China Special Situations Insight (Volume 2, Issue 19)

Investment in Distressed Real Estate in China: Transaction Structures (III) – Acquisition of a Distressed Single Credit by way of Offshore Special Purpose Vehicles (SPVs)

Apart from mezzanine financing transactions, which we explained in a previous article (Vol 2, Issue 18), investors may also invest in distressed real estate in China by acquiring the distressed single credit owed by real estate developers. Investors can use either an offshore SPV or an onshore SPV to acquire such distressed loans, and each type of the SPVs has its pros and cons. In this article, we elaborate on the transaction structure of offshore SPVs. In the next article we will discuss the transaction structure of onshore SPVs.

If a distressed single credit is owed by a real estate developer, the most efficient method for an offshore SPV is to purchase the single credit from one of the big five Asset Management Companies (AMCs) and complete the NDRC filings. Generally, there are four options in which an investor may choose to make a profit from a distressed single credit.

(1) Debt settlement with a real estate company

Due to the strict regulations for the protection of state-owned assets, AMCs are not permitted to waive their claims with respect to the principal amount of a distressed loan, though a waiver of the interest amount is permitted by the regulatory authorities. Such rules restrict AMCs from reaching settlement agreements with debtors. If AMCs pursue all claims under the loans against the underlying obligors, the debt collection will be long and inefficient. However, it is legal for AMCs to sell distressed loans to investors at a large discount, but such investors should not be the debtors. To achieve a quick debt recovery by way of loan sale, many AMCs would agree to waive the accrued interest on the loan plus a certain portion of the principal amount; the final purchase price of the distressed loan therefore could be even lower than the principal amount of the loan.

If an investor acquires the distressed loan at a low price, there will be a large margin for an investor to manipulate. In practice, if an investor (as the creditor) and the real estate company (as the debtor) manage to make a debt settlement whereby the investor agrees to waive a portion of the distressed loan, the real estate developer may become motivated to voluntarily repay the outstanding debts in a short time. This is a good method for an investor to collect the loan and make a profit quickly.

(2) Enforcement of mortgages on real property

Enforcing a mortgage through court proceedings is the traditional method of recovery. Enforcement may be lengthy, but it also has special advantages. Some mortgaged properties are in prime locations and the value of the properties would cover the interest to be accrued in the next one or two years; therefore, in practice, some investors may purposefully slow down the enforcement to accumulate interest.

The price of the real estate may also go up during the enforcement procedures, especially in first-tier cities in China. If the mortgaged property is sold at a higher price, then the investor would be able to recover more proceeds. They would also profit if there is an appreciation of the RMB during the enforcement, which in fact happened during the first cycle of NPL investment in China (from 1999 to 2007).

(3) Sale of distressed loans

Generally, onshore investors have more ways to utilize distressed loans, such as restructuring the debt and taking ownership of the property. If an offshore investor has acquired a distressed loan that is secured by properties with great value, many onshore investors would offer a high price to purchase the loans. This is also a good option for investors to exit their investment safely and quickly.

(4) Taking ownership of a mortgaged property

If the auction of a mortgaged property fails during the enforcement procedures, an investor will have the right to take the ownership of the mortgaged property and the debt (to the extent of the upset price) will be discharged. When an investor agrees to take the ownership of the mortgaged property, the court will issue an order to legalize the transfer of ownership. However, an offshore investor may not be able to obtain an ownership certificate even though the ownership has been legally transferred, because offshore entities are not permitted to hold real estate directly in China.

If an offshore investor has obtained a court order endorsing the transfer of ownership, subject to communications with the local real estate authority, an investor may (i) sell the property to a third party to exit its investment or (ii) transfer the property to a wholly foreign owned enterprise (WFOE) incorporated in China (with all necessary licenses obtained) for further development or the business of leasing.

We have extensive experience in mezzanine financing transactions involving real estate in China and have helped many clients in a range of circumstances and with different commercial demands. For further information, please contact Catherine Miao, Head of Special Situations and Alternative Investment at JunHe LLP: [email protected] or +86-21-2208 6350.