Come onshore

The most famous of Chinese curses – “may you live in interesting times” – has apparently befallen foreign investors in China's booming real estate market. The returns potential of the property market in what is set to become the world's largest economy is certainly interesting, or foreign capital wouldn't be there. But the pejorative use of the word “interesting” might be applied to the many regulatory changes that these investors have faced and will continue to face as they try to buy a stake in the Middle Kingdom.

Given the interest in making money in Chinese property, as well as the significant regulatory roadblocks to success, it was no surprise that at a “China Matters” panel in London last month, hosted by law firm Paul Hastings, the big topic seemed to be the slew of restrictions that the Chinese government has put on foreign investors in property over the past year. The latest came this summer when a circular from the State Administration of Foreign Exchange set out a mechanism by which China will ban foreign investors from borrowing money offshore, where interest rates are lower.

“Essentially everything you know today, 18 months from now it will be totally obsolete.”

The circular was only the latest in a series of rule proposals and changes over the past two years. The sum of all this is that from now on, if foreign investors want to make investments in Chinese real estate companies, they have to move equity in those companies from onshore entities. In addition, it will now be impossible to use assets inside the country to secure debt outside the country. Essentially this will mean that the special purpose vehicles incorporated in Hong Kong, Mauritius or Barbados to directly finance Chinese real estate companies via shareholder loans are not going to pass scrutiny in the future.

But rather than scaring away foreign investment, the changes seem likely to simply force foreign investors to change the way they finance deals. Joel Rothstein, a partner with Paul Hastings' real estate practice in China, noted at the panel that this summer's circulars (numbers 50 and 130) will probably see a similar result to that of last summer's circular 171. In that circular, six different ministries issued a directive saying that in order to do a real estate deal in China, foreign investors would need to do it through a domestic entity. “When 171 came out there was a slowdown in activity, everyone thought, ‘This is the end,’” he noted. “But it had no effect whatsoever. China is in the unique situation of being an emerging economy with scale. You wouldn't go through all this in Malaysia, but in China you have to.”

Rothstein also pointed out that the changes have affected domestic Chinese investors as well, specifically Chinese companies that have incorporated offshore to take advantage of tax benefits that were present before the 2006 rules change. In fact Rothstein estimates that only about one quarter of what is broadly included in “foreign investments” by the government and media actually comes from traditional Western real estate funds. The net effect of all the circulars, of course, is to bring all of the investors, foreign and domestic, onshore.

Still, you could be forgiven for letting all the rule changes give you a headache. The general trend is for the government to bring investors onshore, but the actual rules to enforce that seem to change all the time. Paul Hastings partner Maurice Hoo told PERE that as the firm has been working on deals in China, they've seen the rules change every six to 12 months. “You can always bet that the rules will change further,” he said. “Essentially everything you know today, 18 months from now it will be totally obsolete.”

However, Hoo points out that rather than happening suddenly, these changes are usually laid out beforehand in academic essays, newspapers and discussions. Considering that the one certainty here seems to be that everything needs to move onshore, investors would do well to anticipate the next wave of changes by continuing to develop strategies that work based entirely on the mainland.