Foreign Direct Investment

 In recent years China implemented various restrictions to cool down the real estate industry due to overwhelming amount of foreign direct investment. This article address the key restrictions imposed on foreign investors in the real estate industry.

As China’s economy is growing stronger, empowered by a constant and impressive flow of foreign direct investment, real estate prices in its metro cities have dramatically increased, leaving many local Chinese without the ability to purchase a home. According to the Chinese Ministry of Commerce, during 2005, over 5.4 billion dollars have been invested by foreign enterprises.

Moreover, newly established foreign-invested real estate enterprises increased by 25.4 percent in the first half of 2006 compared with the same period of the previous year.

As of May 2007, the average price per square meter in central Shanghai was RMB 23,139 (US$3,259). Therefore, a 100 square meter apartment (1,076 square feet) costed approximately US$325,901. We should recall that the average monthly income in Shanghai is only RMB 2,464 ($US332). According to a published survey issued by the Financial Research Center of Beijing Normal University, 70% of the urban residents of Beijing are unable to afford to purchase a house.

Local Chinese complain that due to the growing number of foreigners in the larger cities, who are paid western salaries, the real estate market has been inflated beyond control.

Due to the public outcry, the central government in Beijing has been continuously trying, in recent years, to cool down the real estate market by issuing a series of regulations.

I shall try in this issue to summarize the key restrictions that apply to foreign investment in the real estate industry.

Purchase of Real Estate for Self Use or Commercial Purposes

Typically purchasers of real estate property can be divided to buyers who purchase property for their own use as residence or commercial office space, and commercial buyers who intend to use the property for other speculative commercial purposes, such as land development, property construction, etc.

A foreign individual is allowed to purchase real estate if he or she has worked or studied in China for one year or longer. The purchaser must present supporting documents such as visa permits to support his status. Also the owner of the apartment is required to reside in the apartment and may not sublease it.

Similarly, a foreign invested company or representative office may purchase real estate in China for its business use.

Real Estate Investment for Commercial Purpose

A foreign investor who seeks to purchase real estate for commercial purpose must establish a foreign invested real estate company in China. Offshore direct ownership of land use rights that was common in the past is no longer permitted.

All Foreign Invested Real Estate Corporations Must Receive Approval from Beijing

China is operating under the leadership of the Central government in Beijing which uses macro control tools to regulate its foreign direct investments. When the central government seeks to encourage a specific industry it empowers the local and provincial level governments with the discretion to regulate and execute the approval procedures.

However, when the central government wants to restrict the investment in a particular field, the level of approval is elevated, which substantially delays and complicates the approval process.

According to government regulations issued on March 2007, any establishment of a foreign invested real estate enterprise must be approved by the local authorities and by the Ministry of Commerce (MOFCOM) in Beijing. This approval process may delay the procedure for months. To assure the compliance with the regulations, any real estate company that fails to receive approval from central MOFCOM will not be able to utilize its foreign exchange account.

Financing Restrictions: Elevated Minimum Registered Capital

In contrast to the practice in the United States and Israel, every Chinese corporation is subject to a statutory and regulatory minimal registered capital. In order to establish and maintain its business license, the corporation must inject a statutory amount of funds to the corporation, in a limited time frame as required by the relevant authorities. The problem is that often, the minimum registered capital exceeds the investor’s current commercial needs and forces the investor to inject more capital to the corporation when it is not economically desirable.

For instance, according to the Corporation Law of the People’s Republic of China, the minimum registered capital for the establishment of a corporation is RMB 100,000 (approximately US$13,513) for a one shareholder limited liability company or RMB 30,000 (approximately US$4,054) for a limited liability company owned by two or more shareholders. This might seem as a reasonable requirement taking into account the operation costs of a business. In practice, however, the decision on the minimum registered capital varies from one city to another according to their internal regulations. Those internal regulations provide the local authorities with a major discretionary tool to encourage or discourage any specific type of investment by changing the minimum statutory requirement according to the local government’s needs. For instance, in the city of Dongguan, in Guangdong Province, an investor which seeks to establish a small scale processing plant must invest a minimum registered capital of US $1,000,000 which is 7400% higher than the statutory amount and far exceeds its business needs.

