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Prime Minister Narendra Modi’s sweeping victory in the national elections in 2014 on the back of his electoral promise of “Acche Din” (good days) for the country created mass euphoria in the country at the time. Riddled with tepid economic growth and policy inertia, the country looked to the leader to make sweeping reforms.

Over a year and a half later, and business sentiment has turned from euphoric to realistic. In real estate, last year did not see the full-fledged revival many people in the sector had expected Modi’s election to accomplish.

While there is an admission of this mindset change among the participants at PERE’s annual India roundtable, they remain hopeful a revival is still forthcoming.

“It is true that initial expectations ran too high and the reality has taken time to settle down,” says Nitin Goel, managing partner, real estate investments, at Mumbai-based private equity investment firm Milestone Capital Advisors. “The government has taken incremental steps rather than big bang reforms. But with the opening up of FDI laws and opening up of the AIF sector to get foreign money directly, the property sector is indeed poised to grow.”

A striking dichotomy is also at play. India’s residential sector has been beset with sluggish sales and high unsold inventories across key markets, according to multiple research reports, as buyers wait for a price correction. Consequently, developers continue to face a challenging operating environment with project delays and weak cash flows.

International fund managers and institutional investors, however, are no longer sitting on the market’s fence. In the first nine months of 2015, private equity firms invested around $2.8 billion in the sector, the highest volume seen since 2008, according to a Cushman and Wakefield report. Not polarized to one or two deals, there is a noticeable increase in the number of equity investments and entity-level transactions too, a trend the participants believe reflects a growing confidence in the long-term fundamentals of the sector.

“Post the opening up of FDI in 2005-2006 a lot of funds rushed to India taking large bets in RE; however, after the global financial crises they became a lot more cautious. Things have changed in the last 24 months,” says Chintan Patel, partner, deal advisory, real estate and hospitality at KPMG India. “A number of large global pension and sovereign funds are investing in India. They are investing equity money as compared to structured debt. This is definitely a positive for the sector.”

Subodh Runwal, director of the Runwal Group, a Mumbai-based real estate developer, says he has been getting many queries from sovereign wealth funds and private equity real estate funds from China, Korea, Middle East and the US that want to invest in large projects in the country. He says the average deal sizes being explored by the new entrants is around $70 million.

The participants also spoke of how international engineering and construction companies are circling the country for development opportunities.

And so, by the looks of things, there is no shortage of capital wanting to enter India.
Its form and investment approach, however, is changing.

Mixed bag
“The new wave of capital has done its homework. It is more of a cash flow model. Investors are not going into the land bank story,” explains Runwal. “The IRR is not the Holy Grail. They are looking at various parameters such as the approval status of the project, the partner, the risk associated with the project and the region where investment is being made.”

The tenure of investing is also increasing. Runwal says international institutional investors are now talking about coming for a period of 10 years, not a short term horizon of three years to four years.

Participants agree that international capital has started focusing more on selecting the right partner. A case in point is the Singaporean sovereign wealth fund GIC Private that has been investing directly with developers via joint venture partnerships, of late a commonly-used investment route by large global institutional investors. In September, the state fund announced a $300 million investment in two residential projects being developed by a subsidiary of the Gurgaon-based property developer DLF. GIC also increased its exposure to the commercial sector with a 50:50 partnership with US developer-cum-manager Tishman Speyer for an office development project in Hyderabad at the end of last year.

Buying a stake in operating companies also underlies a growing confidence in the long-term health of the sector. Warburg Pincus’ $284 million investment in Piramal Realty in July was pegged to be one of the largest foreign investments in the sector. Investment bank Goldman Sachs also invested $150 million in Piramal Realty, followed by another investment of $66 million in SAMHI Hotels, an Indian hotel development company, only months later.

For Goel, such a preference toward direct investing by large sovereign wealth funds doesn’t spell doom for domestic managers raising offshore capital for blind-pool vehicles. However, he does point out the changing tactics being employed.

“Compared to 2006-2007, the strategy is sharper now,” he adds. “Earlier opportunistic funds invested across sectors in hotels, residential and commercial, whereas now the funds are more focused on a pure asset class. Fund managers have the experience of knowing what deals they want to do and with whom they want to partner with. Funds have reduced the management fees and are just covering the costs in some large separate accounts.”

Since the last few years, a liquidity-constrained environment has also increased the appeal of structured credit and mezzanine finance deals given the high returns that could be generated via a more defensive debt offering.

Not anymore. Returning liquidity has led to margins evaporating and the participants report that debt fund managers have been facing investors’ ire as a consequence.
“The expectations of mezzanine and structured credit investors have come down,” says Patel. “Those who wanted to get 22 percent to 24 percent IRRs are now okay with getting high teens.”

