May 21, 2012
By Joel Rothstein
For more than two years China’s housing policy has been dominated by a series of government measures designed to cool a super-charged market and battle rising home prices. Strange things have been happening. Transactions have stalled, and housing prices are falling in cities across the country. For many homeowners this is an unfamiliar trend. Now some local government officials, economists and property industry players are predicting that China’s housing policy is about to change. Property controls will be relaxed. Yet at the same time, the word from central government officials and others is restrictions will continue firmly in place. In a recent speech, Premier Wen Jiabao affirmed that China will not waiver on its real estate controls and remains resolute in its efforts to bring home prices down to a reasonable level to ensure fairness and stability.
In China’s complex regulatory environment, paradoxically, the proponents of regulatory easing and the proponents of continuing regulatory restrictions are both correct. China is entering a new transition phase that will be characterized by a dual housing policy. Under this evolving policy framework, two different housing policy approaches will exist side-by-side — restrictive and promotional. Restrictions will remain in place for some segments of the market, but there will be loosening of restrictions and even investment incentives in certain other segments of the market. This dual housing policy should create opportunities for savvy and creative international investors, fund managers and advisers.
FROM STIMULUS TO COOLING: THE RESTRICTIVE PHASE
In order to understand the rationale for China’s current dual housing policy, it is necessary to consider the events and policies leading up to the current policy framework. The story begins with the collapse of Lehman Bros. and the subsequent global financial crisis. China responded to these events with a massive stimulus program. According to some estimates, more than US$700 billion was pumped into the economy. The market was flooded with liquidity. Large sums flowed into fixed-asset investments, including real estate and infrastructure projects. Residential housing prices soared to new heights. The stimulus policy had its intended effect and unfortunately much more. Facing the prospects of a possible dangerous property bubble and perceived real risks of social unrest caused by large portions of the upwardly striving urban population being priced out of the housing market, China reversed policy course.
Instead of stimulus, the guiding force of China housing policy became restriction. No one law, rule or regulation became the underlying basis for the country’s restrictive policy framework. Instead, China turned to a whole arsenal of policy tools designed to cool the market and reduce speculation. Key policy measures included, among others, limits on multiple home purchases by individuals, stricter mortgage qualification rules including higher down payment requirements, the introduction of property tax schemes in some jurisdictions, and aggressive reductions in the availability of financing to developers.
Not only were banks required to reduce their book of new real estate loans, but Chinese regulators also cracked down on the “informal” lending market, including trust companies and their various products, which had become a key source for funding many real estate deals. Finally, the central government put pressure on local governments and various governmental agencies to more stringently enforce rules already on the books that had a restrictive impact on real estate investment, such as controls first introduced in 2006 making it more difficult for foreign institutional and individual investors to invest in China real estate.
China’s restrictive housing policy phase continued for some time and had significant effects. For example, by January 2012, according to the National Bureau of Statistics, new home prices in the nation’s four major cities of Beijing, Shanghai, Shenzen and Guangzhou had declined for four consecutive months in a row. In addition, none of the 70 cities surveyed by the bureau posted any notable gains in home prices, a first since the National Bureau of Statistics started conducting the monthly 70-city survey of home prices.
RESTRICTING AND PROMOTING: THE NEW DUAL POLICY PHASE
The success of China’s restrictive housing policy phase together with world financial trends, which decelerated growth in China, pushed the government into its new current policy phase. Government officials recognized that they could not sit on the sidelines and watch real estate prices fall too far, particularly when other forces in the economy, such as declining manufacturing and exports, affected growth. The property sector, and particularly the residential housing sector, is recognized as a key driver of economic growth in China. China’s gross domestic product is fueled by the production and purchase of building materials and equipment, the payment of wages of construction workers, and the revenues and fees generated by banks, real estate brokers and others from property transactions. Moreover, the real estate industry is an important funding source for local government budgets. Local governments depend upon land sale premiums and taxes from the sale of housing units to fund operating expenses and repay debt.
