China Economic Review recently published an article by CLB’s own Steve Dickinson on foreign investors entering into long term leases of Chinese real estate. The article is entitled Don’t play for keeps, and since it requires a paid subscription we will provide the article Steve wrote before the professional editors gussied it all up.
The Chinese real estate market remains a continuing lure to foreign investors. Though many North American and European investors have attempted to enter the market during the last decade, few have achieved solid success. Since China continues to be the strongest economy in the developing world, foreign real estate investors continue to search for the secret that will allow them to crack China’s real estate market.
One strategy gaining in popularity is to use a long-term lease instead of outright purchase for a development property.
The use of the long-term lease is designed to deal with two major issues. First, since a lease is a contract and not a transfer of an ownership interest in property, approval of long-term leases can be completed at the local level. Local level approval is both more likely and much quicker than approval at the provincial or national level, as required for ownership transfer projects. Second, the long-term lease provides access to properties that simply would not be available for development in a sale context. Throughout China, many desirable urban properties are simply not available for sale to any party, foreign or domestic. For example, in Qingdao where I live, the beautiful historic German buildings from the early 20th Century are desirable targets for upscale retail and boutique hotel development. However, as historic structures, they are not available for sale. The city is, however, quite interested in having these properties developed and they are very much amenable to having foreign investors do this. The long-term lease is the only solution to allow for such development.
Though long-term leases address these issues, their flexibility creates important legal issues that foreign real estate investors must address. Surprisingly, one of the most common issues is the difficulty in determining the actual property owner for purposes of the lease. Many leased projects are for state owned buildings that have never been converted to ownership by a specific corporation or other legal entity. Though ownership is clearly in the hands of the state, just who is authorized to act on behalf of the state can be quite unclear. The lease is often negotiated by a low-level organization, when in fact only a higher-level agency has the right to lease the property. Many of these higher authorities seldom visited the properties under their purview and when they do go there and discover that they are being leased, they have been known to insist on terminating the lease and ending the project.
The other major concern arises from a lease being a contract and not an interest in real property. A lease therefore achieves no more protection for either party than any other contract under Chinese law. Though Chinese courts are actually quite good at enforcing written contracts, there is always a degree of uncertainty in any contract setting. In a property lease situation, this uncertainty is compounded by two factors. First, since the landlord is often a government agency, it is important that the investor be comfortable that the local courts will faithfully enforce the terms of the lease. Though this should not be much of a concern in major cities like Shanghai and Beijing, it can be a factor in second and third tier cities. Second, since lease law is relatively new in China, it is difficult to predict how the courts will rule on key issues. This makes it critical to address all important issues in writing in the lease as it will rarely be possible to rely on code provisions or customary practice. This results in a long and complex lease, which is not typical in Chinese commercial practice. Landlords frequently resist signing such a complex document, which increases the uncertainty on the part of the tenant.
Much of the uncertainty concerning the validity of a China real property lease can be resolved by formal registering the lease with the local real estate authority. Registration offers a number of benefits to the tenant. Most important, registration provides notice to third parties of the existence of the lease, which should prevent the landlord from leasing the property to a third party, an unfortunate practice that sometimes occurs in China. An additional benefit of seeking to register a lease is that the local authorities will simply refuse to register it if the landlord has no authority or if the terms are invalid. This refusal can prevent the prospective tenant from entering into a facially invalid lease.
Despite the critical importance of registering your lease, many landlords resist such registration. They do so for two primary reasons. First, the purported landlord often knows it lacks authority to enter into the lease. Second, registration of the lease ensures the landlord will be required to pay real estate taxes on the rental income. It is therefore absolutely essential at the very start of any lease negotiation to make clear that the lease must be registered.
The long term lease solves some problems with real estate development in China, but it raises other legal issues. It remains to be seen whether the lease approach will prove to be a viable real estate mechanism in China. Care in due diligence and drafting is therefore essential as foreign investors experiment with this alternative approach.