Real Estate Funding : The ebb and flow of funds in this century
Post 2005 once the gates were opened for the foreign funds to invest in the realty market, there were slew of funds setting up their offices in India to look for opportunities to invest.
Post 2005 to 2008 saw the first round of private equity players raising funding for investment and in highly inflated market also invested heavily in the projects. The majority of the investment that were done during that time was done with structured approach replicating the matured market working. Such approach was contrary to Indian way of working at that point of time.
So what was the result, most of the investments were not able to make money and the expected returns were not seen. Large number of PE funds lost money and also shut their offices in india and moved their attention elsewhere. The funds who remained were the ones who had initially taken slightly conservative approach to investment and who had tried to understand the indian real estate market and its pitfalls.
After the topsy tuvry existence for large part of the last decade, slowly steadily there has been improvement in the business dynamics in all sense.
The regulatory framework has been reduced of the red tapes
The Funds have become more prudent in their understanding of the real estate market. They have started evaluating the projects based on the Indian context. They have started evaluating the risk and adopting risk mitigation tools
The developers having realized the importance of funding and equity participation in development viz a viz debt have also become more and more transparent in their modus operandi
This all is changing the funding scenario in India. But before we move forward we need to briefly understand what Private Equity Fund is all about.
Private Equity
Private equity in a way is a term for pooled capital available of deployment for a long term
The investor capital is pooled in together, under a fund, with an intention to investing project/ business which are capital intensive in nature and the gestation period for returns are longer. Equity deployments are about partnering the businessman in his venture and jointly reap the profits, or in worst case lose out. Typical Fund cycles are around 4- 7 years. Most of the Real Estate Projects of size which can take private equity have similar project cycle and real estate projects are equally capital intensive.
Just to give an example, we have been discussing in our various articles earlier that the Housing, esp affordable housing is the key to growth of the healthy vibrant and happy population of nation.
If we are to extrapolate the housing deficit of 2.4 Crore as noted in various reports and articles, at an average cost of around 10 Lacs it shall mean an economic cycle of close to 24Lac Crore Rupees. That is big number. Backward calculation shall mean that one shall need close to minimum of 14 – 18 lac crore to build such projects. This is just the basic housing requirement. What about the office space and the retail space factories and warehouses to store the goods that we consume. The need of financing is so huge that there always will remain a gap.
Most of the banking sectors based on their policy and government regulations will not be able to fund such requirements. So there is where the private equity comes into picture. A clear cut of supply mismatch can be resolved only by availability of easy funding and necessary regulatory framework in place. The fund also in presence of transparent market regulation, right location and right business partner has potential to make decent returns on their investment over the period of time.
So how has been the funding activity till now
In the pre lehman phase, those were the heady days, most of the fund felt that there investment shall reap returns upwards of 30 – 40 % and they all invested as partners with the developers. A large part of this investments were based on market sentiments rather then actual rational of where there was a demand or not, which shall keep the buoyancy in the realty market.
But so were not the cases and most of the projects failed to kick start due to regulatory issues. In some cases the developer defaulted and as equity partners the fund was left with under constructed sites, with no knowledge of how to execute to remainder of the sites and exit the projects.
Then the Lehman Fiasco happened, the and firm went bankrupt. All hell broke loose. The funds which were so active in the equity market went of the radar. The ease of liquidity went away. The funds which were private equity players suddenly became qausi lenders, wherein instead of partnering the developer in their venture, only became lender asking for guaranteed returns.
Earlier the PE fund would invest in projects where the potential for return were around 25 – 30 %, which then came down to 20% bare minimum. This again further was squeezed in as 18% as fixed return which essentially was debt at 18% to the developer also first right of profits if the developer managed to make such profits.
Developer on other hand who was in need of money, had no other option to agree to such funding norms. All these factors jointly put a brake funding activity. At least till 2011 the equity funding was practically non-existent but present in form of quasi lending as noted above. From the heights of 6- 7-Billion-dollar investment in the indian real estate market in 2007, the funding activity had crashed to less than billion dollars in 2011.
For a country which has such huge market to cater to, and continuously growing economy it was only time that the bullishness returned. It was coupled with the better and transparent regulatory framework. The government has taken positive steps towards the funding regulations, decreasing the project size requirement for eligibility of Foreign PE Funding, the timeline before which the funding can be monetized etc…
This change has in turn allowed the smaller players in the larger cities or developers in the smaller cities who have been good reputed developers but looking at the size of the market pie in which they were working, tended to do smaller developments, keeping them out of the PE funding ambit.
