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Investing in China Real Estate: What It Really Takes to Succeed

Of all the U.S. companies and private equity real estate funds that have invested in real estate assets and real estate operating companies in the People’s Republic of China (PRC), few have achieved demonstrable, positive returns above investor thresholds. Attendees of a recent U.S real estate conference underscored the point: only one of the more than 150 participants admitted to having made money in China. Past results, however, are not necessarily reliable indicators of future performance. Particularly at a time when real estate investment firms are sitting on billions of dollars in capital and foreign investors are increasing inflows to the region, China presents enormous potential for real estate investment growth. Distinguishing the winners from the losers moving forward will be planning and execution.

While challenges are considerable, most of the missteps that resulted in early exits could have been avoided. Problems related to operations and performance, joint venture partner liquidity, cultural mismatches, financial repatriation difficulties and onerous government regulations are, in fact, preventable and surmountable. The key is conducting a thorough evaluation of the opportunity from an investment, operational, partner selection and government process perspective – well in advance.

Market Issues

Like most countries, China is reluctant to let profits be repatriated and has a tax system and foreign currency regulations that can stifle investors – particularly those looking for quick returns. The PRC currency, the RMB (renminbi or yuan), remains closed and the government tightly controls cash and the ultimate repatriation of equity, which is likely subject to numerous taxes. As a result, it is important to understand investment lifecycles and create contingency plans to mitigate inherent risks throughout the process. Only investors committed to building long-term local relationships and trust will succeed. As one executive recently suggested: “It is not about making money, but preserving wealth” and waiting for the currency legislation to change.

Creating Sustainable and Profitable Real Estate Platforms

To operate sustainable and profitable real estate platforms, investors must rely on local partners and established foreign entities with western ties, such as investment firms, banks and professional services firms to help navigate an economy governed by different ideals, cultures, economic status and history. The complexity of venturing offshore requires extensive project and risk management experience including:

• Experienced leaders who are proven managers of international companies
• Strong financial management (including the people, processes and technology)
• Proven operational management teams and well-formed corporate structures
• Thoroughly addressed entity and legal issues
• Trusted partners in the PRC who are well connected in government and banking circles

Leadership

Investors should consider using proven interim management with PRC experience until the operating platform reaches stabilization. This provides a chance to assess management before locking in costly executive (often expatriate) compensation packages. Then, over time, highly experienced change management teams can be transitioned to more operationally focused, growth-oriented leaders.

All “C-level” executives, whether interim or permanent, should be versed in functional and industry matters, familiar with cross-border funding and government issues and good cultural fits. There should be no compromise leadership recruiting. Compensation packages should be highly competitive (with equity provisions) and potentially expatriate conditions (including tax equalization, immigration and relocation costs).

Financial Management

In addition to having in place strong leadership that combines financial, operational, industry, local and international expertise, cash management must be paramount. Enabling efficient currency movement through various methods (e.g., offshore currency hedging, cross-collateralized loans, transfer pricing and other forms of onshore / offshore offsetting reinvestment) is often necessary. When undergoing significant capital investment, including land purchases, development and large leases, rigorous government processes that approve the injection of capital onshore must be followed. (Government processes are even more difficult when withdrawing capital.) Finally, the need for strong financial systems and controls is critical for providing timely and transparent reporting to international and local investors.

Corporate Infrastructure

For successful growth, corporate infrastructures must be scalable, flexible and sustainable. Since it is often difficult to predict resource needs, interim strategies for people, office space, technology and other overhead considerations can play an important role. Management teams and employees must be cohesive and support scalability and sustainability. In addition, the corporate services infrastructure (IT / HR / Office) must be flexible, as the speed of growth is often uncertain. All of these factors will be particularly important when exiting the operating platform.

Entity Structures

It is also critical to establish entities that consider investors’ needs, including minimizing tax effects on those in different jurisdictions, limiting filing requirements and protecting investors from potential liabilities. When creating a presence in the PRC, there are four main options: representative office, joint venture, wholly foreign-owned entity or a foreign-invested commercial enterprise. Regardless of structure, it is important to have clearly drafted agreements in both English and Chinese that are executed before investing or commencing operations. There should also be a sound corporate governance structure and entity stewardship that sets out the “chart of financial authority” and makes clear management is responsible for fulfilling all regulatory requirements.

Policy risk in China is always a major concern and can change without warning. For example, in the wake of recent inflation and an over-heated residential economy, the government developed restrictions, including lending rates and taxes, to curb investor purchases of homes. These restrictions and others have effectively flattened market-rate house pricing and illustrate the government’s ability to control market forces. As a result, the more closely aligned investors are with the government’s agenda, the easier business becomes.

Trusted Partners

While it is essential to have significant capital partners when entering China, identifying trusted local partners who share similar values can be extremely tough. Hong Kong and Singaporean investors, with their well-documented success in the PRC, should be pursued first, as they have the inherent ability to move cross border culturally and financially and possess the party associations necessary to expedite government approval processes. In addition, companies with long-term success in the region are certainly candidates.

Foreign Corrupt Practices Act

Finally, investors must be aware of the implications of the Foreign Corrupt Practices Act, overseen by the U.S. Justice Department and first passed in 1977 to deal with matters relating to transparency of accounting information and bribery of foreign officials. When requesting PRC government approval, processes must be clearly understood and followed to avoid running afoul of the law. In China, trusting relationships between the partners and PRC officials (or “guanxi”) drive business development and usually involve the exchange of gifts or favors. If this cultural practice is fulfilled at all, it must be with full knowledge of anti-corruption laws.

Conclusion

Although challenges persist, significant opportunities remain for real estate investment in China. History has, and will continue to show, that the process demands extensive planning and preparation. With experienced people, sound financial management, a scalable, sustainable and flexible operating and financial corporate platform, and the appropriate onshore and joint venture partners, the “Great Wall” can be overcome and produce substantial returns.

David Chen and Neal Yung, Managers, contributed to this article.