Guarding against real estate trust investment risks

Where returns on bank wealth management products have dropped significantly, ordinary investors have started to place their confidence in investing in real estate trust investment products. The basis of this confidence is that effective measures are taken by the trustee (trust company) to strictly control the risks associated with trust products, and that such risks are disclosed to investors.

Preliminary due diligence

The main risks of real estate trust investments derive from the real estate projects themselves. Below are the two main areas where due diligence must be carried out at the outset to control risks. Due diligence of the party with the financing needs, i.e. the project developer, covers its basic particulars, business position, financial position, etc. Particular attention needs to be paid to: the particulars of the company’s shareholders, especially the actual controller; whether the capital contributions have been paid in by the shareholders of the party with the financing needs; any material restructurings of the party with the financing needs; and the business track record and credit standing of the party with financing needs in other investment projects.

Due diligence of the lawfulness and compliance of the project covers the securing and construction of the project. Particular attention needs to be paid to: the four certificates – the state-owned land use right certificate, construction land planning permit, the construction project planning permit, and construction project construction permit – and whether the environmental impact report has been secured; whether a major violation of laws or regulations has occurred; whether the project capital percentage satisfies the specified requirements, and whether the construction funds are being used for their intended purpose and there are oversight measures in place; and whether any rights restrictions exist, such as mortgages, pledges, and a placement under seal.

The development of, and returns from, real estate markets in different regions are extremely unbalanced, and an investigation of the market where the project is located should be carried out at the outset.

Creation of security

Common forms of security for real estate trusts include: a mortgage of the land use rights and the project under construction; a pledge of the project company’s equity; and a third party guarantee. Almost all real estate trust projects involve security provided in the form of a mortgage over the real estate project in which the trust funds are invested.

It should be noted that:

1. Pursuant to article 286 of the Contract Law and the Official Reply of the Supreme People’s Court on the Issue of the Priority Right of Repayment from Construction Project Proceeds, “the priority right of repayment of the contractor of a construction project takes precedence over mortgage rights and other claims”.
2. The official reply specifies that “once a consumer has paid all or most of the price for the purchase of a commercially developed residential premises, the contractor’s priority right of repayment from the project proceeds for the commercially developed residential premises cannot be used against the buyer.” From this it can be seen that the property rights and interests of the above-mentioned buyer have greater priority.
3. Article 54 of the Security Law specifies that the realization of mortgage rights is done in the order of precedence of the registration of the mortgaged things, or the order of precedence of entry into effect of the mortgage contracts. Accordingly, the mortgage rights created first take precedence for repayment.

The value of the project company equity essentially overlaps with the value of the real estate held by the project company, although in some cases it is lower than the value of the real estate. Accordingly, the significance of a pledge of the equity of the project company mainly lies in restricting the shareholders of the project company from circumventing their debts and oversight by an equity transfer.

Security provided in the form of a third party guarantee usually means a guarantee provided by the major shareholder or actual controller of the party with the financing needs, usually in the form of a joint and several guarantee. When creating the security, the asset position, liability position, credit standing, source of funds and solvency of the guarantor should be investigated.

Project oversight

Oversight of the right to make decisions on project development and construction. This usually involves the trust company
appointing a sufficient number of directors to the project company to control the votes of the board of directors on material matters, as well as the financial controller, and amending the company’s articles of association so that the board is authorized to make the decisions on material matters, rather than the shareholders’ meeting.

Oversight of project work. This refers to oversight of the project schedule and quality. Given that a trust company generally does not have project management capabilities, it will usually entrust the task to a professional firm.

Oversight of project sales. This includes oversight of sales progress, pricing and sales proceeds. It should be specified that if the sales lag to a certain degree, the trust company has the right to reduce the sales price to recover the funds. It should also be specified that a certain percentage of the sales proceeds be placed in a deposit account to ensure the safety of the trust funds as the real estate mortgages are progressively released. And it should be specified that the sales proceeds may not be used for any purpose other than the project.

Oversight of project moneys. This is mainly realized through oversight of the project accounts. Dedicated accounts – e.g. a trust fund escrow account, sales proceed escrow account and deposit escrow account – should be opened and the intended purpose of each account specified. The accounts opened by the project company must be confirmed by the trust company and the seal of the person designated by the trust company must be treated as one of the seals recorded with the bank for the accounts.

Oversight of the project company’s licences, certificates, approval documents and seals. It should be specified that the above-mentioned documents of the project company and other important legal documents are to be delivered to the person designated by the trust company for safekeeping. Use of the project company’s existing official seal, contract seal, etc. should cease and the same be destroyed when the trust project is established. Replacement seals should be made and entered into use to permit identification of prior hidden debts and hidden matters. It should be specified that the new seals are to be delivered to the person designated by the trust company for safekeeping, and destroyed when the trust project ends.