Professional Interpretation

Abstract:
Under the situation that the regulatory authorities issued the new regulations to prohibit the private equity funds from conducting entrusted loans and other loans, the project of Country Garden REITs was approved by the Shenzhen Stock Exchange with a “100% Stock + Debt” model. It marked that the regulatory authorities approved the project of Class Reits with the trading mode of the “Stock + Debt”. It complies with the new overall financial regulatory policies and requirements, and also conducts penetration analysis on the development status and specific business conditions of Class REITs, and gives them reasonable recognition in line with actual conditions, reflecting the rigorous and flexible nature of supervision. The Finance and Capital Market Team of Beijing Docvit Law Firm hereby presents a brief analysis of the trading mode of the “Stock + Debt” combining the Project of Country Garden REITs.

REITs is a new type of financial investment product that originated in the United States and can effectively integrate three financial instruments: real estate, investment, and asset securitization. With the continuous development of economy, REITs gradually entered the real estate market in China. The domestic REITs mainly depend on the existing trust legal system, but in the strict sense it is not a real REITs, only some of these items have the shape of REITs. It generally referred to as “Class REITs”. The domestic Class REITs in China have certain differences in the structure of transaction structure, the level of tax burden, the source of operating income, the income distribution method and the form with the foreign exchange REITs.

A.The type of the trading structure of Class REITS Product 

China's domestic laws and regulations for REITs are relatively lack. It determines that the present stage of the current market Class REITs product trading structure has its stage of particularity.

The trading structure of Class REITs product is different from other asset support special programs. In general, the special plan does not directly hold the equity of the project company, but indirectly holds the equity and debt of the project company by holding the SPV share/benefit rights, so to achieve the goal to hold all the rights of the target property. Compared with the special plan directly holds the equity and debt of the project company, the advantage of the above operation is that in the future, if the relevant policies of the REITs are introduced, the special plan holder can exit by transferring the SPV share/benefits right.

In SPV design, the current mainstream model is to establish the private equity funds. Private equity funds will purchase equity from the project company. At the same time, they will also issue corresponding entrusted loans/trust loans or shareholder loans to the project company in lieu of their existing debts (if any). And when SPV controls the project company, it will also adopt two structures:

a.Pure equity 

The structure of pure equity is usually due to the absence of stock debt at the project company, the SPV can only hold the equity of the project company. The disadvantage of this type is that the operating income generated by the project company can only be transferred to the SPV through the shareholder dividends. So it should pay more taxes and fees;

b.“Stock + Debt”

The structure of “Stock + Debt” is that the SPV purchases of equity of the project company, and issues the entrusted loans/trust loans or shareholder's borrowings to replace the original debts of the project company and enjoy all the rights and interests of the project company. The operating income generated by the project company can be returned through the entrusted loan/trust. The loan or shareholder's loan principal and interest model is transferred to the SPV and can also be transferred to SPV through shareholder dividends. The amount of taxes and fees can be deducted to a certain extent by repaying the entrusted loan/trust loan or the shareholder’s loan principal and interest. To a certain extent, the loss of the operating income of the project company is reduced. This method is generally the current mainstream method.

B.The objective reason why the Class REITS adopt the trading structure of “Stock + Debt” 

Under the current regulatory environment, REITs adopting the “stock+ debt” mode through private equity funds to become a more mainstream transaction structure can mainly be attributed to the overall consideration of product cost income and tax burden, specifically in the following aspects:

a.If there is only equity investment, the priority income of REITs is realized through the level of equity dividend of the underlying property. The annual dividend of the underlying property is mainly from the net profit after the tax payment in the current year. If the project company wants to distribute, it must pay 25% of the company's equity first. It will affect the return of investors. In practice, private equity funds generally issue entrusted loans to project companies. However, the regulation of new regulations has forbidden private equity funds from entrusting loans. Therefore, Country Garden REITs project borrows from the shareholders in the form of a loan to the project company. The loan is subject to repayment of interest. Under certain conditions, taxes and fees are deducted so that cash flows can be allocated upwards by repaying shareholders’ borrowings, so that tax avoidance can be carried out reasonably and legally to provide investors with benefits.
b.The property held by the project company is subject to reasonable amortization and depreciation according to certain accounting policies. The depreciation and amortization expenses will also affect the distributable profits of the project company and affect the investor’s income. Therefore, the effect of depreciation, amortization and other factors on the return of earnings is effectively avoided by repaying the loans of shareholders.
c.The general project company will have a certain amount of stock debt (bank loans or real-name debts). If the debt is clear, it may not need to build a "stock + debt" model, and direct transfer of credits and equity through SPV. The reason why the “stock + debt” model was adopted was mainly due to the fact that some project companies had unclear claims and debts, which needed to be re-established, making the basic assets clear and better performing asset securitization.

C.New Regulations issued, Country Garden's "stock + debt" REITs project approved 

On January 5, 2018, Promulgation of the Administrative Measures for Entrusted Loans Undertaken by Commercial Banks by the China Banking Regulatory Commission stipulated that the commercial banks shall not accept the Funds of others under its management as entrusted.

On January 12, 2018, China Securities Investment Fund Industry Association issued the Regulations on the Registration of Private Equity Funds. It said that investments of private equity funds should not be borrowing activities. The fund industry association will not handle the filing of such funds: By means of entrusted loans, trust loans, etc. directly or indirectly engaged in lending activities and through special purpose vehicles, investment companies, etc., disguised as such activities.

The above new supervision provisions of the two regulatory agencies may directly lead that the original mainstream investment model(“stock+debt”)of the original REITs product will be not meeting the new regulations, which is a major impact on the Class REITs products.

So the fund industry association asset securitization professional committee convened a special seminar on REITs business on January 24, 2018.The meeting clarified that private equity investment funds are feasible investment tools for participating in REITs business. The meeting put forward the process of optimizing the filing and listing process for the filing and listing of private equity funds for participation in REITs-like businesses and asset exchanges. On the investment side of private equity funds, private equity funds can use equity, mezzanine, convertible bonds, and shareholder loans that meet the constraints of capital weakening to invest in the invested companies, forming equity capital, and private equity fund products that meet the requirements can be properly filed.

Under the above-mentioned regulatory conditions, the project of Country Garden REITs was approved by the Shenzhen Stock Exchange with a “100% Stock + Debt” model. The Country Garden REITs project uses private equity as a basic asset to establish asset support special plans, and private equity funds directly control the project company through “100% Stock + Debt”.

From the current point of view, Class REITs products have been developed for many years in China, but there is still some way to go from the real REITs. In the period when we have not formally introduced the public REITs system, the core idea of REITs has been used to explore and develop REITs. It has become an important part of China's asset securitization business, which is conducive to promoting the healthy development of the real estate market, promoting the revitalization of stock assets, and supporting real estate companies to reduce the leverage ratio. It is an important means for the capital market and asset management industry to serve the real economy. With the continuous introduction of regulatory requirements, while deepening the reform of the financial system, we will enhance the financial service entity’s economic capabilities and promote the healthy development of multi-level capital markets.