Realty Rush!

The Indian real estate sector is rising from a trough, going by the spurt in capital commitments. Amid buoyant industry sentiment, private equity funds investing in the sector are undergoing a paradigm shift to attain equity-like returns with debt-like risks. The new Governments focus on the real estate sector, as evident in the recent Union Budget and RBIs notification to give the sector infrastructure status, is set to accelerate growth. Given this bullish sentiment and much-awaited revival, it is no surprise to see the rush to launch property funds worth billions of dollars in this fiscal itself. As per industry estimates, since private equity (PE) investments started in 2005, as much as $14 billion has been invested in about 700 transactions with nearly 300 developers across 33 cities in India. Flood of funds According to a recent report by Brookfield Financial, during January 2013 and March 2014, $3.8 billion of offshore capital has been raised for Indian real estate private equity. Further, over $3.7 billion of offshore capital is currently being raised by India real estate specific funds, which is expected to achieve closure in 2014 and 2015. This marks the renewal of interest from global institutional investors. Capital commitments by sovereign wealth funds based out of the Middle East have contributed to this increased activity of offshore capital being raised for Indian real estate. Many large global investors, which include sovereign funds, have already made the first move by partnering with successful local investors and developers to invest in Indian real estate. According to Brookfield Financial, over $3 billion of capital has been committed largely by global pension funds and sovereign wealth funds to Indian real estate in the past 18 months. The investment approach of global institutional investors has shifted from investing as limited partners in blind-pool funds to strategic partnerships with local developers or managed accounts with domestic institutions having an established track record. Opportunities abound Tanuj Shori, CEO/Founder, Square Yards, and former director, Nomura International, Hong Kong, offers a macro perspective, saying, "With the Indian Governments concentration on the sector at large by focusing on larger goals such as housing to all by 2022, reduced rates for affordable housing lending, easing foreign direct investment (FDI) norms for real estate investments and the introduction of real estate investment trust (REITs), the timing seems best for real estate funds to get investors to raise capital and invest in projects." Meanwhile, Khushru Jijina, Managing Director, Piramal Fund Management, is more optimistic about the sector in 2014-15 compared to last year owing to a stable government and the overlying expectations for the economy to perform better. "Beyond sanctions and approvals, today affordability and ticket size both directly determine velocity and a well-located project will always see healthy end-user demand," he points out. "Developers are more realistic in their assumptions and more careful with capital, which are both positive signs for the industry. Also, there are now sufficient pools of capital becoming available for the right developer and project." Echoing the positivity in the air, with the Governments focus on creating 100 new smart cities, better guidelines for REITs and favourable FDI terms, JC Sharma, Vice Chairman and Managing Director, Sobha Ltd, is hopeful that funding opportunities will grow and there will be more scope for investments in an otherwise fund-stricken sector. "Developers as well as fund houses have evolved over time to have a better understanding of all viable investment options," he says. "We believe that with a reduction in approval times, there will be increased demand. This will allow real estate funds to invest at more favourable terms." For his part, KG Krishnamurthy, CEO and Managing Director, HDFC Property Fund, offers a reality check for real estate funds vis-a-vis the smart cities. "Smart cities require a minimum 8 to 10-year timeframe to develop, whereas real estate funds have a limited timeframe of about five to seven years," he elaborates. "Therefore, there is a need for sovereign funds (pension funds), which have a longer timeframe of investment horizon, to invest in smart cities." In terms of other opportunities for PE funds, Krishnamurthy mentions the rent yielding assets of many developers who are willing to sell these core assets (commercial assets that have been leased). "Besides, several developers are looking for tail-end financing, ie, securitising their future receivables from sold and unsold stocks," he adds. "This is an opportunity for PE funds to invest where the investment horizon is relatively short, ie, only a couple of years." So, which are the quality projects at good investment valuations? Ramesh Jogani, Managing Partner, IPAL (Indian Property Advisors Pvt Ltd), has an answer. "Subdued demand over the past few years has resulted in a cash-flow crunch for developers across locations and categories," he reasons. "Hence, there are a number of quality projects available at attractive terms. Additionally, established markets and segments like residential in Mumbai continue to witness demand. Also, with REIT clarifications in place, there is a significant opportunity in the leased office space segment for assets yielding 9-10 per cent returns per annum. Special segments like redevelopment in Mumbai will see strong interest from funds with the requisite expertise and understanding. However, the key challenges for real estate funds continue to be partner selection, domain expertise and proactive hands-on asset management." According to Brookfield Financial, "With the office rental curve having bottomed out, a prevalent upward bias in the demand outlook for office spaces and the proposed REIT regulation serving as an exit option, several funds are being raised focused for investing in core office assets across the top seven cities in India." On REITs as an immediate opportunity for the real estate sector, Jijina avers that the REIT regulations present an interesting opportunity while some clarity remains on account of the tax treatment of such vehicles. He further adds, "Novel concepts such as the apartment fund we have launched or the focused redevelopment fund we closed two years ago will find favour in this market given that these products have been specifically designed to address a dislocation that exists in the market and earn a relatively high risk adjusted return." While opportunities are manifold, not having a significant track record in terms of performance would continue to challenge new appetite for investment dollars, observes Shori. Returns in reality The returns given by real estate funds over the past few years have been muted with only a handful of funds being able to manage double-digit returns. Comments Shori, "A combination of poor equity performance of listed real estate companies and muted capital price appreciation in asset values in Tier-I