Investment appetite for core real estate has greatly expanded since the financial crisis, yet demand from international investors for core real estate in China is still lacking. What is responsible for this limited appetite? A combination of capital controls and yield differentials seem the likely culprit.
Capital controls have successfully insulated the Chinese economy from financial shocks and, in recent years, have been used to stem currency outflows related to rapidly increasing levels of offshore investment. We are often asked by investors whether offshore investors can get money out of China once it is invested.
The simple answer is “Yes” – but it requires an approval process with the State Administration of Foreign Exchange to convert your renminbi into foreign currency which, in our case, is US dollars. As part of this process, it is necessary to pay the applicable local taxes plus a dividend withholding tax of 5 percent, if the dividends are being paid to a Hong Kong company. It is all quite straightforward – but time consuming, which makes it hard for core investors looking for regular income on a timely basis.
The workaround solution often used is a back-to-back loan: renminbi is deposited in a bank onshore collateralizing a loan offshore with the same financial institution. This structure has a friction cost of the differential between income on the deposit and expense on the loan, and remains subject to challenge if the practice is abused or seen as a way of circumventing capital controls. Shareholder loans into China were prohibited in 2007 but occasionally we see structures with shareholder loans in place. Shareholder loans facilitate quicker and easier remittance of profits as the payment of interest expense on the loans is very straightforward.
We recently came across a case where it took a developer three months to repatriate dividends offshore, and over time, we have seen that foreign investors encounter greater delays when the renminbi depreciates or when foreign exchange reserves decline, as was demonstrated in early 2017. In the current environment, with escalating trade tensions between the US and China and the renminbi depreciating, history tells us that the conversion process will likely take longer.
Another issue facing core investors in China is that dividends can only be paid offshore from accounting profits. In China, it is necessary to depreciate the value of the property over 20 or 40 years. The depreciation charge, while non-cash, effectively creates a cash trap, reducing offshore distributions and the cash-on-cash yield for overseas core investors.
A further issue facing core investors is the negative yield differential. Prime office yields in Beijing and Shanghai are around 4 percent, whereas lending costs are in the range of 6 to 7 percent per annum. The differential is exacerbated by relatively high taxes on income in China (12 percent on rental income plus 25 percent corporate income tax on profits). The negative yield differential makes the cost of carry painful, especially for even a modestly leveraged investor holding for the long-term.
A smart approach
Considering those challenges, an investment strategy in China based on a combination of mezzanine financing and value-add investing makes most sense. Capital market inefficiencies in China allow for lending to Chinese developers offshore, generating attractive income yields where the timing risk resulting from capital controls is transferred to the borrower.
In terms of value-add investing, a strategy focused on capital gains from transforming well-located and poorly managed commercial properties is workable. In these transactions, you are not looking for regular income and can engage in a one-off repatriation on exit, either by selling to a domestic buyer or by selling the shares of the offshore company. With these strategies, the impact of capital controls is effectively negligible.
For these reasons, it is likely that the majority of investor appetite for China will remain value-add and opportunistic – not core.