This paper discusses the development of real estate industry in China in recent years. It argues that Hayek ’s theory of econom ic fluctuations can help to explain the contraction of the real estate market in 1994 in China as a whole. However, as a theory of the closed economy, Hayek’s theory is found to be no longer robust when applied to cities where there is heavy foreign direct investment, such as Shanghai. We believe that it is the foreign direct investm ent that is making the real estate industry in Shanghai perform well, despite the government’s tight monetary policy and the contractio n of the industry in other parts of the country over the same period. The paper also argu es that, while most foreign investm ent in real estate is classified as direct investment, it is very differen t from `typical’ foreign direct investm ent except in form and in fact shares most of the characteristics of portfolio investm ent. Foreign direct investm ent in real estate refects the imperfectio ns of China’s capital markets.