Real barriers to investment

    These gloomy figures are partly due to the global financial problems which mean that foreign enterprisers are either short of cash or unwilling to take many risks. But some of the blame can also be put on actions the central government took in 2006 to control the amount of hot money flowing into the overheating market: Circular 142, issued by the State Administration of Foreign Exchange is a good example, as it gives banks responsibility for checking who is investing and where the money is coming from.

    “The restrictions put on domestic banks have made it very difficult to foreign developers to come in shore,” says Richard Wageman, of counsel at DLA Piper.

    These national-level restrictions were never removed, and foreign developers' hopes of entering the real estate market are still minimal.

Money isn't everything
Restrictions on financing are one hurdle, but there are other barriers, too.

    Between 2006 and 2007, the central government issued four circulars (171, 192, 50 and 130) which not only restrict the amount of capital which has to be injected into foreign-invested enterprises, but also stop those enterprises in China from borrowing funds offshore.

    “From Circular 171, the circulars become stricter and stricter. And when it comes to Circulars 50 and 130 in the summer of 2007, the government basically stopped all cross-border debt financing by foreign developers,” says Jeanne Kang, a Jones Day associate.

    Foreign companies, under the restrictions, are also required to have venture capital that is equivalent to 50% of their total investment. If they are buying a piece of property for Rmb100 million (US$14.6 million), for example, they will have to put in capital of Rmb50 million.

    This is a tough requirement for foreign developers, especially as they also need to take the risks of investing in China into account. Furthermore, under the measures, a wholly-foreign owned enterprise (WFOE) will not be able to borrown any money unless the venture capital has been paid in full, in renminbi.

    “This is extremely onerous and could have been avoided by a grandfathering provision,” says McGinty.

    It was previously acceptable to own a property in China directly through an offshore company, but after Circular 171 was issued, clients were told they had to re-register the property under a WFOE in order to register the leases and remit the rental payments out of China. This can cost a lot of money to set up, and so the inability for developers to develop their projects without debt financing (not normal practice anywhere in the world) will hit them hard.

    “You have to look at how the international market works. Under the current rules, you have to fund land purchase with equity all the way down to the commencement of construction, and that's actually very unusual. Most jurisdictions will have slightly more flexible regimes that would allow you to get financing earlier. And they will also allow you to have higher ratio of leverage than under Circular 171,” McGinty says.

Some local progress …
Certain steps taken at the local level in the last few months have somewhat eased the situation. Shanghai and Tianjin, for example, now allow foreign investors to make their deposits in foreign currencies instead of renminbi.

    McGinty has spoken to the Shanghai municipal government and also to officials in Chongqing, Fujian and Nanjing. All of them, he says, have taken certain types of measures such as cutting taxes and reducing minimum loan down payments to stimulate the real estate market in their localities based on the national package of tax cuts to stimulate individual real estate investments.

    “What's interesting is that we are hearing that many local governments appear to have been given some kind of signal to relax the restrictions on foreign investment in real estate at the local level. The fact they are willing to talk about it means that they have been discussing these for some time. It might not be too far away,” he says.

    In Beijing, the local government in early 2009 issued the Implementing Opinion for the Promotion of the Healthy Development of Real Property in the Municipality, which partly focused on foreign individual investors. Such measures repealed the previous rules that granted foreign individual investors the right to buy one property only. But now, as demands of housing have dropped, the government has loosened the limitation in an attempt to prop up the property market. This is a significant local-level move.

    “Beijing Municipality's decision to temporarily suspend enforcement of the provisions on minimum residence requirements … does suggest that there is going to be a certain degree of local relaxation of the rules,” McGinty says.

… but national complications
This local relaxation has unfortunately been offset by increased complexity nationally. In order to set up a company in mainland China, a foreign company must secure four certificates, including ones for land-used rights, planning and commencement of construction. A further hurdle was added in 2007, when the government issued Circular 50 requiring all property development companies with foreign investments to file with the Ministry of Commerce (Mofcom) in Beijing.

    “Those filing requirements turned out to be a big bottleneck for foreign investors to set up foreign companies in China. It takes so long, and the timeline is uncertain. [It's even uncertain] whether or not Mofcom will object to the particular projects,” says Allen Wong, a partner of Simmons & Simmons.

    According to Jun He Law Offices partner Tang Yue, there are many projects in Beijing and Shanghai that satisfy the government's requirements. Yet the new approval process has significantly limited the number of investments that are coming into the country.

    Although Mofcom in 2008 issued the Circular on Delegating Matters Concerning the Examination and Approval of Foreign-invested Commercial Enterprises (Circular 51) (关于下放外商投资商业企业审批事项的通知), delegating approval powers to provincial-level counterparts, projects still need to wait for Mofcom's final approval.

    “At the end, it adds so many uncertainties into the pictures that it might be very difficult for you to precede,” says John Grobowski, managing partner of Faegre & Benson. “It might also be difficult for the other party in the land contract, because they don't know if the deal is going to go through or not.”

    Other policies, although not actually negative for foreign investors, simply level the playing field for foreign and domestic players. The repealing of the Tentative Regulations on Urban Real Property Taxes at the beginning of 2009 is one example. Under the old regime, there were two types of property taxes on owners of real property in China: urban property tax and real property tax. The first applied to foreign individual companies and foreign-invested companies in China only, while the second type applied to all domestic owners; the tax rate for foreign owners was higher than that for domestic owners.

