How investors turned innovative in HK skyscraper deal

The lobby of Hong Kong skyscraper, The Center, was one of the sets in Hollywood blockbuster ‘The Dark Knight’. The sale of the building and efforts to pull together a $4.1 billion short-term financing package has also been the subject of a corporate drama in recent months. 

Unusually, financiers for the world’s most expensive tower were able to bypass the traditional bank loans and sell very short-term bonds to a handful of institutional investors hungry for the high yield on offer, two people familiar with the transaction told AsianInvestor's sister title, FinanceAsia.

The tale begins with a year-long slog by Asia’s richest man, Li Ka-shing, to sell The Center skyscraper located in the heart of Hong Kong’s business district.

In November he nailed an offer of HK$40.2 billion ($5.1 billion), the highest price every paid for an office building. Li is not called Superman for nothing by the Territory’s retail investors.

Li’s CK Asset Holdings sold the tower to a consortium called CHMT Peaceful Development Asia Property. However by February the deal looked in jeopardy as consortium member, state-owned China Energy Reserve & Chemicals Group, pulled out after its loans became ensnared in Beijing’s general efforts to rein in leverage.

China Energy had mostly been working with state-owned Chinese banks, which Beijing had instructed to curb lending against overseas property, the two people said. 

The consortium quickly reconfigured and China Energy sold its 55% stake to Hong Kong tycoon Pollyanna Chu and the founder of mainland developer Shimao Property, Hui Wing-mau.

Other property investors in the building include David Chan Ping-chi, Lo Man-Tuen, Raymond Tsoi Chi-chung, and Ma Ah Mok.

As the new consortium looked to pull together the HK$40.2 billion asking price, they asked their financiers to refinance the property at a punchy 80% loan to value (LTV).

In Hong Kong, the most typical real estate financing structure is for the buyers to take out a senior bank loan with a mortgage on the building, potentially with some mezzanine financing on top.

However, the senior bank loan is regulated by the Hong Kong Monetary Authority, cannot exceed 40% of the value of the building, and is fully secured. This can lead to some complex structuring by mezzanine investors at the holding company level, forcing them to rely on very loose inter-creditor arrangements with no security. 

Initially, the financiers at Morgan Stanley worked on the assumption that they would also use a bank loan and began sounding investors privately about their appetite for funding the acquisition.

The financiers discovered there was a lot of interest among large institutional investors to fund the deal with a 60% to 65% loan-to-acquisition value, including from regional sovereign wealth funds and international real estate investors, the two people said. 

What it showed, even though most of these fund managers baulked at stretching to an 80% LTV, is that the rise this week in the 10-year US Treasury yield above 3% -- something not seen since 2014, during the top of the taper tantrum sell-off -- has yet to put property investors off in Hong Kong. 

Rising interest rates tend to be seen as bad for real estate because they mean a higher cost of borrowing and higher required yields for investors in light of the higher risk-free rate.

SWITCH TO BONDS

Given the degree of interest up to 60%, the consortium decided to do away with the bank loan and replace it with bonds. This meant that the institutional investors would no longer be structurally subordinated to the commercial bank.

The new structure also speeded up the process as the commercial banks’ paperwork would have been more onerous for the consortium and allowed the buyers to comfortably hit their deadline for completing the acquisition on May 2.

The short tenor of the bonds, at just 18 months, was highly unusual for real estate financing.

But then the consortium doesn’t plan to stick together very long – it was only cobbled together as Li wanted to deal with only one buyer, the two people said. 

Each consortium member plans to buy their own floors in the 73-storey tower once the acquisition closes. As they do that they will each pay for the floors and the money will be used in a waterfall to pay investors in tranche A of the bonds and then tranche B investors.

The consortium members have drawn up an intricate arrangement through which they have allocated each other floors, which they will either keep or resell in a coordinated fashion.

Coincidentally, investment bank Goldman Sachs is moving out of The Center tower when its lease expires at the end of the year.

While there is some rental income, the principal source of repayment will be when the floors are sold, either to the shareholders or on the open market. If nothing is sold in the first five months then the coupon payment might be deferred. 

RED-HOT REAL ESTATE

In Hong Kong, so-called strata-titled property is rising rapidly in value, almost week by week. The 33rd floor of Admiralty district’s Far East Finance Centre sold for HK$61,000 per square foot this week, 1.7% higher than the previous record set two weeks ago, according to the Hong Kong Economic Times.

Commercial real estate prices in Hong Kong rose by around 22% last year, faster than almost any other major city, and they have more than tripled in value in the past decade, according to data provider Real Capital Analytics. Office property prices in Central stood at $4,983 per square foot per annum at end-2017, up from $3,570 at end-2013, according to property services firm JLL.

Hong Kong has even replaced London's West End as the world's most expensive office location, according to research published in November by property services firm Cushman & Wakefield.

Investors in the bonds were comfortable with the security offered by the tower, which has 1.2 million sq ft of office space,13,000 sq ft of retail space and parking for 402 cars.

The investors are assuming that the market value has risen since the acquisition and that the consortium will have no trouble selling the floors. The tranche A bond is also sizeable at $3.3 billion, allowing this handful of institutional investors to put a large dollop of capital to work in one go, according to a term sheet seen by FinanceAsia. 

On Wednesday the financiers started issuing and settling the bonds. 

Tranche A at $3,328,663,000 bond with a 65% LTV has a tenor of 18 months and carries a coupon of 7.5% for the first 12 months, ratcheting up sharply to 12.5% for the last six months, but of course the consortium hopes to have paid back the principal by then. Investors agreed that the consortium could defer payment of the coupon if they chose.

If the consortium sells the floors very quickly, the money has to be used to repay 45% of the tranche A financing after six months, mimicking a typical repayment schedule of a bank loan in Hong Kong. So the investors will still get their returns on the bulk of the notes even if all of the floors are sold.

Morgan Stanley handled the sale of tranche A on a sole basis. The US investment bank offered to handle the B tranche of bonds, but local asset manager, Hammer Capital, also won the mandate from the consortium.  

Tranche B of about $800 million-worth of notes was sold at 65% to 80% loan to acquisition value to a mixture of hedge funds and mezzanine funds and Hammer Capital kept some of the bonds themselves.

The coupon was 15.25% non-call for the first 12 months, stepping up to 19% for the remaining six months. Crucially the investors in tranche B are secured on the building, which they would not have been in a typically structure including commercial bank loans.