Long ago, the old Silk Road tied China to Asian countries linking it to Europe. Today, China is underwriting billions of dollars for infrastructure investment within 68 Asian and Eastern European countries along an expanded old Silk Road and Belt, which includes land and sea routes. Launched in 2013 through the Belt and Road Initiative, China is investing $150 billion annually in the roads, bridges, railways, airports, and gas pipelines of these nations.
Supported by the internationalization of the renminbi, the Belt and Road Initiative means more than investment, capital spending, and goodwill in international countries. China's outbound activities are accelerating its structural transformation from a government-led economy to a market-driven economy.
The Belt and Road Initiative also creates new channels to absorb surplus capacity for specific Chinese industries, provides high-quality investment routes for private enterprises, and promotes market-oriented capital sourcing for international investments.
Changing Cultural Paradigms
For Chinese investors, the Belt and Road Initiative signals several trends.
Chinese investors have become more diversified. In the past, state-owned enterprises drove Chinese outbound investments. Today, private companies are increasingly seeking their own international investment opportunities.
In 2016, outbound investments by Chinese private entities accounted for 87 percent of the total Chinese international investment. Since 2012, Chinese insurance companies have been allowed to invest up to 15 percent of their assets in overseas investments.
Between 2015 and 2016, Chinese insurance companies made more than 50 percent of all investments from China. Operating through the Qualified Domestic Institutional Investor program, or blind pool funds, private equity companies raise capital for investments by selling shares of international financial products to domestic Chinese investors.
During the last few years, Chinese high net worth individuals have been among the most active in the world. Pursuant to the 2017 China Private Wealth Report issued by Bain & Company and China Merchants Bank, there are 1.6 million HNWIs in China. Their collective assets in 2016 exceed $24 trillion - six times higher than the 2006 level. The percentage of Chinese HNWIs investing internationally increased to 56 percent in 2017, up from 19 percent in 2011.
The motivations and risk tolerance of Chinese investors are centered on maximizing value. In the recent past, Chinese investors focused more on long-term capital preservation than on cash flow. This is no longer true.
More often, Chinese investors seek to optimize return on investment by focusing on the higher-end and value-added aspects of commercial real estate. More Chinese investors conduct development activities to enhance the property's overall value, including new construction and extensive capital improvements to existing structures.
They are weighing the risks and returns of a potential investment in the same way as their global counterparts and are assessing more factors, such as macro-economic concerns. Private equity funds and insurance companies are making investment decisions based on the different risks and returns desired by their partners or clients.
Coming soon: U.S.-style REITs. Historically, Chinese investors have not invested significantly in U.S. Real Estate Investment Trusts or other securitized real estate vehicles. The internationally recognized REIT format is not common in China, due to the complexity of the legal framework and tax issues.
In a move that greatly expands the investor base for this new asset class during 2017, however, China's central bank authorized the first sale of a quasi-REIT in the vast interbank bond market. As Chinese investors become more familiar with the REIT concept, Chinese investment in U.S. REITs may increase.
Demand for expertise in investment management and integrated solutions from commercial real estate professionals has increased. Chinese private enterprises have become more willing to work with a local management team to handle their international investments, with a high level of flexibility and diversity. Pursuant to the 2017 China Private Wealth Report, 63 percent of Chinese HNWIs have their investable assets managed by third-party professionals, compared to 36 percent in 2009.
Family offices have become a popular vehicle to protect families' assets for future generations. Growing numbers of wealthy Chinese families are turning to family offices to assist them with their investments.
Risk management in their global investments has become the top priority for Chinese enterprises. Chinese investors are increasing their requests for comprehensive, thorough due diligence. These stepped-up requests are partly because Chinese investors are facing increased regulatory and macro-economic risks, which do not apply to U.S. investors.
When advising Chinese investors, commercial real estate professionals need to consider certain variables that are critical to Chinese investors. Non-U.S. investors may acquire, hold, dispose of, and enforce their rights in U.S. real property, similar to U.S. investors.
Understanding U.S. Regulations
However, various U.S. laws impose restrictions, as well as disclosure and filing requirements, that only apply to international investors. It is crucial for Chinese investors to understand the potential legal risks and issues with the assistance of experienced commercial real estate professionals and attorneys. Following is a brief illustration of some of the important restrictions and requirements.
CFIUS: A branch of the U.S. Department of Treasury, the Committee on Foreign Investment reviews potential transactions that could result in control of a U.S. business by an international person or entity. CFIUS determines the effect of such transactions on U.S. national security.
With the authority to force divestiture of a completed investment in U.S. business, CFIUS can determine if national security could be adversely affected by a transaction. CFIUS has a process for voluntary pre-clearance of potential transactions that provides assurance that a transaction will not be unwound.
Most commercial real estate transactions will not be deemed to be risks to national security. However, several recent cases show that CFIUS issues may be relevant to commercial real estate transactions. If a target property is close to U.S. government property, military sites, or to critical infrastructure, such as airports, power plants, or bridges, a CFIUS review may be needed. International ownership of office buildings whose tenants include secure U.S. government facilities also will be scrutinized.
BEA reporting requirements. Global investment in a U.S. business or commercial real estate that results in an international person or entity owning 10 percent or more of the voting securities of a U.S. business comes under the administration and requires regular reports to the Bureau of Economic Analysis of the U.S. Department of Commerce. Also through periodic reporting, the BEA monitors an equivalent interest of an unincorporated U.S. business enterprise, including a branch or real estate.
FIRPTA. Under the Foreign Investment in Real Property Tax Act of 1980, the disposition of a U.S. real property interest by an international individual, which is the transferor, is subject to income tax withholding. FIRPTA authorizes the U.S. to tax international persons on dispositions of U.S. real property interests.
Disposition includes a sale, exchange, liquidation, redemption, gift, or other transfers. Persons purchasing U.S. real property interests, which are transferees, from international persons, specific purchasers' agents, and settlement officers are required to withhold 15 percent of the amount realized on the disposition, absent a waiver or exemption.
Some other restrictions. Some federal and state laws impose restrictions on international ownership of U.S. farmland for continued agricultural use. The Agricultural Foreign Investment Disclosure Act requires all global investors who acquire, transfer, or hold an interest in U.S. agricultural land to report these holdings to the U.S. Secretary of Agriculture. Some states may require disclosure of international ownership when forming or qualifying entities in the state. Some state laws also prohibit international ownership or licensing of public lands or exploration and mineral rights.
Overall, Chinese investment in the U.S. is undergoing a transformation. By understanding Chinese investors and embracing their culture, commercial real estate professionals can close international transactions for diverse U.S. properties.
The legal frame work for commercial real estate and general business dealings differ between the U.S. and China, which can affect the success of closing a transaction. Commercial real estate professionals need to understand these differences and structure transactions with these principles in mind.