Hong Kong reits have also had a good run, with their prices rising an average 89 per cent over the past three years; significantly outperforming the Hang Seng Index, which dropped 6.5 per cent over the same period. (See Table 1.)

That hits the zeitgeist. Hongkongers want steady returns, but they also want a bit of something extra - a bit of risk and upside - and reits fit the mood. They are not as dull as bonds, but they are not the sinkhole of equities, either.

There are several reasons why reits have performed so well. Most of the reasons are good news. But some give pause for thought. This article takes a hard look at the reits' hidden risks, and includes a breakdown of Hong Kong's main listed property trusts.

To begin, let's look at the positive aspects. Office reits have shown their resilience in recent years. Because the trusts involve properties with tenants that sign multi-year leases, their income tends to be stable even during downturns. Office reits also benefited from an upward trend in lease rates, as these are renewed. Office rentals rose above their pre-credit-crisis levels during the second quarter of 2011, according a Hong Kong Valuation and Rating Department index.

Reits have also benefited from the mainland tourism boom, which boosted the incomes of those with retail space and Hong Kong hotels in their portfolio.

The reits have, in line with rising property rentals, recognised massive revaluation gains on their property portfolios over the past few years. For instance, Champion Reit recorded a HK$4.6 billion revaluation gain in the financial year 2011, representing more than 70 per cent of its net profit for the period.

Similarly, more than 90 per cent of Sunlight Reit's net profit was derived from such revaluation gains during its 2011 financial year.

Reits have also benefited from declining interest rates, which have lowered borrowing costs as they are allowed to borrow up to 45 per cent of their asset value.

Meanwhile, because of their high yields, some private banks are offering to lend clients money at a low interest rate (say, 2 per cent) to buy reits, which offer an average dividend yield of about 6 per cent. In the minds of some, the difference between the cost of borrowing and the reits' dividend yield constitutes free money - in other words, highly attractive. This has helped drive up prices for Hong Kong reits.

But as the Chinese saying goes, there are no endless banquets under the sun. The same factors that have benefited the reits may come back to haunt them.

Expiring tenancy leases may be renewed at lower rates. Growth is slowing in the number of mainland tourists coming to Hong Kong.

This is already being felt by the retail sector, and this could, in turn, place downward pressure on retail rentals and hotel rates.

Reits are unlikely to continue posting huge property revaluation gains, which together with slower growth prospects, helps explain why most are trading at low historical price-earnings ratios and at significant discounts to book value.

Reduced distributions can have a big impact on share prices. For example, a reit trading at HK$100 might pay a dividend-per-share of HK$6, or a yield of 6 per cent.

If it cuts its dividend to HK$4, the share price will have to drop to around HK$67 to maintain the dividend yield of 6 per cent expected by investors.

If reits' prices were to drop dramatically, investors with highly leveraged positions would face big losses. Leverage, after all, cuts both ways - it amplifies gains and losses.

Reits involve a lot more risk than investors might realise. They are income instruments, yes, but they are ultimately exposed to the highly cyclical property sector with highly variable earnings and dividends.

There are also factors baked into the reit structure that make them a tricky investment to assess.

For example, the trusts commonly involve conflicts of interest, a fact that is routinely disclosed in their prospectuses and annual reports.

In Hong Kong, reits are typically led by major property players. These parties are called 'sponsors', and the reits serve as a platform through which the developers can sell mature properties. The idea is that the developers want to keep selling their developments and then use that money to buy more land and build more properties.

The sponsors also usually control the reit and property managers. (See Table 2.)

The reit manager oversees the reit, tending to matters such as new acquisitions, finances, investor relations and the like, while the property manager looks after the day-to-day running of the reits' properties.

As both the reit and property managers involve well-paid professionals, their fees can be substantial, which enables the sponsors to take back much of the cash flows generated by reits as management fees. (See Table 3.)

For its 2011 financial year, Sunlight Reit paid about HK$61 million in reit management fees to Henderson Land Development, which represented about 38 per cent of its net profit (before non-cash revaluation gains) that year, according to its annual report.

Meanwhile, Champion Reit paid HK$187.5 million of reit management fees to the Great Eagle group in 2011, or about 31 per cent of its net profit before non-cash revaluation gains and changes in fair value of the derivative components of its convertible bonds, also according to its annual report.

Reit managers decide on new acquisitions, subject to shareholder approval. As the managers are typically controlled by the sponsors, the latter might be tempted to sell over valued assets to reits since they receive all of the sale proceeds and bear only part of any losses, as a less than 100 per cent shareholder of the reit.

Then there is the matter of how sponsors sell their properties through the reits' initial public offering (IPO). As reits are supposed to be about steady income returns, they commonly use financial engineering to boost the yields at the time of IPO marketing to make the offer as attractive as possible to investors.

Let's take Sunlight Reit, which was listed in December 2006, as an example. Sunlight Reit has a floating rate loan which cost about 4.5 per cent at the time of its listing on the Hong Kong exchange.

It used about HK$215 million of the IPO proceeds to buy an interest rate swap under which it could cut its borrowing cost to a then lower fixed rate of between 3 per cent and 3.5 per cent. The swap increased the short-term yield of the reit, which was helpful for marketing the IPO.

But the swap backfired when interest rates fell. Sunlight Reit had to continue paying a fixed 3.5 per cent interest rate under the swap even though the cost of the floating rate loan fell below that rate.

As a result, Sunlight had to pay the swap counterparty about HK$37 million to unwind part of the swap and recognise about HK$53 million of losses on the unwound portion during its 2010 financial year. The investors in Sunlight's IPO bore the brunt of those losses.

Sunlight's swap was not unusual. Prosperity Reit, a Cheung Kong spin-off, that listed in December 2005 also used an interest rate derivative to give its IPO an initial yield boost, as did Champion Reit, which listed in May 2006.

The structures prompted the Securities and Futures Commission to publish, in May 2006, a note to investors clarifying that such swaps provided little benefit to investors except to cosmetically boost the short-term distributions of the reit. As clarification, the commission said: 'Investors are funding part of the distributions they receive from the reit by their own [IPO] subscription monies.'

Henderson Land Development, meanwhile, gave up all or part of its dividend entitlements and agreed to accept its reit management fees in the form of Sunlight units for five financial years. Henderson also guaranteed a minimum rental income generated by the properties it sold to Sunlight. Sunlight it turn guaranteed a minimum dividend it would pay to investors, for three years.

Sponsors often use such mechanisms when marketing reit IPOs. This is good news for investors, as fee income that would otherwise go to the sponsor stays in the reit, at least in the early years. The danger is that this arrangement is temporary, and it might give IPO investors an unrealistic idea of a reit's long-term yield potential.

Sunlight Reit's prospectus stated that a whopping 73.6 per cent of its dividends in financial year 2007 and a 'good part' of its dividends from financial years 2008-11 were attributable to the above schemes.

In other words, as the fee deferments unwind and fee income starts flowing to sponsors, investors might be left wondering why dividend income starts dropping.

Investors who suddenly see fluctuations in their reit yields should understand that this might be driven by financial engineering on the part of the sponsor, and this is all part of the risks of owning a reit.

Khor Un Hun is a former investment banker specialising in corporate finance