While concerns about promoting sustained and stable economic growth became paramount, concerns over affordability issues in residential housing continued. Consequently, in the new current housing policy phase, China is aiming to slowly deflate but not burst any bubble, and also to concurrently encourage certain types of activity that can boost the economy and satisfy long-term comprehensive policy goals. During this period of controlled cooling, a dual policy framework, which is both restrictive and promotional, has and will continue to be implemented.
Under this policy approach, restrictions will continue to be kept in place in cities and in types of projects where there have been the greatest excesses, such as in first-tier cities and in mid- to high-end residential projects targeting speculative investors. At the same time, policies will be adapted to promote and incentivize activities in certain areas targeted by the government for growth and promotion, such as affordable housing, housing suitable for first-time homebuyers, and senior living and care facilities. For example, China’s central bank, the People’s Bank of China, recently issued a statement that banks must provide loans to first-time homebuyers. Many believe as a next step the central bank may require banks to offer mortgage rate discounts to first-time homebuyers.
Pursuant to China’s dual housing policy, the extent of housing curbs may increasingly vary by geographic location. To date, the central government has been diligent in putting pressure on local governments not to relax property curbs. Some cities, such as Foshan in China’s Guangdong province and Wuhu in China’s Anhui province, either relaxed or announced plans to relax property restrictions, only to subsequently reverse such plans. No doubt, pressure from the central government played a role in these policy reversals.
Going forward, however, some cities may be able to push through some easing of property controls without push back from the central government, particularly if general economic conditions and growth are weak and the city has not been a particular focus of real estate speculation or it already has experienced substantial price corrections. Consequently, first- and certain second-tier cities that experienced rapid price increases leading up to the most recent period will be the most likely candidates for continuing restrictions in the current policy phase, and a number of second- and third-tier cities with cash-starved local governments will be the most likely locations for easing property controls.
CURRENT POLICY ENVIRONMENT OPPORTUNITIES
In China, the residential real estate market has been a potent source of profits for foreign investors. Nevertheless, the traditional model to profitability in the form of mid- to high-end strata title build-and-sell residential projects in first-tier and some second-tier cities might not be the most viable option in the current policy environment. Instead, foreign investors may need to focus on either specialized residential real estate plays that tie into the government’s specific investment promotional policies under its dual housing policy or on opportunistic plays that capitalize on the distressed situations created as a by-product of the restrictive side of China’s dual housing policy.
INVESTING WITH AND NOT AGAINST GOVERNMENT POLICY
Some of the most successful foreign real estate investors in China have recognized the need to “go with the flow” and to invest in a manner consistent with and not against government policy. In order to “go with the flow” in the current policy environment, the international real estate investor interested in residential deals may need to target areas such as affordable housing and senior living or care facilities. China has vowed to build 36 million affordable housing units during the four-year period from 2011 to 2015 to meet the demands of low-income families. In addition, an aging population, rising wealth and acceleration of reforms in the healthcare industry are all working to heighten government interest to support the growth and development of the senior living and care industry.
Innovative ideas or structures for affordable housing or senior living or care deals will find a receptive audience with Chinese government officials. Not only will these deals likely overcome the burdensome approval process normally associated with foreign real estate investment in China in the dual policy environment, but they also may benefit from specific government incentives and cooperation to facilitate the deals. In contrast, in the current policy environment, proposals for new high-end residential speculative strata title build-and-sell deals in cities such as Beijing or Shanghai are not likely to progress very fast or far.
In addition to specialized residential deals in the affordable and senior housing space, foreign investors may also consider targeting mixed-use projects. These types of ventures may combine a residential component with other uses a local government desires or has been specifically mandated to attract. Examples of projects that may find favor and support include: technology research and development centers; healthcare and biomedical research facilities; and uses that generate ongoing local employment opportunities.
