OREANDA-NEWS. Fitch Ratings says today that Chinese property companies' shift towards an "asset-light" business strategy has limited near-term impact on their credit profiles due to insignificant project exposure, but the risks and rewards of such a strategy over the mid to long term remains uncertain.

In the Q&A below, Fitch's Shanghai-based analysts, Laura Long and Su Aik Lim, discuss factors that drove Chinese developers' "asset-light" strategy and their potential benefits and risks.

Q: Why are some Chinese developers reducing asset ownership?

A: Large-scale investment property development is capital intensive and the wait for returns is much longer than for residential property development. The financial leverage of investment property companies tend to be high until a substantial majority of assets in their investment property portfolios reach a mature stage and generate stable, recurring rental income. Chinese property companies like China Resources Land Limited (CR Land; BBB+/Stable) and Dalian Wanda Commercial Property Co. Ltd. (Wanda; BBB+/Stable) have historically used operating cash generated from residential property development and debt to fund their capital needs for investment property development.

However, developers have found they need to commit more equity to their investment properties or increase financial leverage as residential sales growth has slowed. This has prompted some companies to explore alternatives to maximise return on equity from their projects with less financial burden.

Q: How have companies reduced their assets? What are the benefits?

A: There are two prominent cases that we can study. The first by Wanda aims to lower project-level debt and minimise capital investment through innovative funding structures, such as crowdfunding. In return, Wanda receives management fees and profit distributions from the projects when they start operations. The recurring management fees can help to smooth its earnings and cash flow volatility.

Wanda launched two crowdfunding products in June and August 2015 jointly with 99Bill, an online payment service provider, to fund the construction of five retail malls each. Crowdfunding investors are entitled to annual payments with an estimated yield of 6% derived from the malls' rental income. The investors can exit their investments with a one-time capital gain when the project companies go public in the form of a real estate investment trust (REIT) or are acquired by third parties after three years, or when the investors are bought out by Dalian Wanda Group, the parent of Wanda, at 1.5x their initial investment, if no other parties take over those projects, between the fourth and seventh year.

Wanda also got institutional investors to invest with the crowdfunding investors in Wanda's retail malls. Wanda brought 15 of its retail malls with total estimated investment value of CNY13bn under its asset-light arrangement during August to October 2015.

Wanda consolidates the "asset-light" project companies in its financial statements due to its effective operating control. Although the malls projects using this strategy in total account for less than 1% of Wanda's commercial portfolio by book value, Wanda benefits from the arrangement because it need not make further investment to develop these projects, compared with projects it owns and develops.

In another example, homebuilder China Vanke Co., Ltd. (Vanke; BBB+/Stable) aims to reduce its financial leverage by sharing capital investment with external parties and holding minority equity stakes in commercial property projects, which is not its core business. Vanke in 2014 partnered with Carlyle Group to invest in nine commercial property projects, and has partners other institutional investors for seven other projects. Vanke holds 10%-20% of the equity interests in the project companies and receives management fees as well as its share of net profits. Vanke classifies these projects as long-term equity investments.

Q: What are some potential risks for developers?

A: Developers reduce their initial capital commitment using these asset-light strategies, but they may be exposed to contingent liability risk if they provide guaranteed return rates for investors, as in the Wanda case. Should the projects underperform and result in large losses, the burden of the losses will be borne by Wanda and not by the external investors. Wanda has agreed to make up for any shortfall in investors' annualised returns up to 6% with its own share of profits from the projects. It will also bear any project construction cost overruns.

Wanda's income stream from the asset-light projects may not be stable. The rental income from the projects may be lower-than-expected, which would result in lower management fees and profit distributions for Wanda. Many of these asset-light projects are located in less-developed Tier 3 or 4 cities, where consumption power is weaker. Vanke's strategy, in which it effectively sells these commercial properties and receives management fees, is less exposed to these risks.

The success of the asset-light model hinges on investor demand for investment instruments tied to these properties. Investors will require these instruments to have a sufficiently high rental yield over interest rates for regular income, or strong capital gains potential. Exit options for investors remain highly uncertain without a ready public market for such investment instruments. The domestic REIT market is in its infancy with the first public REIT product listed on the Shenzhen Exchange in July 2015. There is no specific legal framework or any favourable tax arrangement for REITs in China as in mature markets like the U.S.