    This kind of policy is not unique – foreign individuals had been subject to different laws in the past – but in practice most local governments have made adjustments to the ratio so that foreign investors can receive the same treatment as their domestic counterparts. Tax rates for both foreign and domestic investors will then end up the same.

    “For new foreign companies entering the Mainland market, this current practice is favourable in the sense that it assures them equal treatment as local Chinese companies,” says Kang.

    Although tax issues are important to some, most foreign developers would like to see the central government relax the previously imposed circulars on land contracts, the approval process and the requirement to make deposits in renminbi.

    “China is a wonderful market especially if seen from abroad,” Grobowski says. “It's developing, and it's developing very rapidly. But the fact is that it's very hard to make investments in some of these great opportunities.”

    Fewer restrictions would certainly be good news for foreign investors. But the limitations, as Wong points out, have been put in place not only for economic reasons but to follow the government's long term objectives. Any relaxation on the restrictions could lead to social instability, Wong says.

    “The restrictions are no doubt a little bit overdone and too conservative. But if they remove everything now, I would say it is not the best way for foreign investors. It's not for a mature market to have,” Kang adds.

    Changing regulations will also create uncertainties, and will not significantly help the economy.

    As Grobowski says: “The bottom line is if you have the stomach to go through all those difficult procedures, that might still pay off in the end.”

Foreign investors may be left out of real estate trusts

The State Council in November 2008 announced that a legislative framework for Real Estate Investment Trusts (Reits) was underway. It is reported that Shanghai and Tianjin could be chosen as an experimental areas for Reits, but no actual details of how the model works have been released.

    Allowing property developers to divest their commercial rental real property into tradable stocks is no doubt a positive approach for investors. However, it is uncertain whether the final legal framework for Reits will include foreign investors as players – the first draft issued a year ago mentioned nothing about foreign investments.

    Jun He Law Offices' partner Tang Yue, who reviewed the draft of the Trust Company Pilot Real Estate Investment Trust Schemes Administrative Procedures at least a year ago, says the policy was at that point still at a preliminary stage and required a lot of changes.

    Many international specialists, such as Lovells partner Andrew McGinty, think foreign investors have valuable experience in how to operate Reits, which could benefit China.

    “The question is going to be, if you do Reits under a trust company vehicle structure, foreign investment is capped at 20% under the current rules. That very much restricts the role of foreign investors,” McGinty says. “These are the key issues which are not addressed in the draft.”

    According to a DLA Piper newsletter, written by Reits specialists Brad Markoff and Mabel Lui, it is expected that, regarding foreign ownership, trusts will be required to list their shares on either the Shanghai or Shenzhen exchanges. Foreign investment could consist of minority positions with non-controlling management rights, unless the government modifies its 1999 position of allowing foreign-controlled entities to list on either exchange.

    The draft also does not mention taxation issues. Formation of tax is crucial to Reits, as the present tax regime, which includes various taxes such as business tax, corporate tax and deed tax, could be expensive for the real estate assets' contribution to the Reit and the operation of the Reits business.

    “What we are hearing from the Tax Bureau is that they will only start looking at the tax treatment once the legal structure has been defined,” says McGinty. “To me, even if you can get the legal structure right, a Reit is not that interesting until you have a tax package to go with it.”

    While both the Chinese Securities Regulatory Commission and the China Banking Regulatory Commission are formulating the rules and structures, it is unknown to the public how many other ministries are going to be involved.

    There is a possibility that, apart from the Commissions, the Ministry of Construction, Ministry of Commerce and Real Estate Administration will take part in these projects if there are issues related to underlying assets, land and foreign investments.

    “That's a lot of people involved in this whole thing. It's going to be a challenge to get them all facing in the same direction,” says McGinty.

Cities ready to open up, but central government not so sure

There has been much talk in the local media of Nanjing, Chongqing, Shanghai and Tianjin opening their local real estate markets to foreign investors. Though nothing has been confirmed at the national level, those cities are apparently sending the signal that they would like to make it easier for foreign investors to enter their local markets.

    In fact, in August 2008 Tianjin published its own policy: Welcoming Overseas Investors to Participate in Trading of State-owned Construction Land in Tianjin Municipality, which provides an easier channel for foreign investors. According to a press conference hosted by the Tianjin Land Exchange, the Ministry of Commerce has shortened the lengthy filing process for Tianjin to 20 days.

    Although it is unclear whether the approval procedures will actually be completed within 20 days, Liang Shugang, partner of Winner Law Firm, says that Tianjin's move indicates the city's determination to boost its economy by welcoming more foreign investors.

    Local governments can also further open up the real estate market by allowing deposits to be made in foreign currencies during land bidding. Both Tianjin and Shanghai are said to have taken the lead in doing this.

    The central government originally allowed foreign investors to participate in property auctions, but under the condition that the deposit be paid in renminbi. Foreign investors often find this policy discouraging as it could be difficult for those that do not have an onshore entity to have a large sum of Chinese currency.

    “It's as if the government is saying: 'It's your problem. If you can figure someway to get the renminbi and put it in to a special bank account for us, we will include you in the bidding. But if you can't do it, then go away. Don't bother us and come back when you are able to provide the renminbi',” says John Grobowski of Faegre & Benson.

    But, given that Tianjin and possibly Shanghai now accept foreign currency, Grobowski believes the investment environment will become more friendly and attractive to foreign developers.

    But it will not be until restrictions in certain State Administration of Foreign Exchange circulars (such as Circular 142) are removed that foreign developers will be able to conclude that the central government really wants them to invest in the Chinese real estate market.