A New Exit Path for Distressed Real Estate Trust Loans in China: The Property Rights Trust

The traditional judicial disposal methods for a trust company’s real estate trust loans face many difficulties in China. The trust loan is a common financing method for real estate enterprises. It works like this: the trust company raises funds from public investors (trustors), then it, as both the trustee and the creditor, provides trust loans to real estate companies (debtors), in order to invest in real estate construction. However, tightened regulation around debt has been putting China’s real estate projects in distress since August 2020, especially with the strict enforcement of “Three Red Lines” regulations.

These regulations provide that , after deducting the advance receipts, the liability-to-asset ratio must be less than 70%, the net gearing ratio be less than 100%, and the cash-to-short-term debt ratio be more than 1. As more and more real estate companies fail to repay their due debts, trust companies have found it increasingly hard to withdraw their real estate investments. Generally, the trust companies would realise their creditor’s rights through a combination of mortgages, pledges, and guarantees (notarised debt instruments). However, these traditional debt-realising methods have many shortcomings. For example, the assets of the project company may be affected by the bankruptcy of its parent company group, which poses a risk to the rights of the trust company’s creditors (the public investors); in addition, the costs in both time and money of notarisation and enforcement procedures are considerable.

Typically, enforcement will take up to seven months from the application of the enforcement certificate to the successful realisation of the creditor’s rights. It may, however, take as long as one to two years or even longer, considering the extra time taken by enforcement objection and reconsideration, preservation and enforcement at a different location, property evaluations, and failed auctions.

Common exit methods for  distressed real estate trust loans include:

To avoid some of the above-mentioned difficulties, trust companies are turning to a new exit path by establishing a new property rights trust plan, under which the debtor transfers its equity in the real estate project to a new trust plan, in order to exit and achieve effective risk isolation. The original trust plan is actually a collective fund trust plan, also known as a self-benefit trust, and both the trustors and the beneficiary are public investors. In order to overcome the defects of traditional judicial disposal methods, trust companies have turned to establishing new property rights trust plans (hereinafter “real estate equity trusts”), which are divided into two types: single equity trusts and mixed property rights trusts.

The trust company establishes a new trust plan. The debtor entrusts the equity of the real estate project to the trustee as trust properties, so as to separate the project company’s assets from the assets of its parent company group and achieve risk isolation.

In addition to the project company’s equity, the trust company can also entrust its creditor’s right in the original trust plan as trust property in the new trust plan, so the trust properties in the new trust plan would include both equity and creditors’ rights. Under this model, the trust company actually represents the investors of the original trust plan in participating in the new trust plan and receives an income distribution from the new trust plan to repay the public investors, which actually extends the term of the original trust plan in disguise.

Under the first two property rights trusts, the real estate company (debtor) and the trust company (creditor) simultaneously serve as the trustor, financier, and beneficiary. If a new investor is introduced, the new investor will be the priority beneficiary, while the debtor and the trust company will be the inferior beneficiaries, and the original trust plan will convert from a self-benefit trust to another interests-oriented trust. In practice, some trust companies will hire an agent construction company to operate and manage real estate projects under the new property rights trust plan to revitalise the distressed trust plan assets.

Holding the real estate project company’s equity through the trust plan would result in shareholder responsibilities for the trust company. In respect of the real estate project, such typical shareholder responsibilities include the “guaranteed handover” in the case of delayed house delivery, and liabilities resulting from inferior construction quality. One method for the trust company to avoid such shareholder responsibility is to become a nominal shareholder of the project company through an equity transfer guarantee, instead of creating a real estate property rights trusts. However, in terms of risk isolation, equity transfer guarantee is less effective than creating an equity trust, considering the assets of the project company may still be identified as belonging to the actual shareholders (debtor) and so not be immune to the parent company group’s bankruptcy. Another way for the trust company to limit its exposure to shareholder liability is to refrain from taking too active a role in the project business’s day-to-day operations, such as by using an agency construction company.

Since the trust company serves as the trustee for both the old and new trust plans, there is a conflict of interest between the investments of investors of the new trust plan and the original ones, and it may cause a violation of China’s regulations that “trustees must not carry out transactions between the trust properties of different trustors”. However, there is scope for debate as to whether this  constitutes a related-party transaction. The property rights trust does not, after all, adopt the collective fund trust model. This means the investors do not directly invest in the new trust plan when the plan is established; rather, they acquire the trust shares assigned from other inferior beneficiaries after the establishment of the trust plan, then became priority beneficiaries in the trust plan. Taking a step back, even if this constitutes a related-party transaction, the trust company can still be exempted from liability for compensation by arguing that it has implemented a “fair market price” and obtained the consent of new and old investors and other related parties.

The establishment of a property rights trust is proving to be an effective way for a trust company to achieve a real estate investment exit. It is not only more time and cost-efficient than the traditional debt-realising methods, but it also works better in risk isolation by protecting project company assets from being affected by the parent company group’s bankruptcy. In addition, instead of being a pure financing party, the trust company starts to undertake wealth management roles such as real estate operation and management under such a new model. It is an increasingly popular exit path for distressed real estate trust loans in China.