Making money at and successfully operating affordable housing projects, senior living and care facilities, and comprehensive mixed-use projects often requires specialized knowledge and expertise that may be lacking in some sectors of the Chinese real estate community. Consequently, some foreign developers, investors and service providers that have real deal expertise and experience in these areas can bring something to the table that may be attractive to domestic joint venture partners and to government authorities that need to approve the deals.
Foreign investors still desiring to focus on new strata title build-and-sell residential development projects may still find opportunities in the current policy environment. This type of investor, however, may need to focus particular attention on jurisdictions where restrictions have been lifted or about to be shortly lifted or on certain opportunistic plays involving distressed developers or projects.
DISTRESSED ASSETS AND COMPANIES
The fact that China may be continuing curbs on the property sector under its dual housing policy may not be all bad news for foreign investors and market participants. Continuing restrictions may actually create opportunistic plays for investors and others who were disappointed when such opportunities did not arise in the aftermath of the collapse of Lehman Bros. and subsequent global financial crises. The opportunistic plays did not arise during this period because China’s massive stimulus policy propped up the market, saved deals from becoming distressed, and substantially reduced need for foreign capital and involvement to support the market.
According to some market observers, this time it may be different. Under the previous restrictive housing policy and under the current dual housing policy, many domestic real estate developers and specific projects have faced and will continue to face extremely tight credit conditions. Attractive funding from Chinese banks or from the “informal” lending market including various trust company products has become less readily available. At the same time, prospective purchasers of housing units contending with higher down payment requirements, lending restrictions and the prospects of future falling prices have increasingly moved to the sidelines. Inventories of unsold units have begun to pile up. All these factors point to an increasingly distressed market.
These kinds of market conditions may create an ideal environment for foreign investors to forge Sino-foreign joint ventures with domestic developers designed to reposition distressed projects and infuse needed capital into cash-starved deals. Chinese developers that previously saw no need for foreign capital or involvement may now seek out partners.
Chinese real estate projects and developers that currently have offshore structures, such as upstream holding companies established in jurisdictions located outside of mainland China, may be particularly attractive to international investors. In contrast to Sino-foreign joint ventures that are formed onshore in mainland China, offshore structures are not subject to the same stringent Chinese government regulatory approvals as domestic joint ventures. In addition, offshore structures offer a greater variety of options in terms of structuring debt and equity investments than onshore structures. Nevertheless, due to regulatory restrictions, in many situations only an onshore joint venture may be feasible. Approvals for some onshore Sino-foreign joint ventures could win the support of local governments and secure government approvals, particularly if the repositioned project includes some affordable housing component or other amenity or benefit appealing to the local government officials.
Another potential avenue of opportunity for international real estate players, including fund managers, is in the private equity fund space. With access to traditional funding sources such as banks and trust companies reduced, Chinese developers are seeking alternative funding sources. In many cases, Chinese developers are turning toward private equity funds.
For example, in some instances Chinese developers with no experience in creating or managing private equity real estate funds are teaming up with foreign fund managers to create joint venture China real estate funds. These funds — which may either be purely domestic RMB funds or parallel onshore RMB and offshore foreign currency funds — offer the developer a new source of capital to fund deals; offer the fund a pipeline of deals in which to invest; offer the international fund manager fees, a promote and the opportunity to develop a track record of managing a fund in China’s relatively new but growing private equity space; and offer the fund investors exposure to Chinese real estate.
China’s private housing market is surprisingly new. The private-sector housing market started in earnest only around 1998. In a short time, millions of units have been constructed, purchased, sold and financed. Through it all, the Chinese government’s housing and economic policies have constantly changed and evolved in an effort to guide and to respond to changing market conditions. China’s prospects for future economic growth and robust GDP figures are inextricably linked to whether the country can maintain stability and managed growth, including a stable but expanding housing market.
China’s dual housing policy of simultaneous restriction and promotion is squarely aimed at achieving this goal. Foreign investors and other market participants who understand and capitalize on the implications and effects of the current and future housing policies will find opportunities to profit.
