China is taking new steps to curb foreign investment in commercial and residential real estate and to quell fears that offshore investors are driving up prices to unacceptable levels. Announced June 11, the new rules extend licensing and equity-participation requirements for property purchases to cover investments in Chinese holding companies as well.

The latest measure not only clamps down on foreign investors, it will also curtail a practice known as “round-tripping,” through which many domestic developers circumvented taxes on profits and capital gains by routing capital through offshore companies. Closing that loophole will weed out under-capitalized and speculative developers, foreign and domestic, while adding red tape to slow new projects by foreigners, experts say.

Overseas investment is exploding in China in hot spots like Shanghai, where volume more than tripled to $1.93 billion in 2006 from $592 million in 2005, reports Colliers International.

Real estate professionals argue that rent growth projections, not foreign investment, are driving up prices. Nationwide, office rents climbed 29% in 2005 and another 13% in 2006, according to Jones Lang LaSalle, which is projecting steady rent increases through 2009.

“There is a misconception that foreign capital is driving up prices for commercial real estate,” says Kenny Ho, research head at Jones Lang LaSalle in Shanghai. “Foreign investors are much more rational, yield- and cap-rate driven, in their investment decisions than most domestic investors.”

Nevertheless, for more than a year Beijing has attempted to cool the nation's hot property sector to avoid oversupply and to slow rising prices. Last July, the government required foreign companies to create a China-based wholly owned foreign enterprise (WOFE) before developing or buying real estate valued at more than $10 million, and to provide at least 50% of the equity for large projects.

The new regulation prevents foreigners from skirting the WOFE requirement by acquiring shares in real estate companies, rather than direct property purchases. Buying companies is allowed, but the purchased entity must then declare itself to be foreign-owned and must meet the 50% equity requirement for large projects. The entity must also obtain special land-use rights from local authorities, and register with the national Ministry of Commerce.

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. Now, buying into a Chinese property company with offshore capital will trigger the same restrictions that come with direct property purchases.

“The intent is not just to more clearly regulate investment by foreigners, but also to eliminate round-tripping,” says Michael T. Hart, managing director of Jones Lang LaSalle in Tianjin, China.

Long term, the restrictions will bring greater discipline and stability to 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.”