The "build-to-rent" model isn't new in China but has gained traction in the wake of the COVID-19 pandemic. In this article we share what you need to know about using the model and the challenges you might face.
The “build-to-rent (BTR)” model is often offered by local government as an incentive tool to attract foreign investment. Under the model, the local government (eg industrial parks) agrees to build factories, offices or R&D centers according to the design and specification required by foreign investors, then lease the property to them upon completion. An option to purchase the leasing property is also granted. BTR examples include the Suzhou factory of Knorr Bremse, the headquarters of Volvo China and the BMW training center in Shanghai.
The BTR model has gained traction recently in the aftermath of the COVID-19 pandemic. Nearly all businesses were impacted and many faced difficulties completing construction as originally planned.
Understandably foreign investors prefer the BTR model as it releases the pressures of immediate funding and shifts the construction risks and ESG obligations onto local government. On the other side, cash-rich local governments with the necessary resources are keen to share the burden of funding with foreign investors and take over the risks of construction, enabling investors to start running businesses as swiftly as possible.
The requirements of the model
Local governments adopt the BTR model mainly to help secure revenue and tax commitments from foreign investors, rather than to seek higher profits. For example, in 2017 the Shanxi provincial government issued an opinion on measures to open up and better use foreign investment, where the government suggested the transfer price for a factory offered through the BTR model should be set at cost basis.
Under the Shanghai Shanggao Industrial Park Factory Management Rules (2019), when the industrial park sells the leasing property, the price shall be at cost basis. With this in mind, it's no surprise that local government normally offers the BTR model in exchange for investor commitments on high amounts of revenue or tax which is substantiated by contract terms and becomes legally binding for the tenant (ie the local entity set up by the foreign investor).
Local government may also require regular reports from the tenant on the amount of revenue and tax and set a deadline when the tenant will put the leasing property into operation. Rights of walkway and “going dark” (normally available under commercial leases) are generally blocked or restricted. For example, in February 2021 the Tongding industrial park located in the Jiangxi province issued its management rules on standard factory (“Tongding Rules”) which require tenants of a BTR model to start operation within six months after delivery. Any suspension of business for more than six months are prohibited.
In a number of cases, we've seen local governments impose requirements of prior approval or restrictions (in terms of lock-up period) on tenants to dispose of the leasing property after the tenants exercise the option to purchase and becomes the owners. The rationale behind this is simply to prevent tenants from moving away without fulfilling their revenue or tax commitments. Otherwise, tenants have to pay back all the benefits enjoyed under the BTR model.
Legal challenges of the model
- The validity of the BTR model is conditional on obtaining certain construction permits.
According to publicly available court cases, the BTR model is recognised by courts primarily as a leasing relationship. However, a property leasing relationship is typically based on completed buildings and leasing unfinished buildings may put the validity of a lease agreement at risk.
In 2009 the Supreme People’s Court (SPC) issued the interpretation rules on hearing leasing dispute cases (“2009 SPC Rules”). Article 2 stipulates that a lease contract is void and null if the relevant leasing property is without the construction planning permit. In 2017 the SPC applied Article 2 of the 2009 SPC Rules to a leasing dispute involving the BTR model and held the relevant agreement invalid.
The relevant request of the lessor for contractual penalty (mainly losses of profits due to failure of timely delivery of the premises) was overruled. Some courts in later cases followed the above SPC’s case and ruled relevant BTR agreements invalid due to a lack of the construction planning permit. However, this SPC ruling isn't followed consistently and some local courts recognised the effectiveness of the BTR model without referring to the 2009 SPC Rules to avoid potentially harsh consequences.
- Transfer of the leasing property is subject to the special state-owned asset rules.
The leasing property is normally invested in and owned by a funding/development platform of the local government (a state-owned enterprise), and therefore recognised as a state-owned asset under the PRC laws. So when investors exercise their option to purchase the leasing property, the specific state-owned assets regulations, including asset valuation and public tendering procedures need to be followed.
- Piecemeal regulatory environment may bring issues.
BTR is still an area absent of clear legal definitions and unified rules and practice at the national level. Most of the rules so far are scattered under local regulations, some of which may even not be openly available. Problems may arise when foreign investors try to find out the legal boundary of their obligations.
Our advice
Foreign investors need to take great care when trying to use the BTR model offered by local governments. They'll need to carefully structure the BTR model to overcome validity hurdles and it's best to have the local government endorse the undertakings given by the developer or owner of the leasing property.
From a commercial perspective, foreign investors should avoid making binding revenue and tax commitments. The negotiation process with local government can be complicated, and it's wise to have a local consultant with regional experience to navigate the process.