To compound matters, recent news reports indicate that many real estate debt funds have been lagging on their interest payments to investors amid weak cash flows of developers and delays in project completion. According to an Economic Times article published in October, half of the 50 mezzanine funds in the market are estimated to have delayed making coupon payments, with many even extending the principal repayment schedules by almost 12 months to 24 months.

“In the last few years, generally real estate equity investment did not give returns investors were hoping so many moved to the other extreme wherein 100 percent guaranteed returns of 22 percent to 23 percent were being given in structured debt,” explains Goel. “The pendulum is again swinging to the other side where investors want to partner for projects with good developers who may not give guaranteed IRRs, but are open to partial downside protection and profit sharing.”

“The bane is that some funds raised in the past promised investors everything under the moon – like a monthly coupon rate of 18 percent – without realizing that it is difficult to predict cash flows month-on-month and for the developer to actually service it” he goes on to add.

However, he sets aside fear of the potential threat of default among debt funds in the industry in most cases.

“I have seen projects where there has been delay (either due to approvals or general market slowdown) and managers will have to work a way to ensure that they get the projected IRRs if the project has value. But to expect that it will happen month-on-month is unfair marketing. Managers could have newer repayment terms – it could be payable when able or a lower coupon with more flexible terms,” he explains.

According to Runwal, the problem arises due to the short tenure of a debt fund.

“If it is a 5-year fund and the money has only been put out in the third year with managers looking to make an exit by the fourth year that is a recipe for disaster,” he says.

Sentimental malaise
The performance of debt funds is not the only cause of distress. ‘Slowdown’ is now a commonly featured word in almost every news article written on the Indian real estate industry.

A report released by broker Jones Lang LaSalle last year threw up some worrying statistics for the residential sector, for instance. As of the end of the second quarter of 2015, the total number of unsold housing units in Bangalore was 84,000 while the Mumbai Metropolitan Region had 77,000 units. The mismatch between “affordability and pricing”, according to Runwal is making potential buyers hold off purchases in anticipation of further price falls.

While the participants agree all is not well, they blame various negative but perhaps not justified perceptions for fueling much of the prevailing sentiment. Runwal questions the validity of several research reports that point towards high inventory levels, for example.

“We are currently developing 25,000 houses under a large township project in Dombiville (Mumbai). Only Phase 1 and 1000 units have been launched so far but one inventory report showed The Runwal Group to have 25,000 unsold units,” he says.

In a speech made in August last year, Raghuram Rajan, governor of The Reserve Bank of India, urged developers to stabilize prices to help the sector. The real estate industry in turn holds the government partly responsible for the high prices.

“In Bombay as per new the Development Plan 2034, the premium paid to the government in a suburb is INR2000 (€27; $29.4) per square feet, up from INR500 per square feet. These costs are being passed on to customers and projects are becoming more expensive.”

Acche Din
In other sectors, however, visible signs of a turnaround are starting to be seen. According to Patel, there are more private equity real estate funds waiting to acquire a Grade A office property than what is available.

Goel agrees: “India is back to the peak demand of 37 million square feet in the commercial sector and typically residential demand takes off with a nine month lag from commercial demand. So if the office demand is increasing, it indicates that there is a turning point.”

Looking ahead, many ongoing regulatory reforms, once fully rolled out, are expected to give a further boost to the sector.

One cannot expect solutions overnight. It will take at least four to five years and the government is working very hard on it. Since Modi took over, we haven’t heard of any scams. Things are becoming more transparent,” says Runwal.

One such area is in the establishment of Real Estate Investment Trusts, which were brought in shortly after Modi’s victory. Another came when his government announced a low-cost housing program promising housing for all by 2022. Modi’s government also decided to identify and build 100 ‘Smart Cities’ by the end of 2017.

He has also eased norms for foreign direct investment in real estate, a reform Patel calls a “game-changer for the industry”. As per a notification released last November, the central bank has allowed foreign investment to come into alternative investment funds (AIFs) through the automatic route without any intervention by the Foreign Investment Planning Board as was the case earlier. This means non-resident Indians and foreign portfolio investors are now allowed to invest and trade in real estate, private equity and hedge funds directly.

In another policy revision, the government has imposed a three-year lock-in period for a foreign investor in a project while earlier investors were prohibited from exiting a project before its completion or completion of trunk infrastructure. In Patel’s view, barring this lock-in period, the entry-exit norms for a foreign investor are now in line with those for domestic investors.

In his view, and perhaps less obvious, India also stands to gain with the economic jitters in China.

“If China’s growth begins to stagnate, India will be a primary beneficiary in terms of investments. From an absolute standpoint, India is the fastest growing economy today. With the ease of doing business and the Modi government making sound bites globally, India has become an attractive destination.”

Some international groups have started to recognize the positive signs and are increasing their exposure to the country. Others, still jaded from their past experience, will need more conclusive evidence before recasting India in their investment blueprint. The gentlemen at today’s roundtable will do what they can to provide it.