Developing Hotels in China: Do You Really Understand the Rules of the Game?
 
April 17, 2008
 
Ying "Geneve" DuBois- Ft Lauderdale

If you think you know how to play Chinese Chess (XiangQi) because you have mastered the skills of Western Chess, you may want to think again. At first glance, XiangQi may look very similar to Western Chess. They have similar pieces and some even have similar moves. However, there are many differences in the rules of the two games. Some differences are obvious: in XiangQi, there is a river that divides the two sides and the pieces are placed on the lines dividing the squares, instead of within the squares. Other differences are subtle, but of great consequence. For example, unlike the horses (i.e., knights) in Western Chess, the horses in XiangQi cannot jump; unlike the pawns in Western Chess, the pawns in XiangQi can move all directions once they cross the river. Not only do players need to be aware of all the differences, but they must also understand the rules completely in order to win the game. Simply applying the rules of Western Chess to play XiangQi will only guarantee a loss. Losing a game of chess may not be a big deal, but the implications of a losing result in developing a hotel in China is unthinkable for any investor.

Similar to playing XiangQi, if you think you can develop hotels in China because you have mastered hotel development in the Western world, you may want to think again. While many people may be aware that the rules in China are very different than the Western world, they still fail to achieve their goals in China because of one fatal mistake: they do not understand the rules of the game completely and planned their moves based on the obvious differences of the rules and their knowledge and presumptions from the Western world. They may have done so unknowingly. Therefore, understanding the rules of the game – the obvious and the subtle ones – is the key to developing and implementing a strategy for successfully developing hotels in China.

Overview of the Rules of the Game in China

Understanding the rules in China is not easy. Not only do the rules change periodically, but some are unclear even to the rulemakers. There were significant changes in China’s real property and real estate investment laws in 2006 and 2007:

• China adopted a new Property Law on March 16, 2007, that among other things, codified many administrative practices in acquiring the ownership rights in real property and provided for a unified registry of real property rights.
• Key Chinese administrative agencies issued a series of administrative regulations tightening approval standards for foreign real estate investment, limited the use of leverage in financing real estate development and prohibited the use of foreign loans, including shareholder loans, in financing such projects.

These efforts were intended to slow down the overheated real estate market in many major Chinese cities. It is more critical than ever for foreign entities developing hotels in China to understand the impact of these new rules and the regulatory obstacle course that confronts foreign hotel developers in China.

The following are some of the important rules that any foreign hotel developer should know in developing hotels in China.

Rule #1 – The ownership concept of real property in China is very different than in the U.S. real property law.

The first rule concerns the nature of real estate ownership in China. In China, private parties cannot obtain fee simple title to land. Land is generally either owned by the state or by “collectives,” depending on the nature of the usage of the land. Agricultural lands and lands for residential purposes located in rural villages are owned by “collectives.” Any lands that are not owned by “collectives” belong to the state. However, the state may grant private parties rights to use and develop land for a set period of time, depending on the nature of the use of the land. For purposes of developing hotels or resorts, a developer may receive land use rights for a term of up to 40 years. The land use rights can be transferred, subject to the 40-year term. At the end of the 40 years, the holder of the land use rights may apply for renewal; however, it is unclear whether a renewal fee is required and, if granted, how long the renewal term might last. If no renewal is petitioned or granted, the land use rights revert to the state. Although this may sound like a “lease” under the U.S. property law, in China, leases are not property rights, but are contract rights; therefore, “use rights” should not be referred to as “leases” in China.

Another subtle, but critical, part of this rule is that land owned by the “collectives” cannot be transferred to private parties directly for development of hotels or resorts. It must be first acquired by the state. The payments for such acquisition cannot be funded by any private parties. After such acquisition, the state may sell the use rights to private parties, as long as the sale is through public auction or competitive bidding. The “winner” of the public auction will then enter into a land grant contract with the state, acting through the Ministry of Land and Natural Resources. These contracts typically require the developer to provide certain basic infrastructure and pay a land grant premium.

In addition, not all state-owned land can be transferred. For example, many state-owned lands are subject to allocated land use rights which are not transferable. Therefore, it is important that foreign hotel developers conduct thorough due diligence to ensure that (i) the initial land grant procedures by the state and the first purchaser were properly conducted and (ii) the land is transferable by the state. Any improper transfer may have an adverse impact on your use rights of the land.