cities has led to disappointing returns over the past two to three years." And Amit Bhagat, CEO and Managing Director, ASK Property Investment Advisors, says, "It is fund-specific. Equity funds look at a target 25 per cent internal rate of return (IRR), while mezzanine funds are targeting 20-22 per cent IRR." In this context, Jogani says, "Most reported exits over the past couple of years have generated gross multiples in the range of 1.5X to 2X. However, these exits have been largely limited to established markets like Mumbai and Bengaluru and a majority have been by way of promoter buybacks or stake sale in the case of competed and leased commercial buildings." Popular cities and projects The current focus seems to be on seven cities: Mumbai, Pune, Bengaluru, Chennai, NCR, Kolkata and Hyderabad. "NCR has been the most popular among real estate funds," says Shori. "The reasons range from high land appreciation in these cities to lack of job creation in Tier-II and Tier-III cities and the fact that investors or users churn properties more frequently in Tier-I cities. Going forward, both residential (owing to attractive distressed deals with developers, potential capital appreciation) and commercial (steady returns, regulatory changes like REITs) should continue to attract PE capital." Piramal Fund has a strict investment focus that extends only to Tier-I cities, namely Mumbai, NCR, Bengaluru, Pune and Chennai. "These larger cities tend to have a proper civic infrastructure, strong employment markets and strong demand for middle-income housing," explains Jijina. "We typically underwrite only residential real estate development and believe the market to be attractive owing to the large demand-supply imbalance that continues to exist for mid-priced housing. Given the self-liquidating nature of such developments and the ability to ultimately monetise the completed units, such investments are more appropriate given the fixed fund tenures most of our vehicles have." Due diligence by fund houses Given the growing size and competitiveness of real estate funds, many fund houses have their own risk rating metric and apply it to the transactions they underwrite. "Every new relationship and transaction is subjected to our stringent underwriting norms and an independent in-house risk assessment matrix that prescribes certain scoring guidelines," reveals Jijina. "We also often stress-test our assumptions to forecast various scenarios that may unfold during the tenure of the investment so that we have identified and mitigated the risks associated with each transaction." For HDFC Property Fund, its focus is on level 2/3 developers who have a good management bandwidth but do not have financial strength to grow. Krishnamurthy elaborates, "Some criteria that we follow to rate prospective developers include the number of units they have completed in terms of area and units, size of built-up space developed, any customer complaints, default with banks, behaviour with contractors, fully accounted for transactions, and so on." To this Bhagat adds, "We have a comprehensive rating system of evaluating a developers track record - financial and delivery - along with the track record of rewarding every stakeholder. We also evaluate specific opportunity and target entry point with margin of safety." Echoing the focus on internal proprietary assessment, Jogani says, "We do not rely on any external rating systems and prefer to internally evaluate developers through a combination of secure third-party reports, off-market checks and extensive engagement." Market challenges Real estate being a state subject, its approval system varies from state to state and invariably puts a spanner in the growth of the sector nationally. "The Government should provide a national policy to monitor and streamline the approval process and local authorities need a time-bound approach as additional support," says Krishnamurthy. "This will help financers, developers and end users. Also, it will streamline prices and eventually enable affordable housing. For foreign real estate funds, retrospective change in tax laws poses another challenge. For example, owing to recent information-sharing issues between India and Cyprus, we are now levying 30 per cent regular income tax on real estate fund investments from Cyprus as against only 10 per cent of withholding tax in line with an earlier treaty between the two countries." According to Jogani, "Some key challenges related to land pricing around established Tier-I cities continue to be a deterrent, as is land title and grant of infrastructure status to such projects to prevent coming under the draconian Land Acquisition Act. Another aspect that would determine the success of smart cities is infrastructure and connectivity that needs to be tackled upfront." What more we need Shori believes Indian real estate is at the cusp of regulatory transformation, with a new bill likely to regulate both developers and brokers; and SEBI announcing final guidelines for REITs. "India requires more proactive coordination between the industry and regulators to ensure key impediments to the sectors growth are addressed on priority," observes Jogani. "Additionally, regulators need to take into cognisance the ease of implementation of the proposed initiatives. For real estate funds, alternative investment funds (AIFs) guidelines were a step in the right direction although enhanced clarity will need to be provided on some aspects related to applicable taxation for various jurisdictions and the impact of draconian regulations such as general anti avoidance rules (GAAR). Also, focus on shifting to transparent systems and processes like online application and sanction of project approvals, single-window system and the real estate regulatory bill will inspire investor confidence." To this DS Kulkarni, Chairman & Managing Director, DS Kulkarni Developers, adds, "The regulations governing the real estate sector are framed at the central, state and local levels. Often, these are conflicting and delay genuine projects. Regulatory intervention should be minimal and self-governance should be encouraged." Looking ahead India currently seems to be at an inflexion point for the real estate sector and the next set of steps by stakeholders will determine if the present positive sentiment results in returns for investments through real estate funds. Brookfield Financial sums up the shift by saying, "With a focus on capital protection, the investment strategy of private equity funds investing in Indian real estate has undergone a paradigm shift from taking equity positions in companies developing large township or office projects to structured debt transactions in mid-size projects with a lifecycle of four to five years." "We are very optimistic on the future of real estate markets in India. However, prudent and selective investment strategies will be imperative for the success of real estate funds," Jogani concludes. Indeed. To share real estate funding opportunities, write in at feedback@ASAPPmedia.com - MANAS R BASTIA