Article Financial Times

Changes in Real Estate Law Ease Constraints on Foreign Investors

Foreign investors continue to pile into Chinese real estate in spite of last July's government measures apparently aimed at cooling down an overheated market.

According to the National Bureau of Statistics, real estate investment in 2006 in China, including Hong Kong and Macao, was about $18bn. Overseas capital investment in mainland real estate was nearly $8.25bn, a

51.9 per cent increase from 2005. The National Development and Reform Commission reports, moreover, that foreign investment in real estate during the first quarter of 2007 was $1.7bn, up 154.4 per cent fromthe same period the previous year.

Notably, the investments include some made by new entrants, including private equity shops, and in new markets, such as the "Tier II" cities of Chengdu, Wuhan and Tianjin.

Favourable shifts in the underlying legal infrastructure are afoot. The property law adopted last month for the first time expressly, if tersely, acknowledges that both collective and private ownership of Chinese real property is protected by law.

Practically, the regulatory regime is still daunting, especially for the sophisticated, iterative investment programme elsewhere typical of the hospitality and retail sectors and certain types of investors, such as real estate investment trusts.

A foreign investment in Chinese property generally now may be conducted only through a China-domiciled foreign invested real property company. Although 100 per cent foreign ownership is permitted, formation - and thus the proposed business scope - requires approval by the NDRC and the Ministry of Commerce.

Local NDRC and MOFCOM approvals generally suffice where total investment is expected to be less than $100m and ordinarily can be obtained in four months. If greater, central agency approval is required, typically resulting in additional delay.

Both local and central approvals tend to be project-specific, thus implying a potentially serious approval burden

for a multi-property investment strategy, particularly if designed to develop over time in response to evolving opportunities. In practice local governments may require the formation of a local operating company to employ local staff, thus magnifying the potential administrative burden of a business plan with geographic breadth.

Another challenge is "registered capital". Under Chinese law, a foreign invested company must obtain approval from the government for the initial amount of contributed equity to be invested and each subsequent addition.

Because each such approval typically requires an additional two to four months to obtain, careful planning is required and transitory investment opportunities can be lost. Without rarely granted special approval, registered capital may not be withdrawn prior to liquidation.

As in other markets, foreign property investors in China can overcome certain challenges and mitigate risks with appropriate legal structures. The risk of over-funding non-withdrawable equity, for example, can be reduced by purchasing each property with a separate foreign invested company capitalised only to the extent necessary for that project.

The risk of even that amount of "registered capital" becoming "trapped cash" until liquidation - a frequent pricing issue in global buyouts involving Chinese assets - can be minimised with the use of appropriately structured shareholder loans. (Subject to registration of the loan agreement with the State Administration of Foreign Exchange, such a loan can be repaid at any time).

Although any legal strategy may entail risks and must be carefully tailored to the respective business plan, creative commercial advisers can usually add value to the status quo in a heavily regulated environment.

Although the potential rewards may be immense, the regulatory regime applicable to foreign investment in Chinese real estate is still in transition.

To maximise opportunities in this market, foreign investors will require a flexible approach and advisers skilled not only in articulating the law and its impact on potential business, but also in analogising from other markets and innovating bespoke solutions from disparate and shifting rules in this one.

The authors are partners at Kirkland & Ellis