Amid fears that competing offshore investors are driving up real estate prices to new heights, China took new steps this week to curb foreign investment in that country’s real estate market. The new rules unveiled June 11 extend existing licensing and equity-participation requirements for property purchases to cover investments in Chinese holding companies as well.

For more than a year, Beijing has attempted to cool China’s hot property sector in order to avoid oversupply and to prevent foreign investment from driving up prices. Last July, the government required foreign companies to create a wholly owned foreign enterprise (WOFE) in China before developing or acquiring real estate valued at more than $10 million. A WOFE must provide at least 50% of the equity for large projects upfront, a requirement that is intended to reduce speculative construction and potential overbuilding.

Due to the steep equity requirement and a high tax burden on asset transactions, most investment by international institutions has been through acquisition of shares in Chinese real estate companies rather than direct property purchases. The new regulation, however, prevents foreign investors from skirting the WOFE requirement in this way.

Buying companies is allowed, but the purchased entity must then declare itself to be foreign-owned and therefore required to meet the 50% equity requirement for large projects, obtain special land-use rights from local authorities, and register with the national Ministry of Commerce.

While the latest measure appears to clamp down exclusively on foreign investors, it will in fact curtail a practice many domestic companies have used to circumvent taxes on profits and capital gains, real estate experts say.

By a process known as “round-tripping,” China-based investors have been able — until now — to create offshore companies with domestic capital, and then use those funds to invest in businesses that own Chinese real estate. The low-cost offshore holding structure incurred only a 10% withholding tax upon the sale of a property, as opposed to the standard 33% corporate income tax rate, according to Mac Chan, senior manager of research and consultancy at Colliers International in Shanghai.

Under the new rules, however, offshore capital used to buy ownership interest in a Chinese property will trigger the same restrictions that come with direct property purchases, eliminating the opportunity to avoid local taxes. The new rule ensures taxes are paid to local governments and gives the central Chinese authority more oversight into who is making investments, according to Michael T. Hart, managing director of Jones Lang LaSalle in Tianjin, China.

“The intent is not just to more clearly regulate investment by foreigners, but also to eliminate round-tripping, where Chinese nationals would take money offshore and then reinvest through a generic vehicle that disguises the original source,” Hart says.

As a result, only well-capitalized firms will be able to tackle large projects, predicts Chan of Colliers. “The new measures will screen out speculative developments by less financially strong domestic developers that used to adopt the offshore ownership approach,” he says.

This latest round of rule-tightening will likely slow the pace of acquisitions by foreign investors in China, but isn’t likely to choke off the foreign capital contribution to China’s development boom, says Kenny Ho, head of research in the Shanghai office of Jones Lang LaSalle. “Foreign real estate investors are still developing large-scale commercial, retail, hotel and residential projects in China,” he says.

There is evidence to support the government’s worry over price escalation, according to real estate researchers. Competition from overseas capital has driven up prices on investment-grade commercial properties in Shanghai, for example, even though international buyers account for only about 4% of all acquisitions in that city.

Coupled with that is the public perception that foreign investment is increasing rapidly, although actual volume remains small in relation to the overall market. China’s real estate has only been available to private investors for about six years, as the government has moved from a system of state-owned housing and space providers to allow acquisitions by individuals. The government already bars foreigners from investing in golf courses, residential villas and other luxury properties, a restriction intended to keep those properties within the means of at least some Chinese nationals.

Ho says the measure announced June 11 is merely intended to formalize the investment and regulatory structure the government put in place last summer. He does see the potential for a more restrictive policy stance in the future, however. “The requirement that foreign investors must obtain land-use rights (when) applying for company licenses suggests that government regulators will try to control the market through the approval/disapproval of foreign real estate company licenses,” he says.

Long term, the restrictions on foreign investment will bring greater discipline and stability by culling less-capitalized developers and investors from the market, says Chan of Colliers. “The new regulation in effect will screen out the smaller players and the opportunistic, short-term investors, while prompting overseas investors generally to adopt a longer investment horizon for their real estate undertakings in China.”