According to JLL's newly released report titled Financing China's Real Estate: Pragmatism and Creativity Will Prevail, China's rapid-developing real estate finance sector stands at a crossroads.
JLL's new report gives a comprehensive picture of the various financing models currently used by China's real estate developers, including bank loans, domestic and foreign corporate bonds, senior debt, perpetual bonds, trust firms, P2P lending, crowd-funding, and joint ventures. In addition, the report conducts in-depth studies of the opportunities and challenges faced in China by emerging financing models such as CMBS and REITs.
According to JLL China's Head of Capital Markets Research Dave Chiou, the Federal Reserve's efforts to taper off Quantitative Easing and raise interest rates mean that the days of easy financing or re-financing for Chinese developers and assets holders may be ending. In particular, China's central government may introduce a new wave of tightening policies, which will further increase financing difficulties for businesses. "In order to obtain necessary funding and reduce financing costs, developers and asset holders must rely on a combination of traditional financing models (such as bank loans or corporate bonds) as well as other financing channels."
"Although asset securitization is still in its infancy in China, it has vast potential and is expected to become a major financing model for Chinese developers and asset holders. This model is likely to influence the overall development pattern of China's real estate finance sector," said Joe Zhou, Head of Research for JLL China.
Bank loans, corporate bonds and senior notes are the traditional primary funding sources for Chinese developers. Corporate bonds and senior notes in particular are characterized by easy access of capital and low interest rates.
These financing models alone are insufficient to satisfy the ever-growing financing needs of real estate developers, however. Rising land prices in particular have led many developers into a state of high leverage. In addition, China's rapidly-changing policy environment heightens the risk for firms relying on a narrow range of financing models.
As a result, developers are expected to actively seek more diversified financial channels. In recent years firms already have begun to favour relatively new funding sources such as perpetual bonds, trust firms, P2P lending, crowd-funding, and joint ventures.
Opportunities and challenges for asset securitization
Asset securitization - which already has reached a state of maturity in the US and other countries - remains in its infancy in China.
The forms of asset securitization most relevant for Chinese developers include commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS) and asset-backed securities (ABS). All three types help asset holders release value while retaining the underlying assets' future growth potential.
After the People's Bank of China relaxed its rules for the sales of such structured products in 2015, their popularity in China has grown. That said, the scale of China's mortgage and asset-backed securities market remains a drop in the bucket compared to developed markets such as the US. Statistics show that the total issuance of CMBS in the US hit USD 76 billion in 2016, accounting for 98% of the world's total. Since the 2008 financial crisis, annual issuance of CMBS in the US has held steady in the USD 50-100 billion range.
Asset securitization still has vast potential for development in China. "Considering the huge scale of China's real estate market and the needs of banks and developers for alternative financing channels, CMBS, RMBS and ABS will become increasingly popular, and their issuance will grow in the years to come," said Chiou.
The trend towards greater use of mortgage and asset-backed securities in China is evidenced by innovative recent examples. In December 2016, Asia Pulp & Paper launched its first CMBS product in China, with a total deal size of RMB 7.8 billion. In August 2016, Everbright Real Estate Investment Consulting Limited launched its first ABS product in China in partnership with its investment affiliate, with a total transaction volume of RMB 1.6 billion.
REITs: The next big thing in China?
Real Estate Investment Trusts (REITs) are another relatively new financing model with vast potential in China. REITs differ from CMBS, RMBS and ABS in that they securitize on the equity of underlying properties rather than the debt of assets. They help asset holders realize their asset value, and provide retail investors with relatively a low-risk option for real estate investment. From the perspective of developers and asset holders, REITs are a means to reduce debt leverage ratios and obtain long-term financing.
REITs have been welcomed by investors for their advantages in diversification, affordability, liquidity, tax benefits, and transparency. In 2016, the US REIT market exceeded USD 1 trillion in market capitalization. REITs remain a new type of asset in Asian markets, however, with only Japan, Hong Kong, and Singapore having established REIT markets. Legal and procedural barriers so far have prevented China from launching true REIT products.
"Over the short-to-mid-term, REITs are unlikely to develop in China, even if policy makers loosen regulations or provide tax preferences to investors," observed Zhou. "Low rental yields are the biggest barrier. At present, yields for many assets are only 4% or even lower. In addition, and lack of professional management talent for REITs and property assets also have restricted the development of REITs in China."
In spite of many difficulties, REITs are still regarded as a promising alternative approach for China's real estate financing sector. "Further relaxing of policy and evolving mindsets from investors, developers and asset owners could allow REITs to emerge as a major funding solution in China over the long term. REITs' ability to offer stability, returns and diversification that no other asset class can mimic ensures that they will continue to receive consideration in the years ahead," said Zhou.