Many people might wonder what the difference is between a REIT and a listed real estate company.

At first glance, they appear very similar because both are engaged in real-estate projects with funding that can be raised publicly through the capital market.

While in some respects, the two forms of investment share some similar advantages, when one looks further into the nature of a REIT and a listed real-estate company, the regulatory framework and other conditions governing their operations respectively, one can see that there are actually many significant differences between them.

A Real Estate Investment Trust (REIT) is a collective investment scheme. This is stated in the Hong Kong code on REITs. It is a trust that invests primarily in real estate with the aim of providing to holders, returns derived from the rental income of the real-estate investments. Moreover, funds received by a REIT through the sale of units in the REIT are used in accordance with the prospectus to maintain, manage and expand a real-estate portfolio.

There are several advantages of using REITs as a mode of real estate financing. A REIT may be listed on the stock market whereby funds from investors are utilized for investment in specific real estate projects. Real-estate projects are normally disposed of by the original owner and passed on to the REIT at values very close to the market values at the time of listing. Units in a REIT are listed securities that are tradable in the stock market, thus providing liquidity to both the financial assets of the securities and the underlying physical assets of the trust, namely the properties. Under certain circumstances, the original owner may retain control and management rights of the real-estate projects even after disposal of the properties to a REIT. There are usually preferential tax allowances for REITs in certain countries that result in higher asset return performance.

Listed real-estate companies, on the other hand, are ordinary public companies that have their shares listed on a stock exchange. Broadly speaking, there are two types of real-estate companies.

The first type is comprised of property investment companies that acquire or develop properties and then retains them. In other words, they invest in income-producing properties. The rental income is used to cover running costs and interest charges and to pay dividends. The market price of its shares should theoretically reflect the value of the underlying properties. The second type of company comprises of developers/traders that construct or acquire properties and then sell them for profits. As a result, such companies' shares tend to be priced according to their expected earnings growth.

The market price of a listed real-estate company's shares is generally lower than its net asset value (NAV) per share. Academic research results indicate some possible reasons for such a discount when determining NAV, including asset-management fees, effects due to tax, agency costs incurred due to different aims of the asset owners and managers, excess volatility in the stock market because of uninformed trading in shares and the stock market's lack of confidence in the management of the real-estate company. However, the market price of a unit in a REIT is generally much closer to its NAV per unit. This may be due in part to the various protective measures which are in place and set out in the constitutive documents establishing the REIT as well as better returns generated by the REIT because of lower tax charges.

Listed real-estate companies need only comply with the listing rules of the stock exchange on which the companies' shares are traded, while REITs, in addition to listing rules, have to comply with the code of practice on REITs. The code imposes many restrictions on the functions of the REIT including its investing, financing and distribution policies.

Like other public companies, the management of a listed real estate company is empowered to make decisions on property investment and development. However, the management of a REIT must operate under very tight restrictions , as set out in the code, including investing in real-estate projects that provide steady returns to unit-holders; being restricted in the way it invests in real-estate ventures and in the type and location of real-estate projects.

A REIT is allowed, under the regulations set out in the code, to borrow funds to finance investments or for operating purposes, but the aggregate borrowings are not allowed to exceed 35 per cent of its total gross asset value. A listed real-estate company normally does not have any borrowing limit imposed on it other than sometimes by its own lenders.

The management of a listed real-estate company also has absolute discretion when determining the dividends the company will pay out - they may declare a high or a low dividend payout ratio. It has recently been reported that Hong Kong's listed real-estate companies, on average, pay dividends to a value of 40 per cent of their net profits. On the other hand, REITs are required to pay out a much higher portion of their profits to their unit holders. As stipulated in the code, not less than 90 per cent of a REIT's audited annual net income, after tax, has to be distributed among its unit holders. Because of this requirement, returns to unit-holders of a REIT, while steady, are normally low, at a rate of 2 per cent to 3.5 per cent above government bonds, while returns to investors of a listed real-estate company will fluctuate.

In countries like the US, where REITs play an important role in real-estate financing and investment, a REIT may elect, where permitted under local tax laws, to qualify to become a pass-through entity that distributes, to its unit-holders, almost all of its profits and capital gains generated from the disposal of its properties.

The REIT does not pay taxes on its profits, but the distributed profits do represent dividend income to unit-holders and are taxed accordingly.

An independent trustee is required to be appointed for a REIT. The trustee is responsible for exercising all necessary due diligence and vigilance in carrying out the functions and duties of the trust and protecting the rights and interests of holders.

Such appointees should be able to achieve and maintain a higher standard of corporate governance through an effective overview of the work performed by the property management.

On the other hand, a major shareholder of a listed real-estate company very often controls the composition of the board of directors and thus the functioning of the management - this may sometimes affect interests of minority shareholders.

* Richard Ho is Partner and China Industry Leader of the Real Estate and Construction Practice, Deloitte Touche Tohmatsu

(HK Edition 08/30/2004 page15)