PERE looks at three deals - one good, one bad and one that has the potential to be both - and the reasons for their divergent turns of fate. RREEF's deal to acquire a $510m office in Beijing went badly thanks to a local seller who falsified due diligence materials. PERE July/August 2009

There are several colourful episodes in the classic business book “Mr. China” that exemplify the difficulties Westerners have in doing business in the country. Whether it is $58 million going missing from a joint venture or a chief executive suddenly vanishing, the pitfalls are clearly myriad.

RREEF, the New York-based alternative asset manager led by Chuck Leitner, found this is out the hard way when it acquired a large Beijing office and retail building for $510 million in 2007. Only later did RREEF discover the true worth of the property was closer to $470 million – 9 percent less. The seller had inflated the rental income for all 85 leases.

Beijing Gateway Plaza

Even in 2007 with the credit crunch just around the corner, there was great interest in Chinese property from the West. Having already struck one or two investments in the country, RREEF was among the throng of Western companies looking to capitalise on what everyone said at the time was a huge opportunity as China began to allow more foreign investment.

The original plan was elegant. In acquiring the Beijing property – called the Beijing Gateway Plaza – RREEF would float a property company on the Hong Kong Stock Exchange partly to fund the acquisition, but also to provide a springboard to expansion in Greater China. The Government of Singapore Investment Corporation (GIC) was to be a cornerstone investor.

The IPO was a success. Shares in the company were oversubscribed and began trading in June 2007. HSBC and Deutsche Bank, the latter of which had introduced the acquisition via its investment banking group, jointly arranged the successful offering. Simultaneously, the acquisition of the property was completed and everything looked healthy at the Gateway Plaza.

RREEF's due diligence on the building had been what you would expect from an experienced professional real estate investor. It used legal counsel to verify the leases and nothing untoward was found. The firm also interviewed tenants, while KPMG checked all of the invoicing records.

The Beijing Gateway Plaza stands out in Beijing because it is arranged as a skyscraper in two separate 25-storey towers covering around 130,000 square metres. Many of the tenants are Western companies such as BMW, Sony, and Zurich Financial Services as well some local financial groups such as Bank of China. The property is located in the Chaoyang District of Beijing where many other offices jostle for space. Foreign embassies reside nearby. When RREEF acquired the asset, it was 94 percent leased and around 4.4 percent of the leases were due to expire in the same year as acquisition. Had this not been the case, RREEF would not have discovered a major problem with the investment until much later.

In late August 2007 – around two months after the IPO – sources say that RREEF was renegotiating leases with some of the existing Gateway Plaza tenants.

When RREEF acquired the asset, it was 94 percent leased and around 4.4 percent of the leases were due to expire in the same year as acquisition. Had this not been the case, RREEF would not have discovered a major problem with the investment until much later. 

During negotiations, the tenants grumbled about the size of the increase. The new owner argued back that the increase was actually far smaller than what the tenants were saying. However, it dawned on RREEF that the tenants were right when they produced lease agreements. It became clear that figures in the lease agreements were different, and far lower, than in the copies of the lease RREEF had been relying on at the time of acquisition.

RREEF immediately began to investigate and discovered that the seller, private Chinese developer Tin Lik, had produced incorrect lease documents. The rental figures in the 85 leases the tenants had did not match the numbers in the leases RREEF had received from the seller.

In total, the rent promised by the documents Tin Lik had provided was about US$36 million higher than what was actually being paid by the tenants. To make matters even more complicated, the developer had a 10 percent stake in the listed trust and was a 10 percent shareholder in the management company which bore RREEF's name.

The New York firm immediately had to issue a statement to the Hong Kong Stock Exchange, saying it had found “discrepancies” in the lease arrangements. RREEF contacted Tin Lik about the apparent overstatement of rent. After some unsuccessful attempts to meet, a portfolio manager from RREEF flew to Hong Kong in order to meet face to face. At this meeting, Tin Lik claimed that the discrepancies could be explained by rental concessions granted to tenants, but this did not convince RREEF. Finding themselves entangled with a part owner of the trust and management company who RREEF believed was not giving an accurate picture, RREEF threatened to contact the police. More importantly for the health of the trust, it also demanded that Tin Lik pay into an account the US$36 million in question within 24 hours to make up for the rental shortfall. Tin Lik paid the money.

Paper trail

According to sources, RREEF's investigation suggested a comprehensive job undertaken by Tin Lik to amend all 85 lease documents. The investigation concluded that each page containing the rent figure had been replaced with a page containing a higher figure. It also came to light that the banking invoices and receipts that had been checked during the due diligence stage had been falsified, and the inflated leases had been registered with the relevant tax and government authorities. Further, the tenant interview process had been tampered with. RREEF issued tenants with term sheets to sign, but the investigation called into question whether documents in the post had been intercepted and amended.

The resultant devaluation of the single asset in the trust had a damaging affect on the net asset value of RREEF China Commercial Trust. RREEF had to inject some of the sale price withheld from Tin Lik into the trust to set off against the dimunition of the NAV.

Investors were frustrated by the situation, of course, but at least they could see that RREEF had been successful in recouping all the money to compensate them, and fairly quickly. By contrast, this is something that many investors have failed to manage in China.

credit crunch and subsequent downturn in the global economy made it virtually impossible for RREEF China Commercial Trust to acquire any more property. The Beijing Gateway Plaza remains the only investment in the trust, which was supposed to have been a springboard to expansion across Greater China.

When RREEF acquired the asset, it was 94 percent leased and around 4.4 percent of the leases were due to expire in the same year as acquisition. Had this not been the case, RREEF would not have discovered a major problem with the investment until much later.

According to sources, the Hong Kong police and the Beijing police were notified of events along with the Securities and Futures Commission in Hong Kong. That commission found that no one other than Tin Lik was involved in the discrepancies and its findings have been passed to the Hong Kong police. Investigations are ongoing.

Lik was removed as a director from the management company; however he still owns around 10 percent of the trust.

The experience of RREEF in China has been difficult and the deal it struck over the Beijing Gateway had a significant flaw. Sadly, those that operate in the country say this is far from a unique situation. Tim Clissold, the author of “Mr. China”, suffered a heart attack during his most challenging days. We're sure that the pros at RREEF can relate.