This is the second in a multi-part series on the changes to China’s foreign investment laws as reflected in its 2007 Catalog of encouraged, restricted and prohibited investments. Part I of this series can be found, entitled, “Breaking News, China Changes Foreign Investment (FDI) Rules,” can be found here.

China’s new catalog on foreign investment continues Beijing’s trend to restrict foreign investment in Chinese real estate. This process started in 2006 when direct foreign investment in real estate was prohibited. All foreign investment in real estate was required to be made through a Chinese company, either a WFOE or a Joint Venture. In May of this year, the notorious Circular 50 was issued, closing many loopholes in that rule. Circular 50 requires all foreign invested real estate projects, no matter the size or nature, be approved at the national level in Beijing. This allows Beijing to turn the market on and off through its approval authority. In July, the State Administration for Foreign Exchange issued Circular 130, regulating and limiting the use of foreign exchange in real estate investments. After the 17th party congress, a number of officials indicated foreign investment in real estate was still viewed as a major problem. The problems were seen in two areas. First, foreign investment is believed to drive up real estate prices to the detriment of local citizens. Second, the flood of money into the real estate market was exacerbating China’s excessive accumulation of foreign reserves. Many foreign investors do not agree with this analysis, but it is widely accepted in China. It is therefore no surprise the Catalog would include provisions restricting foreign investment in real estate.

The changes in treatment of real estate are as follows:

The 2004 Catalog put development of residential housing in the encouraged category. The 2007 Catalog removes this reference. Under the new investment policy, foreign investments not in the encouraged category are strongly discouraged. Since Beijing’s approval of such projects is required, this change means approval of investment by foreigners in any form of housing development is unlikely. On the other hand, investment related to energy efficiency in all areas of real estate is strongly encouraged.

The 2007 Catalog includes three areas concerning real estate in the restricted category. Placement in the restricted category means the investment is strongly discouraged and is seldom approved. Foreign investment is restricted in the following:

Foreign investment in the development of raw land is restricted and limited to joint ventures. WFOEs for this purpose are prohibited. This change was expected, although the limitation to joint ventures is a surprise to me. Raw land development in China is a very sensitive issue, since it usually involves either expropriating the land of urban residents or converting agricultural land to use for construction. Foreign involvement in this highly political and sensitive process is now seen as undesirable. Though the restriction is understandable, the change does raise some important issues. Funds for building construction are plentiful within the Chinese system, but funds for raw land development are not. Provisions in the new Property Law make raw land development even more difficult. We have seen many local governments actively seeking the assistance of foreign investors to provide seed money for such projects. Now that this source of funding has been restricted or eliminated, it is not clear to me what source of funding will take its place.

Foreign investment in both the construction and operation of high level (luxury?) hotels, villas, high level (luxury?) office buildings and international convention centers is restricted. It is hard to imagine what the motivation was for this restriction since these have little to no impact on the domestic real estate market and little to no impact on foreign exchange reserves. These restrictions seem to have no relation to the stated reasons for limiting foreign investment in real estate. Further, these areas are inherently international and are expected to be funded by international investors in nearly every market in the world. Comments in the local press also express confusion about the motivation for this restriction. It seems counterproductive. For example, the second tier cities in China have no surplus of luxury hotels. Is it really the intention of the Chinese government to prohibit Starwood and Shangri La from building new five star hotels in any city in China?

Foreign investment in secondary market real estate sales and all real estate brokerages and consultancies has been restricted. Though many foreign brokerages have an active presence in China, this provision means no new brokerages will be permitted. This is consistent with the policy that foreign investors will not be permitted to invest in real estate development or purchase existing properties. With this restriction in place, what role is there for foreign owned brokerages or consultants?

Much of the Chinese press has reported these changes prohibit all foreign investment in real estate, but this is not strictly true since no area of real estate has been placed in the prohibited category. However, the effect of these provisions, when combined with the prior regulations, is to effectively eliminate most areas of foreign investment in real estate. Even where Beijing might approve a project, the requirement to seek such approval involves such a significant delay most conventional real estate projects cannot succeed. The practice in Beijing has been to simply fail to respond to requests for approval. In this way, a formal denial from Beijing is not required. The effect is a prohibition. I should note that no one in China is at all concerned about these restrictions. The Chinese real estate companies and brokerages are quite confident they can handle all of China’s current needs in the real estate area. There is therefore little chance of a change in policy in this area in the near future.

UPDATE: Stan Abrams, China lawyer extraordinaire, has come out with a post pretty much affirming the death of foreign real estate investment in China, aptly entitled, Real Estate RIP? Check it out.