All such developers got a chance to pitch for PE funding. The Funds having learnt from past mistakes have been taking a very conscious approach towards investing in projects. Also the developer has taken more transparent and accountable approach. As a result an inclusive platform is being developed wherein the investment cycle can again become conducive and beneficial to all.
Amidst this above the SEBI took a positive outlook and created conducive framework for Indian individuals and institutions alike to raise local funds for the purpose of deploying the same in the market. In fact such funds though maybe small in size may be more productive in terms of their investments as the people raising and deploying the same shall be governed by the local bye laws and they shall be having complete understanding of the local ways of working.
The SEBI regulations are also very clear and easily comprehensible for the funds to operate within the ambit in form of AIF Category Funds.
AIF Category fund should go a long way in establishing a transparent mechanism of funding the developers for their capital needs. Most importantly AIF Cat 2 Fund can be established
for a small corpus as 20 Cr.
Minimum investment by investor shall be 1Cr
Total Number of investors cannot be more than 1000
Other important aspects are
As per the definition such funds are privately pooled vehicles, hence the fund to be raised shall also happen via private placement. Such Funds cannot raise fund by reaching out to public at large. The Fund is required via submission of Information Memorandum or Placement Document provide salient feature of the fund, clearing defining the investment strategy of the fund and geographic locations where the investment are envisaged.
Also equally important is the details on the Team who shall be managing the fund and sponsors.
To provide better transparency, each placement document shall by way of annexures shall have a tabular example of how the fees and charges shall be applicable to the investor and how the profit accrued shall be distributed.
In simple terms, other than the actual investment, large part of the investment cycle is cleary predefined for the investor to review and take a decision. If one is to look at the traditional mechanism of the investment for the most of the investors, the investor manager per se and the perception that person/ firm has is equally important tool in the decision making.
This stands true world over. How this works well especially for the small size funds is the structure how the fund is supposed to operate.
Typically individuals or firm comes together with a view to set up a pooled resource to invest in particular way to garner the best returns for the investors. This group is termed as Sponsorer of the fund.
To secure the interest of the investors at large, the sponsorer have to remain invested in the fund to the tune of 2.5% of the fund size or 5 Cr whichever is higher during the entire cycle of the fund.
This sponsorers form a trust/ company/ llp and register the same with SEBI as AIF Fund. This fund shall have to appoint an Investment Manager Team to manage and advise the fund on the investment strategy. This Investment manager shall source and propose investment oppurtunities to the fund advisory board. This investment committe comprising of sponsorers and few independent members shall accordingly take decision on investment.
Hence here the Investment Manager becomes very important. This is where the traditional approach comes. The Fund as an entity may or may not have any precedents, but it shall be the Investment Manager whose accountability and prior experience shall be the reason of investing in the fund.
As part of the SEBI application for fund formation, the SEBI specifically insists on knowing the Investment Manager team and their prior experience of real estate and fund management skills.
AIF actually make a excellent case of formalizing the advisory services in the real estate, as it provides structured approach to investing, Investing which anyway was happening through advisory firms/ brokers informally.
Unlike other investment avenues, informal or otherwise, in case of AIF the tenure of investment is specified and exit routes are well defined. The minimum tenure for such funds is 3 years. the placement document shall clearly define the tenure decided for that particular fund. Other important point is the actual investment by the investor. One would think that investing 1cr is large amount, but it is important note that the initially the Fund shall only take the commitment from the investors and only call for money when the investment opportunity comes. For all practical reasons any committed investment is called upon over period of 18- 30 Months. This means that investor may have committed to 1CR sum but he shall be required to pay up over the period 2 – 3 years depending on the investment opportunities.
Investment from HNI’s / partnership firms etc or other funds can also be done in the fund. Over and above that even two investors can join together to invest. AIF regulations clearly have set out norms on joint investors in such cases. An investor can invest along with his or her spouse / an investor and his/her parents vice versa. Two friends/ family can form a partnership/ LLP firm to invest jointly, in which the funding amount by each party can also differ.
In a way there is significant flexibility for the fund/ investor under this regulatory framework to operate. Such flexibility allows better operating environment to structure investments in real estate developments through debt/ equity/ partnership/ acquisition mode to maximize the returns for the investors.
Here the investors have willingly invested in wherein the investor is ready to invest in a business with no expectation of immediate return or profit; the investor is ready to wait for better returns in the long-term. The general trend has been that even when corporate investors took a break from investing, PE funds showed no aversion in investing. PE investors are normally focused on capital-intensive sectors such as energy, retail, infrastructure and consumer goods, etc.
