While the past several years saw muted foreign investor activity in China real estate, due to governmental restrictions and competition from domestic capital, a change is now underway. Restrictions in China on shadow banking activities and other domestic sources for capital, combined with selective reduction of barriers to foreign investment in some jurisdictions, are leading international private equity firms and other cross-border investors to take another look at China.
At the same time, however, structuring and completing real estate investments in China continues to be a daunting, complicated task. To provide context for this changing environment and the critical considerations for successful deals, Paul Hastings partner Joel Rothstein shares his perspective on investing in China real estate:
What are the biggest differences between investing in real estate in China and investing in real estate elsewhere?
In China, land use ownership, the real estate development process, and foreign investment in real estate are all subject to multiple layers of governmental laws, regulations, and controls at the local, provincial, and national levels. China’s legal system is still in the process of catching up with its economic growth and its integration into the international markets. Consequently laws, regulations, and controls change on almost a daily basis. These changes sometimes have dramatic impacts on how foreign investors may structure their real estate transactions. Many of China’s laws, rules, and regulations are broadly worded and afford substantial implementation discretion to governmental officials. Foreign investors navigating the investment landscape often discover that the interpretation of key laws, rules, and regulations can vary significantly from jurisdiction to jurisdiction and can even vary over time within a jurisdiction.
At the heart of the inconsistent and varying application of laws, rules, and regulations are government officials. One striking feature of the Chinese real estate investment market that many foreign investors from developed economies often find surprising is the scope and breadth of governmental authority involvement in the entire process. The reality of the market is that the government, through regulatory oversight and approvals, is an active participant in the real estate investment process. As a result, deal structures, including even certain terms of a joint venture with a Chinese joint venture party, need to be acceptable to the relevant governmental authorities. In this way, not only do direct transaction participants help shape deal structures, but the relevant government officials also may play a role in influencing the structure of an investment transaction.
What particular issues should foreign investors be aware of in structuring their real estate investments?
Despite the challenges facing them, a number of foreign investors have successfully structured and completed China real estate deals by adopting the following common strategies:
Successful foreign investors in China real estate value the importance of careful due diligence. The due diligence process is particularly critical in light of China’s land ownership system, where real estate investors do not have fee title ownership to properties, but rather have only land use rights for a set period of years. Due diligence not only confirms whether all appropriate governmental approvals are in place to acquire and own the land use rights with regard to a property, but it is also helpful in revealing local policies, procedures, and practices that can influence the optimum method for structuring an investment.
Alternative Investment Strategies and Offshore Structuring Alternatives
There are numerous ways an investment in Chinese real estate can be structured. For example, it can be structured as an acquisition of a building or project onshore through the formation of a foreign invested real estate entity in China. Among other alternatives, it also can be structured as an acquisition of equity of an existing onshore project company that owns real estate in China or the acquisition of an offshore holding company that owns the real estate through a subsidiary located onshore in China. In most instances, if the foreign investor has the opportunity to enter into an investment completely from offshore, it will adopt the offshore investment approach. Offshore structuring of investments may enable the investor to avoid long and complicated governmental approvals and procedures in China as well as burdensome capitalization requirements associated with forming new investment entities in China. Therefore, in assessing any investment opportunity, many foreign investors consider whether it is feasible to structure the investment from offshore.
Successful investors in China real estate have also recognized that there are many ways of structuring an investment and gaining exposure to the Chinese real estate market other than directly acquiring ownership of a real estate project. Creative investors have found other ways to invest, such as by acquiring preferred shares in offshore holding companies whose subsidiaries own real estate projects in China, by extending bridge loans to offshore holding companies, by investing in pre-IPO stapled debt and equity deals of Chinese real estate developers who are targeting listing in such markets as Hong Kong, or by acquiring participation interests in real estate loans extended by international banks to offshore holding companies that have subsidiaries that own real estate projects in China.
Plan for the Exit
In view of the complexities associated with currency conversion and repatriation, and the liquidation and winding up of entities formed in China, most careful investors will consider the plans and procedures for winding up and exiting an investment upfront, at the time of entering into the original investment. The most common approach is to have several possible exit strategies embedded into the investment structure, including sale of the real estate, sale of the equity to an offshore holding company, and various forms of put and call options which require one or another joint venture partner, where applicable, to buy out the other partner upon the occurrence of certain trigger events.
Tap Advisers with Local Knowledge and Experience
Investing in Chinese real estate requires specialized knowledge and expertise, even if the investment is in an offshore holding company. Successful foreign investors typically have staff on the ground in China and/or rely upon advisers, such as attorneys, accountants, and consultants, with specific expertise and experience in Chinese real estate transactions. A track record of completing successful real estate investments in New York, London, Paris, or Tokyo does not assure success in completing a successful real estate investment in China. The assistance of qualified China-based advisers who are aware of the latest market practices, procedures, and requirements is necessary in successfully structuring and completing each deal.
Is there anything else that will best equip foreign investors?
Foreign real estate investors who have successfully navigated the market have discovered there is no one single path or structure for accomplishing a successful investment in China. Investors who have enjoyed success have relied upon creativity, flexibility, and patience to find the structure that fits each particular investment opportunity. In China’s developing economy and markets, each real estate investment is still an adventure. With the right strategies, the investor can maximize the possibility that each adventure will end in success.