The development of real estate funds in China has gathered momentum in 2010, and more are in the pipeline. By Phill Smith, partner, and Ren Yong, registered foreign consultant (New York, USA), Mayer Brown JSM, Hong Kong
Following a number of regulations issued earlier this year to dampen price inflation in the residential property market, and just before the week-long national holiday at the start of October and the expected “golden week” for property sales, several ministries of the PRC central government, including the Ministry of Housing and Urban-Rural Development, the Ministry of Finance, the State Administration of Taxation and the People’s Bank of China, promulgated further measures on 29 September to curb speculation and stabilize home prices.
These new measures built upon prior regulations by providing detailed implementation requirements and emphasizing enforcement activities, but also went further in many respects. For example, the minimum required down payment was increased from 20% to 30% on first homes for all residential property types, and the ban on mortgage loans for a third home was broadened to the entire country instead of limited to a few key cities. The new regulations are viewed as a response by the central government to the waning effect of prior measures and the continued rapid rise of residential real estate prices, which increased over 10% nationwide in August and September alone. The new regulations demonstrate the government’s determination to keep residential property prices from getting out of control and prevent the bursting of a property bubble, which could have adverse consequences not only for the real estate and banking sectors but also for the wider economy.
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Liquidity squeeze
The central government’s macro-economic measures, together with implementing measures issued by various municipalities, severely restrict the liquidity of real estate development companies whose traditional sources of capital, namely loans from banks and trust companies, and the issuance of debt or equity, have virtually disappeared (although windows of opportunity still occasionally appear for a handful able to issue high-yield bonds). In the meantime, the central government has called for stronger enforcement of its “use it or lose it” policy, which requires a developer to forfeit land use rights on land that has been idle for more than two years, and more recently, prohibits a developer from participating in land sales if that developer has delayed construction work on a site for a year. Such requirements, together with the inherent capital-intensive nature of real estate projects, have caused real estate development companies to search for alternative sources of capital, among which private real estate funds have emerged as an important capital source.
Real estate funds formed by both international and PRC sponsors have been operating in China since before the crackdown on bank lending for real estate. Notable funds include the Asia/China real estate funds sponsored by Carlyle; funds run by various international banks, including Morgan Stanley and Bank of America, Deutsche Bank RREEF, HSBC/ Nan Fung and Singapore’s Ascendas Group; and more recently, UBS’s joint venture China real estate fund with Gemdale Corporation, a PRC real estate development company, and Angelo Gordon’s second Asia property fund, focusing on China. Such real estate funds are typically denominated in US dollars and formed in offshore jurisdictions. Since last year, however, RMB real estate funds have been formed in China by international sponsors, including Prax Capital and Banyan Tree.
The development of real estate funds in China has gathered momentum in 2010, as real estate development companies have increasingly turned to private funds for capital, and as private funds in general have grown in the PRC. The sponsors of real estate funds include experienced players in the private equity market that wish to expand into real estate, and real estate development companies, which, as new entrants to the field, seek to finance their own projects. Such real estate funds may be raised offshore – for example, US dollar funds raised by China Resources, China Overseas Land & Investment and ICBC International – or among PRC investors. In particular, there have been a number of RMB real estate funds formed by well-known private enterprises in the real estate sector, including the GrandChina Fund (which raised approximately RMB500 million in March) and E-House (China) Investment Funds (which raised approximately RMB880 million in the same month). There are more in the pipeline, such as Nanhai Shengbang Real Estate Investment Fund and, most recently, Xinghao Capital, jointly sponsored by Fosun Group and E-House (China) Holdings, targeting an initial closing of RMB3 billion. The fundraising efforts of such real estate funds are usually undertaken either through private placements via their own network or, more often, in conjunction with private banking or wealth management arms of banks or other financial institutions. At present, there are about 10 such real estate funds operating in China.
Trend will continue
It is expected that PRC real estate companies will continue to source capital from real estate funds, for a number of reasons.
First, the central government’s regulations and efforts to cool the residential real estate market are expected to last for an extended period of time. This will continue to put strain on real estate companies’ ability to access capital, and cause them to search for alternative sources of funds. In the process, real estate funds sponsored and managed by real estate companies will gradually evolve from a mere capital-raising tool to finance their own projects to a sophisticated real estate asset financing and management platform. Such platforms constitute an integral part of the management toolbox of large real estate companies. Major players in the real estate market, like Gemdale Corporation and Fuson Group, have predicted that their real estate financing platform will contribute 20% or more of their total profit in five to 10 years’ time.
Second, all the restrictive measures passed by the PRC central government are aimed at cooling the residential real estate sector and keeping its growth healthy and orderly. However, real estate also includes commercial real estate, mixed properties and industrial parks, to name just a few. These are not subject to such regulations and offer attractive investment opportunities for real estate funds, particularly in second and third-tier cities. Given the importance of the real estate market, it will be difficult to argue that the central government wants to do anything other than to nurture its growth, again, in a healthy and sustainable manner.
Third, there is substantial liquidity among PRC investors, whether from private enterprises or high net worth individuals. Such liquidity needs to find investment opportunities, and in the recent past, has been flowing to real estate assets. With increased risk associated with investment in residential properties as a result of the government’s regulatory actions, real estate funds could potentially provide another form of investment to channel capital from such investors away from holding real estate assets to participating in developing a variety of real estate projects through real estate funds. In September, the China Insurance Regulatory Commission permitted insurance companies to diversify their investments into the real estate sector, except that insurance companies cannot invest in residential properties, develop real estate or set up, invest in or own real estate development companies. All of the above constitute a pool of potential PRC investors which may support the continued growth of real estate funds in China.
Last, the development of real estate funds in China and the thirst for offshore capital that some of them have present an opportunity for offshore real estate funds. Due to delays and uncertainties resulting from China’s foreign investment regulations, approval requirements and foreign exchange controls, the issue of how to compete against domestic PRC companies or funds, which are not subject to similar restrictions, has perplexed potential offshore sponsors. However, when offshore sponsors partner with PRC real estate development companies to raise offshore capital to invest in real estate projects that the PRC real estate development companies already own, such disadvantages otherwise faced by offshore funds in securing deals no longer exist or are substantially mitigated. It is estimated that offshore financing by PRC real estate companies, through private real estate funds or other means, reached US$10 billion in the first eight months of 2010.
Real estate funds, onshore or offshore, could become an important source of capital for PRC real estate development companies. Singapore state investment company Temasek Holdings, through its subsidiary Mapletree Investments, has announced a new private equity fund of US$1 billion, focusing on PRC real estate investments. This fund will become the largest offshore real estate fund investing in PRC real estate. Meanwhile, private Chinese entrepreneurs, led by real estate development companies or fund sponsors, have joined the fray. It is foreseeable that the PRC real estate fund sector could experience a period of rapid growth, accompanied by an increased number of market participants, larger real estate funds and increased competition. Not all such funds will survive, but the ones that do may change the way real estate development companies operate in China. In the future, developers may need to take account of the views of the managers of the real estate funds, create transparency and accountability, and establish more formal reporting proceedures.
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