House rules

Chinese authorities have published a set of strict guidelines to rein in foreign investors looking to cash in on the rising renminbi. Andrew McGinty reports

On 11 July 2006, the People’s Republic of China’s (PRC) Ministry of Construction, Ministry of Commerce and National Reform and Development Commission, as well as the People’s Bank of China, the State Administration for Industry and Commerce and the State Administration of Foreign Exchange, published the ‘Opinions on Regulating Foreign Investment in Real Estate Market Access and Administration’ report. The opinions contain several major changes that, if imp-lemented, will have a huge impact on foreign investment in the real estate market in China.

The aim is to curb perceived speculative investments. Although still relatively small, foreign investment in China’s real estate sector (both on a corporate and individual level) has grown recently as restrictions have been relaxed, and excess liquidity has been looking for higher returns in developing markets.

The background
The Chinese authorities have become concerned about rising prices, fuelled, it is perceived, by overbuilding at the luxury end of the market and increasing market speculation. They are pointing to foreign investment as being one of the forces driving up house prices, particularly in major cities such as Beijing and Shanghai, leading to a lack of affordable housing.

While foreign investment in the sector has tended to focus on the ‘high end’ (and some players see real estate investment as a way of ‘parking’ capital in anticipation of a further upward revaluation of the renminbi), it should be asked as to what extent the lack of affordable housing is down to real estate speculation, or a failure to put in place and enforce effective fiscal and regulatory policies that encourage development at the lower end of the scale.

Market entry threshold
Foreign investors wishing to invest in projects where the total is more than $10m (£ 5.26m) will now have to put in 50 per cent of the capital in equity up front – an increase from 33 per cent. This will raise capital costs (and lower investment returns) for investors in foreign-invested real estate development enterprises (Firees). This puts foreign real estate development at a competitive disadvantage to domestic real estate development.

Furthermore, the rules state that, where the registered capital (ie the paid-in capital agreed to be contributed by the shareholders) has not been paid in full, the enterprise has yet to obtain a State Land Use Rights Certificate, or the paid-in development project funds amount to less than 35 per cent of the total investment, the Firee is banned from taking out domestic or foreign loans (even within its ‘borrowing quota’).

Time limit on land use rights
The opinions require a Firee to be granted a one-year temporary business licence until it acquires the land use rights for a project. If no development is undertaken in this time, the Firee’s business licence may not be renewed.

A fine can already be levied on a developer failing to start work within one year of receiving a land grant, and failure to develop within two years can result in the state recovering the land without compensation. However, enforcement of this has been patchy at the local level.

Presumably, the intention is to prevent the establishment of ‘land banking’ and ‘dormant’ Firees that do not carry out projects within a year of establishment, as these are often seen as ‘covers’ for speculation in land use rights.

At present, making arrangements for the resettlement of employees and the ‘settlement’ of bank debt of a target Chinese company has not been an obligation of the acquirer.

The opinions mean that a foreign investor who acquires the Chinese party’s equity interests in a Sino-foreign joint venture, or who acquires and converts a domestic capital enterprise into a foreign-invested enterprise, must now make proper arrangements for the employees of the target company. It is also required to deal with the target’s bank debt and make a one-time cash payment for the full transfer price. It is not clear what the ‘arrangements’ or ‘settling’ of bank debt involve. As the acquisition price is generally paid to the shareholders of the target company (except in the case of a capital increase), it is difficult to see how its bank debt could be repaid (if that is what is intended) without fresh money going in.

Residency or personal habitation
Another intended goal of the proposals is to curb alleged speculation by individual foreign purchasers in the real estate market.

There was, prior to issuance of the opinions, no PRC residency requirement or any restriction on usage of properties for foreigners purchasing real estate in China.

The opinions mean that any individual wishing to buy property in mainland China now has to prove they have been resident in the country for longer than 12 months. Moreover, all purchases of real estate by foreigners have to be for self-use and self-habitation only. Tax-driven property purchases are also targeted, with a ban on foreign legal persons without any presence in China buying commodity housing.

Practical application
The opinions are issued as quasi-departmental rules, but are backed by no less than six powerful ministries and regulatory bodies under the State Council. Some of the provisions depart significantly from existing regulations issued by the State Council. Because the council regulations carry more legal authority than departmental rules, this could theoretically lead to a challenge as to their validity.

Although the proposals raise many issues as to their effectiveness from a legal perspective, initial soundings suggest they are being taken seriously and are being implemented at the local level. The real estate industry in China has had extensive problems with fraud, market manipulation and irregularity, and certain practices were in need of being reined in. Actions taken by the PRC authorities to address foreign speculation will not resolve these issues, but will play well before a concerned domestic audience.

Given the relatively modest share of foreign investors in the market as a whole, it seems questionable to single them out. But foreign investors do need to structure transactions in a way that complies with locally applied versions of the rules. The real estate markets are regulated and administered at the local level, so each local authority will have its own ‘spin’ on which of these rules will be enforced strictly (and which less so). The biggest concern in the foreign investor community at the time the opinions were issued was whether they would apply retroactively: the opinions are silent on this, but there does not seem to have been any attempt to undo transactions completed prior to their conception, although transactions that were in process at the time did have to be restructured to conform.

If enforced stringently, the opinions will restrict market access to those foreign individuals seeking to acquire investment properties in China, increase capital costs for developers with foreign investment and generally put foreign investors at a relative disadvantage compared with their domestic counterparts. However, ample global liquidity and the lure of the growing Chinese market may be enough to overcome the concerns of the bigger and more established players – at least in the short term.
Andrew McGinty is a partner in the Beijing office of Lovells