Once a hotel developer acquires land use rights, it may freely develop a hotel or resort on the land and transfer such development to others, so long as such transfer is subject to the designated usage of the land and the terms in the land grant contract. The hotel developer actually owns the buildings and fixtures of the hotel. However, at the time of the expiration of the 40-year term of the use rights on the land, all ownership interests in the buildings and fixtures of the hotel revert to the state. It is unclear, under China’s Property Law, whether the state has any obligation to compensate the owner of the buildings and fixtures upon such reversion.

All use rights on the underlying land and the ownership of the buildings and fixtures on such lands must be properly registered at the official land register. The land register is conclusive evidence of ownership. Chinese law does not recognize deeds or other transfer instruments. Therefore, it is important not only to register your ownership properly, but also to investigate the previous ownership rights at the applicable registry before acquiring real property ownership rights.

Once land use rights have been acquired, hotel developers must ensure that the design of the hotel or resort must not violate any neighbors’ rights. In China, all real properties are automatically burdened with basic obligations to neighboring properties that include the following:

• right to access water and discharge of water
• right to access roads and other means of transportation
• right to access cables and pipes
• right to access sunlight, view or airflow
• right to be free from pollution and noise

These rights must be accommodated in the design of the hotel or resort. This can be challenging, since most areas in China are densely populated. The good news is that these rights may be waived by the neighboring properties through written contracts.

Rule #2 – Real estate development must be conducted through a local subsidiary and requires government approval.

Foreign hotel developers may only purchase land use rights and develop hotels or resorts through a locally incorporated entity, commonly referred to as a “foreign-invested enterprise” (FIE) in China. Under the Foreign Investment Industrial Guidance Catalogue, the development of luxury hotels and resorts falls within the restricted category. Thus, foreign hotel developers will generally face stricter scrutiny from the Chinese authorities and will be required to develop the projects through a joint venture with a local party. Therefore, a hotel developer must first identify a reliable local partner and negotiate and sign a joint venture contract to establish a FIE. The joint venture contract together with a feasibility study and other required documents must be submitted to the Ministry of Commerce of the People’s Republic of China (MOFCOM) or its designated agent for approval. One of the required documents is to provide evidence that the parties to the joint venture have obtained the use rights to the land that the FIE intends to develop. This requirement, a recent one, is a challenge because it is unclear how the land use rights can be obtained before the FIE is established, when such acquisition must be conducted by a FIE. This is a chicken-and-egg dilemma.

In addition, if the total investment exceeds $10 million USD, the total amount of equity capital to be contributed by the shareholders (i.e., the total equity) must be 50 percent or more of the total investment required. The contribution by the shareholders cannot be funded by foreign currency loans. Therefore, hotel developers must secure funding from domestic sources in China. Limitations on the use of leverage and debt funding sources are two major differences of hotel development in China vs. in the United States.

In addition to establishing the FIE, the development of hotels and resorts must also be approved by the appropriate governmental authorities. Any project that is $50 million USD or more must be approved by the central government of China. This approval is subject to the government’s sole discretion. Therefore, it is important that the hotel developers are familiar with the approval process and provide sufficient and appropriate information to the authorities. A well respected local joint venture partner may play a significant role in this process. Once the FIE and the project are approved, any significant changes to the project must be approved by the government.

Rule #3 – Know the alternatives.

There are a few other alternatives beyond establishing the FIE. One of the alternatives is to structure the use rights acquisition as a corporate M&A transaction by acquiring the local entity that owns the use rights of the land. The main advantage of such an arrangement is avoiding taxes associated with the transfer. This alternative requires the approval of MOFCOM or local authorities. Which authorities must approve the M&A transaction depends on the location and the size of the investment. It is important that approvals are obtained from the appropriate agencies to avoid adverse implications in the future.

Another alternative is to acquire an existing hotel. The acquisition can be accomplished by either acquiring the assets of the existing hotel, including land use rights and ownership rights to the buildings and fixtures, or acquiring the entity that owns the existing hotel. Although either method is subject to approvals from the applicable governmental agencies, the use of the land as a hotel or resort will have already been approved. This alternative may become increasingly popular in China, especially in areas where additional development of hotels is not likely to be approved by the government.

Conclusion

Like the game of XiangQi, rewards await those who accept the challenge to overcome complex rules. The good news is that unlike in XiangQi, hotel developers do not have to face this challenge alone. Assembling a team of capable professionals who are masters of the rules is essential in successfully developing a hotel in China.
Holland & Knight’s China team regularly advises foreign investors in their real estate related matters in China.

For more information, email Ying “Geneve” Liu-DuBois at geneve.dubois@hklaw.com or call toll free, 1.888.688.8500.