Drilling down on real estate financing
Over the last decade or so there has been dramatic growth in PRC real estate developments in the larger cities, and much of that has been financed by debt.
PRC real estate developers have utilised a range of debt funding sources, including US dollar denominated bonds issued in offshore capital markets[1].
It has been widely reported that tens of billions of US dollar denominated capital markets issuances (some of which carry junk bond status) will mature in 2021, and there are numerous macro factors making it challenging to roll-over bond issuances in the next 12-18 months including:
- challenging (albeit, improving) market conditions for the property sector in PRC; and
- a more complex geostrategic environment.
In such scenarios in the past, developers might have expected to access debt funding from PRC banks. However, following the economic downturn in 2020, policymakers in the PRC have focussed on supporting the domestic economy. This has meant that PRC banks have prioritised making new debt available to SOEs, POEs and foreign investors for their PRC operations to stimulate economic activity and jobs creation on the Mainland.
In any case, on the domestic front, PRC policy makers are concerned about the high debt levels of many PRC real estate developers, and they have proposed hard restrictions on debt levels of such developers, commencing 1 January 2021. These hard restrictions, known as the "three red lines", have not yet been released, but are anticipated to involve requirements that:
- liabilities do not exceed 70% of assets (excluding advance proceeds from projects);
- net debt does not exceed equity; and
- short-maturity debt liabilities do not exceed cash on hand.[2]
Policy attitude
The real estate market is still one of the most heavily regulated sectors in the PRC.
However, it is perhaps no surprise, that PRC regulators are now moving towards policy settings which support the diversification of the investor base, including to offshore PE investment.
The focus of this article is on one of the means of facilitating foreign investor access to the Mainland property sector, namely, the financing of offshore PE investment in PRC real estate, utilising the parallel "onshore/ offshore" financing structure.
Onshore/ offshore financing structure
Assumes a PE investment using simplified Wholly Foreign Owned Enterprise ("WFOE") structure:
The financing involves the following:
- An "offshore" US dollar or multicurrency facility made available to an offshore borrower incorporated in China Hong Kong SAR ("Hong Kong") or in an offshore friendly haven. This facility is provided by offshore banks and financiers.
- An "onshore" RMB facility made available to one or more onshore borrowers incorporated in the PRC and owning the underlying PRC properties. This is made available by onshore banks.
Each loan has a separate security structure, without any sharing of security[3].
Servicing the facilities
The onshore facility is serviced from the income generated by the property. The income generated by the property is not available to directly service the offshore facility.
Rather, to the extent that there are any profits available for distribution at the onshore level, those profits can be distributed as dividends to the offshore borrower.
However, the payment of dividends is subject to a number of PRC regulatory conditions (including compliance with annual audit and tax requirements)[4], making it practically unworkable to require payment of dividends more than annually.
As such, reliance is not placed solely on the dividend stream to service offshore debt, and offshore debt-servicing is typically supported by a combination of the following:
- a pre-funded offshore debt-service reserve account;
- sometimes, a tranche of the facility made available for debt servicing; and
- calls on the fund investors for any debt shortfall.
Debt profiles
The onshore loan should largely amortise during the life of the loan, subject to a requirement to maintain a minimum onshore loan balance (so that the onshore security package is not discharged before the offshore debt is repaid).
The offshore loan will generally not amortise. Rather, it will be structured as a "bullet facility", which will be repaid in the usual PE manner through:
- a PE "exit" i.e. disposal of the property (or the shares in an onshore or offshore holding company) or IPO; or
- refinancing.
In some cases, the dividend stream might be applied by way of prepayment in reduction of the debt balance.
Ultimately, there will be backstop recourse to the PE fund.
Security package
The onshore security package is, as one would expect, a fairly standard package of mortgages over real estate (such as Land Use Right ("LUR") mortgages, construction-in-progress ("CIP") mortgages and/or building mortgages, depending on the stage of construction), blocked account pledges and receivables pledges.
On the PRC, real estate generally cannot be owned by foreign investors or indeed, the private sector generally. However, the private sector can enjoy the benefits of real estate ownership through LURs. LURs are a right to use land for a term, with the consideration payable upfront. It is advisable for investors and debt financiers to develop a detailed understanding of the LUR regime, and the impact on valuation of the LUR during the term of the loan. By contrast, CIP and buildings constructed on LURs can be owned by the private sector[5].
