While industry players eye the sector's development, analysts are worried by the smaller sizes of Hong Kong portfolios and the potential for abuse A new type of investment could signal a change in Hong Kong's property market and the government's policy for funding the budget deficit. The investment is called a real estate investment trust (REIT). Two institutions are now involved in issuing REITs based on properties in Hong Kong. Property developer Cheung Kong (Holdings) has announced the initial public offering of the Fortune Reit, which will contain five Hong Kong shopping malls and will be listed in Singapore. In addition, the Housing Authority is floating the idea of selling a REIT that would contain its collection of carparks and retail stores, in what could be a move towards the privatisation of the government's housing stock. On the face of it, these two deals sound like nothing more than another fancy investment vehicle concocted by investment bankers for wealthy clients or sophisticated portfolio managers. However, analysts and economists say these REITs are significant for two reasons. First, Cheung Kong is backed by Li Ka-shing and is known for being a trendsetter in financial matters. Other property developers are widely acknowledged to be watching the success or failure of the Cheung Kong deal and are likely to jump on the bandwagon if all goes well. In addition, a new market in REITs would portend a shift in the attitude towards the property market, where steady returns in dividends is replacing a hope for rising prices. 'REITs are a good market where we don't expect substantial capital growth,' said Edmund Ho, vice-president of investment banking at JP Morgan. 'We're not going to see substantial growth in the property market in Hong Kong.' REITs, long popular in the United States and Australia, are a listed security that consists of a collection of property investments whose income is distributed as dividends to investors. But there are big differences between Hong Kong and other markets. First off is the question of concentration of risk. The average US REIT contains 143 properties and assets of US$2.1 billion. Australia's REITs have an average of 33 properties and asset size of $3.2 billion. In contrast, Hong Kong - where admittedly the market is just getting off the ground - is looking at its first Cheung Kong REITs with five properties and a total value of about US$250 million. The fewer and smaller the properties in a REIT, the greater the risk of instability in profits, particularly if the group of properties is clustered in a particular sector of the market. Another important risk is the shorter length of leases in Hong Kong, about three years, compared with other countries. Shorter leases mean potentially rapid turnover of tenants. Management of the properties held by the REIT is an issue that investors from Hong Kong and other countries face. When a company sells its portfolio of properties in a REIT, it generally hands over management to an independent firm. However, if the managers do not own the properties, they may not have a long-term interest in developing them. Australia is coming up with new rules that would add clauses for performance-based pay or even grant managers equity in the REITs they manage. Most REITs are a bet on the direction of property prices and interest rates. If prices climb and interest rates drop, REITs perform well. But given the difficulties of the Hong Kong property market, these assumptions must be questioned. For these reasons, some property experts say REITs could be misused by companies seeking to remove troubled properties from their balance sheets in the guise of what appears to be a safe investment in a quasi-mutual fund. 'There are a lot of distressed real estate developers who see this as a way out of their problems,' one property executive said. 'It's being marketed as a product for widows and orphans but it's not.' Goldman Sachs analyst Ting Chuk-kwan believed the proposed REIT was a good deal for Cheung Kong. 'The shopping malls are highly illiquid so it is almost impossible to turn over the assets in an open market,' she wrote. A further note of uncertainty is injected by the possibility that mainland real estate will be included in REITs. Property consultants say the Shanghai Land debacle, where loans were misused, has raised fears a similar problem with a REIT in Hong Kong could quickly turn investors off the market. However, the Securities and Futures Commission (SFC) is attempting to stave off fiascos in the fledgling REIT market. For example, sources said the SFC is debating a rule that would restrict Hong Kong REIts to Hong Kong properties for the first 12 to 18 months of the market's existence. It is also weighing a 35 per cent cap on a REIT's debt level. 'Hong Kong regulations appear much more micro in managing REITs than in Singapore,' noted Moody's analyst Clara Lau. This could provide some assurance to investors, she said. There are aspects of the structure of the Cheung Kong REIT that make it a positive bet for investors. First, industry executives said three investors were buying almost 20 per cent of the deal, providing support. They are investment group Capital Research at 5 per cent; DBS, the issuing bank, at 10 per cent; and Societe Generale, at 4.9 per cent. None of these firms could be reached to confirm their potential investment. In addition, Cheung Kong is offering a three-year guaranteed dividend payout of 6.5 per cent to provide worried investors with a floor on their investment. While a guarantee offers some security, some analysts said it was insufficient. 'We think the Hong Kong retail property yield should be around 7.5 per cent, so the average yield on the Fortune REIT portfolio seems low,' wrote Douglas Sung, an analyst with JP Morgan. One fund manager said the pricing might be too high given that shares of most property companies were now trading at a 20 to 30 per cent discount to their net asset value (NAV). 'I think investors are wary of developers selling assets at par with NAV that trade at big discounts in the market,' one fund manager noted.