, three Reits have been successfully listed on the Singapore Stock Exchange – CapitaMall, a-reit and the Fortune Reit. The last of these is the most interesting for this region as it holds Hong Kong property. At the time of its listing in Singapore, it was not possible to offer such units to the public in Hong Kong.

A Reit is a trust that generally holds a diverse portfolio of real estate. Usually, a manager is appointed under specific financial terms to manage the trust. Investors hold units in the trust that are listed and tradable on a stock exchange. The terms of the trust require all, or a significant portion, of the trust’s net income to be distributed to unit holders. Accordingly, investors are able to receive an annuity-type income stream from their investments.

Reits are attractive as they allow investors to obtain exposure to a diverse portfolio of real estate with expected yields higher than investments such as bank deposits. For example, the forecast distribution yield of Fortune Reit, which listed in Singapore in August, is approximately 6.6 per cent. Unlike a typical Hong Kong land-owning corporate, a Reit will distribute a large percentage of its profit to unit holders and accordingly generate an income stream for the investor. Unlike a direct holding in real estate and subject to the Hong Kong Stock Exchange (HKSE) amending its listing rules, an investor will hold a liquid investment that can be traded on the HKSE.

Legislative background

The Securities and Futures Ordinance provides that a person commits an offence if they issue an advertisement, invitation or document that to their knowledge is, or contains, an invitation to the public to acquire an interest in, or participate in, a collective investment scheme unless the issue is authorised by the SFC under Section 105(1).

Prior to the issue of the Reit code, the SFC would only exercise its powers under Section 105 in accordance with the Code on Unit Trusts and Mutual Funds. Clause 7.14 of that code prohibits a scheme from investing in any type of real estate. Accordingly, prior to the issue of the Reit code, it was not possible to offer units in a Reit to the public in Hong Kong.

The Reit code does not have the force of law, but merely provides guidance on how the SFC will exercise its powers under Section 105 of the Securities and Futures Ordinance.

How will a Hong Kong Reit structure be taxed?

There is no general income tax in Hong Kong. However, profits tax (currently at the rate of 17.5 per cent) is chargeable on the assessable profits arising in Hong Kong from a trade, profession or business carried on in Hong Kong. In calculating assessable profits, a person is generally entitled to deduct interest payable to a bank on a loan. Dividends received from corporations that are chargeable to profits tax in Hong Kong are exempt from Hong Kong profits tax.

Owners of land and/or buildings situated in Hong Kong are subject to property tax at the rate of 15.5 per cent (increasing to 17 per cent in 2004-05) of the net assessable value of such property. The assessable value of property is the amount payable to, or to the order of, or for the benefit of, the owner in respect of the right of use of that property. The net assessable value is the assessable value less certain deductions. Where the owner does not agree to pay rates in respect of the property, the deductions are set at 20 per cent of the assessable value of the property.

A corporation that carries on a trade, profession or business in Hong Kong is entitled to an exemption from property tax.

Accordingly, if a Reit holds property through special purpose companies (SPCs) and those SPCs carry on a business in Hong Kong, which is likely to be the case, then: the SPCs will be subject to profits tax on their assessable profits at the rate of 17.5 per cent; in calculating assessable profits, the SPCs will be entitled to deduct interest paid to certain third parties (such as banks); the SPCs will be able to pay tax-free dividends to the trust; and the trust will be able to make tax-free distributions to unit holders.

Listing on the HKSE

The rules of the HKSE do not currently provide for the listing of Reits, but it is understood that the SFC and the HKSE are discussing the processes to apply to the listing of Reits.

The future

It seems that the only significant impediment to the establishment of a successful Hong Kong Reit market is the need for the HKSE to alter its listing rules to permit the listing of Reits. Hopefully, given the positive steps taken by the SFC, the exchange will be able to quickly amend the listing rules to permit the listing of Reits.

The positive reforms implemented by the SFC should provide both retail and institutional investors with a good alternative to direct investments in real estate. This alternative should help stimulate demand for Hong Kong real estate.

Tom Lennox is a partner and Hayden Flinn, who assisted with this article, a senior associate at Mallesons Stephen Jacques

Key features of the Reit code
Structure: The real estate investment trust (Reit) must be structured as a trust. The Reit may hold real estate directly or through up to two layers of special purpose companies
The manager: The Reit code requires the manager to be an experienced fund manager. The manager must have two responsible officers who have at least a five-year track record in managing collective investment schemes
The trustee: The trustee will generally need to be a bank licensed in Hong Kong
The assets: The Reit code requires the Reit to hold income generating real estate (held directly or indirectly). Initially, Reits will only be permitted to hold Hong Kong real estate
Taxation: Distributions from an authorised Reit are exempt from profits tax
Distribution: The Reit code requires 90 per cent of the income of the trust to be distributed to unit holders
Valuation frequency: The property of the trust must be valued annually
Listing of units: The Reit code requires units to be listed on the Hong Kong Stock Exchange
Redemption of units: There is no requirement for the units to be redeemable
Gearing: A Reit is subject to a gearing cap of 35 per cent of gross assets