The Shanghai government recently issued sweeping changes to the regulation of industrial land use rights (the "Rules").1 Together with a new standard form of the Land Grant Contract (for industrial land use rights, current draft to be adopted prior to July 1, 2014), the Rules will have a major impact on the acquisition and financing of industrial and logistics properties in Shanghai. Set out below is a summary of key changes and practical consideration regarding the Rules.

Key Changes

Shortened Land Use Term

With very few exceptions, the term for new grants of industrial land use rights will be shortened from 50 to 20 years. Industrial land use rights granted prior to the effective date of the Rules will not be affected. However, the renewal of existing land grant contracts that have a 50-year term is subject to the approval of the land administration authority.

Draft Land Grant Contract 

Shanghai's land administration authority is currently developing a standard form contract ("Land Grant Contract") to be used for granting industrial land use rights. Upon finalization of the draft Land Grant Contract, it is likely that this contract will be required to be used for all grants of land use rights for industrial land.

Introduction of Investment Targets 

Investors are required to achieve certain targets with respect to projects involving industrial land, which may include: (i) a total fixed asset investment amount; (ii) a per square meter investment amount; (iii) a minimum annual sales revenue; (iii) a minimum amount of annual tax revenue; and/or (iv) an average annual tax revenue per square meter. Specific criteria may vary between projects and are subject to negotiation with the local government and land administration authority.

Monitoring of Targets 

Local government authorities will begin monitoring projects involving new grants of industrial land to determine compliance with stated investment targets. Failure to achieve targets within the agreed time period may result in damages arising from the breach of the underlying Land Grant Contract and/or reclamation of land. If the land use right is reclaimed, the land grant premium for the remaining term will be returned to the investor, and the local government will compensate the investor for any buildings on the land based on the residual (not replacement) value of such buildings.

Ongoing Appraisals 

Authorities will conduct appraisals with respect to an investor's compliance with the agreed investment targets at various periods of the land grant term (e.g., at the time that the designed capacity is reached, within three to five years after the designed capacity is reached, and/or one year prior to the expiration of the land use term).

Renewals

At the expiration of a 20-year land use term, the holder of the land use rights must apply for a land grant renewal in order to extend the term for another 20 year period. In reviewing the renewal application, the local real estate authority will consider various factors, including whether the investor has a track record of satisfying investment targets and complying with local zoning plans and requirements regarding energy efficiency and environmental protection. If the land administration authority determines that the holder of the land use rights has failed to meet investment targets, or that the land should be used in a more efficient or environmentally friendly manner, it will have the authority to reclaim the land for government use. The government will not pay any compensation to the investor for the value of the land that has been reclaimed following, and will only pay the residual value of the buildings on the land. If the holder of the land use rights does not apply for a renewal, then the local government has the right to reclaim the land and the buildings thereon without compensation. 

Performance Bonds

The Rules provide that the Land Grant Contract must stipulate project development milestones, such as the commencement and completion of construction and operations. Depending on specific project conditions, the local government or land administration authority may require an investor to pay a performance bond, or take other "market-oriented measures" to ensure the granted land will be used efficiently.2 If a performance bond is required under the Land Grant Contract, the investor must pay the bond within five days of executing the Land Grant Contract. Construction is usually required to commence within six months of delivery of the land. Other milestones may be subject to negotiation. Local media reports provide that a project will usually be required to be completed within two years of delivery of the land.3

Transfer Restrictions

Investors must obtain prior approval from the land administration authority for any asset or equity transfer that involves industrial land (including buildings) subject to a 20-year land use term. Prior approval is also needed for transfers of R&D and operational infrastructure facilities located on industrial land.  

Practical Considerations

Valuation 

One of the most immediate effects of the new rules is the impact of the shortened term on valuation and pricing. Presumably, land with a 20-year use term will be valued at a comparatively significant discount to similar land parcels that have a 50-year term. Lower valuations will impact financial leverage calculations and the ability for investors to finance property acquisitions. In addition, the valuation of the buildings and improvements located on industrial land will now be assessed according to residual value, rather than market value.

Increased Premiums

The Rules set the following floor prices for industrial land:

Click here to view table.

Due to the floor prices, and market sentiment that real estate prices in Shanghai are likely to remain on an upward trajectory, it is possible that premiums for land grants and renewals every 20 years will on aggregate exceed the premiums that would have been paid on the same land under a 50-year term. Although the Rules provide that the land grant premiums should be "adjusted" based on benchmark rates, it remains to be seen how the adjustment will be calculated or implemented.

Additional Approval for Equity Transfers

As equity transfers involving land are subject to the land administration authority's prior consent, parties to a land sale involving foreign-invested enterprises will need to consider not only local MOFCOM approval, but also approval from the local land administration.

Application of Investment Targets

The imposition and enforcement of investment targets, and the mid-term and renewal evaluations creates an layer of uncertainty with respect an investor's long term business plans.

Conclusion

From an investor's perspective, the introduction of the new regulations for industrial land is a great leap backward in terms of stability, predictability and affordability, and will require investors to reassess the risks and pricing of industrial projects in China. While the Rules will create some uncertainty in the investment environment over the short term, they do appear to be the "new normal" for nation-wide land grant policies in the industrial sector, particularly since other major Chinese cities (including Shenzhen, Linyi City in Shandong, Foshan City in Guangdong and the Beijing Economic and Technical Development Zone) have or are in the process of adopting similar policies.