The onshore security package does not secure the offshore debt.
The offshore security package comprises share security (often including a direct PRC law governed pledge over the equity of the WFOE), security over the DSRA and other accounts and, where available, all-asset security. Typically, the offshore borrower and its subsidiaries will be special purpose vehicles, and there will be undertakings to maintain SPV status.
There may also be security – where feasible – over calls on the PE funds' investors.
The offshore security package does not secure the onshore debt.
Onshore covenant packages
The onshore covenant package varies according to the transaction, but there may be an LTV, ICR or sometimes, no covenants at all. Generally speaking, the onshore financiers have a lower risk profile compare to the offshore financiers. They typically have lower debt levels and have the benefit of direct, physical security.
Offshore covenant package
The offshore covenant package should measure both the PRC property and the recourse to PE fund investors.
With respect to the PRC property:
- the LTV should be measured against the aggregate of the onshore and offshore loans; and
- there would typically be an ICR or DSCR measuring the extent to which the net income generated by the PRC property is sufficient to service:
- debt service at the onshore level; and
- interest at the offshore level, disregarding the limitations or regulatory restrictions on distribution of profits generated at the PRC level to the offshore borrower.
There would normally be a net worth (or equivalent) covenant with respect to the PE funds.
There are a variety of different approaches taken to such covenants depending on the nature and structure of the PE investor. To the extent reliance is to be placed on the capital calls of PE investors, the covenant should use funds-financing techniques to appropriately measure the expected value of those calls.
Intercreditor issues
Finally, it is worth considering intercreditor issues.
As mentioned above, the onshore financiers typically have a much stronger security position than the offshore financiers. To avoid too great a divergence in this respect, it is helpful to align the interests of onshore and offshore financiers by ensuring that one or more financiers (either PRC banks, or foreign banks with PRC branches) participate at both the onshore and offshore level.
In any case, the intercreditor agreement ("ICA") would typically regulate the position of the onshore financiers to a greater degree than the offshore financiers.
Under the terms of the ICA, there would usually be, amongst other things:
- restrictions on onshore financiers allowing any variation of the onshore payment schedule (and the requirement to maintain a minimum onshore loan balance);
- restrictions on enforcement of the onshore security package by the onshore lenders, giving the offshore lenders power to control enforcement at both levels during a "standstill" period; and
- an option for offshore financiers to take over the onshore facilities by buying out the onshore debt subject to applicable PRC foreign exchange regulations at the time of buy-out.
In addition, the offshore financiers would typically wish to ensure that the onshore security package remained in place, and in the name of the onshore financiers, during the life of the onshore and offshore facilities.
Whilst, as noted, the onshore security package does not secure the offshore loan balance, it provides the following protection to offshore financiers:
- it ensures the onshore security package is, at all relevant times, controlled by financiers who are bound by the terms of the ICA; and
- it allows the offshore financiers to control enforcement at the onshore level for a period, to facilitate enforcement at the offshore level.
Investor opportunities
The offshore facility structure provides an interesting opportunity for international debt investors to gain exposure to the PRC property market. For the following reasons, we think it is an attractive structure for debt investors new to the PRC property market:
- there is recourse to offshore PE investors, in addition to the recourse to the PRC property, which diversifies the risk;
- there will likely be experienced PE investors involved; and
- there will likely be the involvement of experienced PRC banks or foreign banks with PRC branches at both the onshore and the offshore level.
[1] However, the use of offshore bonds as a debt financing sources has been subject to increased regulation in recent years.
[2] See e.g. "What China's Three Red Lines Mean for Property Firms", Bloomberg News, 9 October 2020.
[3] If security over onshore assets secured offshore debt, it would be necessary to consider a range of PRC regulatory restrictions and approvals, including with respect to the State Administration of Foreign Exchange ("SAFE") and at the various local mortgage registration centres. If security over offshore assets secured onshore debt, restrictions may also apply on the basis that the offshore security provider has a right of contribution or subrogation in relation to the onshore borrower.
[4] It is also necessary to complete a profit repatriation form, ensure tax obligations are met and make a Corporate Income Tax ("CIT") filing and, in most cases, a filing with the tax bureau in charge.
[5] A detailed analysis of PRC tenure and property rights is beyond the scope of this article.