To reduce the strong flow of foreign investment in the real estate market, the new regulations require a substantially higher minimum invested capital. For instance, while the minimum registered capital for traditional non real estate projects of over $30 million dollars is 33.33% of the total investment, the minimum registered capital for real estate projects is 50% of the investment.

Further Obstacles in Debt Financing – Restriction on Obtaining Domestic and Foreign Loans According to Circular 130 issued by the State Administration of Foreign Exchange, a real estate company may not borrow any loan, domestic or foreign if its registered capital is not fully paid, or if the land use right certificate is not obtained.

Moreover, any foreign invested real estate enterprise is not permitted to borrow foreign debts (including shareholder’s loan) if its establishment was approved after June 1, 2007.

The new regulations require that any investment will be in a form of equity injection. Thus, registration of foreign debt (including third-party loans and share holders loans) will not be permitted.

Every Project Requires the Establishment of an Independent Real Estate Company

In contrast to the common practice in most countries, a foreign investor must establish a separate real estate company for each project. Naturally, this requirement adds additional costs and delays the completion of the project.

First Obtain Land Use Rights than Incorporate

Traditionally, real estate investors prefer to conclude their contractual relationship by establishing or using an existing corporation which enters into a formal legal contract with the seller. Pursuant to the governmental circular issued on May 2007 obtaining the land use rights or entering to pre-assignment or sale agreement on the land use rights is a prerequisite to the establishment of a foreign invested real estate company. This switch in the traditional order of business may be inconvenient to the small scale investor.

Prohibition on Fix Investment Return Clause

Typically, investors agree on a fixed return on investment to attract investors to contribute capital to the project. This arrangement is often incorporated into the shareholders’ agreement and to the company’s articles of association. According to the new regulations, any clause regarding a fixed return on the investment will be regarded as unlawful and will likely be declared as void by the People’s Court.

Catalogue for Guidance of Foreign Investment Industries 2007

During December 2007 the central government has amended the foreign investment catalogue which divides the foreign investment market to encouraged, restricted and prohibited industries. Prior to the recent amendment, development of residential housing was an encouraged industry and received governmental incentives. However, the new catalogue of 2007 removed the development of residential housing from the encouraged industries and thus complicated the approval process.

Restrictions on Development of Raw Land

The 2007 catalogue lists the development of raw land as a restricted industry. Moreover, any development of raw land requires a formation of a joint venture with a local partner, abolishing the option of forming a wholly foreign owned enterprise (100% ownership by foreign parties). Some observers opinioned that this change has been incorporated due to the elevated political sensitivity associated with the change of agricultural land to commercial urban land and the social unrest which derives from the relocation of local residents from their property.

Restrictions on Construction of Luxury Hotels, Villas, and Office Space

Foreign investment in the construction and operation of high ranking (luxury) hotels, villas, office buildings and international convention centers is listed as restrictive industry. Similarly, real estate brokerage and consulting agencies will also be regarded as restricted industries.

The Future of Foreign Investment in Chinese Real Estate Market

What is the future of foreign direct investment in the Chinese real estate market? Clearly there is still a lot of confusion among members of the industry. Some observers claimed in an outcry that “foreign investment in the real estate industry has been declared dead”. Others have commented in a much more relaxed tone suggesting to wait and to see the implementation of the new policy.

In our mind, there is no doubt that the new regulations place substantial burden on the foreign investors in the real estate market and will likely deter the small investors. However, it is our experience that foreign investors are still investing and are looking for opportunities in China.

We must remember that the new regulations do not prohibit foreign investment in the real-estate market, but just add additional obstacles to cool down the market. It is our experience that financially sound real estate investors find in China, in particularly in its second tier cities, fruitful grounds and cooperative local authorities that are eager to accommodate foreign investors in the real estate industry.

This article is provided for general information purposes and is not to be regarded as a legal advice or a legal opinion. This article was published in March 2008 and the regulations may have changed. Please note that facts and laws relating to each case may vary.

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