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Foreign Investment in China Gets Tougher

Chinese government takes cautionary approach

Sensing an overheated property market, the Chinese government restricted investment in real estate to Chinese residents this week and increased the equity requirement for major acquisitions using foreign capital.

“The rules close the door for investors wanting to directly invest and hold Chinese real estate from overseas,” says Wayne Zane, director of research and consultancy at Colliers International in Shanghai.

The new regulations, announced July 24, are only the latest measures in a so-called Macro Economy Control program the government has instituted to cool a hot Chinese economy, especially in the investment sector, Zane says. “The Chinese government identifies the risk of overcapacity (of space) and worries about the economy depending too much on investment for growth.”

Under the new regulations:

  • Foreigners must live in China for at least a year before they can buy a property, which must be for their own use. Foreigners meeting the residency requirement may be able to obtain government approval to purchase a property they don’t intend to use.
  • For any real estate investment valued at more than $10 million, foreign investors must create a Wholly Owned Foreign Enterprise (WOFE) specifically for development or investment in real estate, and must provide at least 50% of the equity for large projects upfront.

In the past, as little as 35% equity was required for investments by overseas investors, with the rest sourced through debt financing, according to Michael Hart, head of research at Jones Lang LaSalle’s Shanghai office.

“The real change for commercial real estate is that previously, a wider range of off-shore and onshore vehicles were possible,” Hart says. The effect on overall investment will likely be slight, however: While foreign investment in the market increased rapidly in recent years, it remains a small slice of a much larger pie.

In 2005, foreigners placed $5.52 billion in U.S. currency in prime, investment-grade properties in China, according to Jones Lang LaSalle. That represents about 3% of the overall Chinese real estate market. Properties other than investment-grade were almost exclusively purchased by Chinese funds.

Only $350 million of the $5.5 billion in U.S. dollars came directly from U.S. investors, with the rest coming in from individuals and institutions in other nations, adds Jones Lang LaSalle. International funds with a significant amount of U.S. dollars mingled with other currencies contributed another $1.9 billion to overall investment.

Why is the government putting the brakes on this fledgling sector? The government is probably reacting to rapidly increasing foreign investment, which has coincided with significant price appreciation driven in part by overseas investors, Zane says. Competition from overseas capital has driven up prices on investment-grade commercial properties in Shanghai, for example, even though international buyers account for only about 4% of all acquisitions in that city.

Coupled with that is the public perception that foreign investment is increasing rapidly, although actual volume remains small in relation to the overall market. Before the market started to heat up in 2003, most investment by foreign companies took the form of new development rather than purchases of completed projects, Zane says. “The growth rate in terms of the total investment volume looks high because the base was small.”

Bear in mind that China’s real estate has only been available to private investors for about five years, as the government has moved from a system of state-owned housing and space providers to allow acquisitions by individuals. While the transition has been largely successful, rapid price appreciation means many individuals have been priced out of the market.

“As such, the government is playing the role of the guiding hand to keep markets stable,” says Hart, the Jones Lang LaSalle researcher. “The government feels it has the obligation to make sure foreign investment is only having a positive effect on the market, and thus (issue) rules that continue to welcome foreign investment, but regulate it more closely.”

Hart doesn’t expect the new rules to significantly impair ongoing foreign investment in Chinese real estate. “The challenges of foreign investors will be more about getting comfortable with a lower level of market transparency and finding the right products to purchase.”

China could promulgate further restrictions, however, and the recent restrictions alone will discourage some investors, says Zane, the Colliers researcher. “This will mean more control from the government and potentially higher tax for investors,” he says. “This, coupled with the increase in the upfront cost, will reduce investors’ interest in the market.”

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