A Rough 6 Weeks for Real Estate Investors

Tuesday, August 8, 2006 8:53

if foreign investors in the Chinese real estate market feel like the Chinese government is out to get them, the are right. the last 6 weeks have seen a barrage of regulatory activity aiming at foreign investment in the sector due to a belief that it is foreign investors who are primarily responsible to for the recent meteoric rise in prices of Shanghai, Beijing, and other hot markets.

It all began on June 1, 2006 when the central government announced that the June 1, 2005 regulations would be revised in the following manners:
1) Residential properties sold within 5 years of purchase would be subject to a 5% ax on the gross sale of the property
2) Building permits for single unit family housing would no longer be issued
3) 70% of new residential developments must be of units under 90 square meters
4) Owners could mortgage up to 70% of the value of apartments under 90 sqm meters, or 60% for units above

Later, in July the government announced their second series (AP, IHTBloomberg and China Daily) of regulations to further restrict speculative investments in the sector by limiting the ability and access of foreign investors to residential properties:
1) Foreigners (persons and companies) were barred from buying properties that were not for their own use
2) Foreign developers would need to provide 35% cash up front before receiving the backing of Chinese banks
3) Foreign investments of over $10 million USD would require the registration of at least 50% of the total investment size
4) Transfer of ownership would require government approval

Finally, the Ministry of Tax announced (China Daily; Shanghai Daily; WSJ) it would begin collecting on the 20% capital gains tax for all properties sold within in 5 years of purchase. this announcement did not come as a surprise, and it is actually one that ha been on the books since the 90s.

So what does all this mean? Initially, it meant a rush to the market to beat the implementation and enforcement of the regulations, but many fear that it could have a crushing impact on local developers, agents, and investors alike in the short to medium term (Shanghai Daily).

Where local officials should have moved in months ago to reign in property prices, the delay caused the central government to act by implementing a macro level policy to solve a . In the words of one investor “China is using a broadsword where something more like a steak knife is needed”, and he is right.

Where a stricter guidelines on ownership, taxes, and lending may have been be warranted in markets like Shanghai and Beijing, the way that the regulations were implemented could have a larger impact on second tier cities like Chengdu, Chongqing, and Wuhan where foreign investment is greatly needed..

Overall, the long term impact is uncertain as:
1) There are loffshore legal structures available that eliminate the effect of the 5 year gross taxes
2) There are domestic China structures available that allow foreign to establish a special purpose vehicle to invest in local properties as a local entity
3) There is a loophole in the regulations that may mitigate all but 2% of the 20% capital gain tax
4) There is a belief that these regulations will be removed on a national level once the government feels the market has cooled down
5) With many second tier cities still in desperate need of foreign investment, many believe that the regulations will go largely unenforced

One thing is for certain, the government is concerned about the average prices of residential properties rising beyond the reach of the local residents. There are now reports that the government is going to take more action so as to ensure that more affordable housing is available to the masses.

As such, the result could be that over the long run, these regulations have a much larger impact on the property developments themselves than those looking to buy property.  Future developments, rather than well designed and decorated that they have become, could take a step back to the old days where housing developments looked like dormatory housing as foreign developers find themselves unable to sell luxury housing (and thus, find themselves unable to finance the developments).

For foreign investors, the last 6 weeks have been tumultuous to say the least. For those who were already invested, the only real impact is that a longer hold term may be necessary to avoid paying either the 5% gross tax or 20% capital gain tax. If investors were in the research, discovery, or closing stages of a deal, a complete reassessment may be required. Whether it is reevaluating the hold period or the acquisition structure, foreign investors must now accept that the game has changed. Leveraged yields will be reduced, exit strategies will be restricted, and larger investments may be more heavily scrutinized by the central government.

However, for those investors who are willing to tough it out, the gains are there.  opportunities still exist for good investments in the Chinese real estate market. It may take a broader investment criteria, or a little more time, but the opportunities for real gains still exist.

Relevant Posts: June 19; July 17

Relevant Reports: 2nd Tier Real Estate Trends; Real Estate Investment Announcement; Real Estate Developer Map

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