‘ Real estate- making India; Adapting Indian real estate to evolving avenues’: EY-FICCI
Realizing the importance of cities to the economic performance of the country, urban development and housing form a key part of our new Government’s vision of a digitally evolved country. The report elaborates on the role played by real estate in India to achieve the goals set by the Government — be it establishment of smart cities or achieving housing for all. It also illustrates how our mega cities have been responding to the omnipresent demand for housing across income segments through extended development beyond their municipal boundaries. In addition, the report provides profiles of destinations that cater to this demand as well as of emerging trends in these. Being capital- intensive, funding has emerged as one of the greatest challenges facing the real estate sector in recent times. The global economic crisis considerably reduced funding options available to developers, who have been looking for alternative sources of fundingdue to reduced deployment of gross bank credit to commercial real estate and housing from 10% in FY10 to 8.3% in FY14. Policy reforms and a macro-government vision mark the start of a new era. In this report, we outline the role of real estate in the evolution of a new India.
Randhir Kochhar, Partner, EY, says:
“High office space yields, coupled with an ever-increasing visibility on Indian REITs, have led to investors building sizeable portfolios of high-quality rentable commercial spaces. This has led to PFs/ SWFs partnering with developers, operators and managers to create/acquire such assets. Direct investment in the Indian Real Estate industry has evolved due to increased allocations to real estate as an asset class by SWFs and PFs on account of increasing real estate and sovereign debt yields.”
Approval of REIT: In September 2014, the final guidelines for REIT were notified by the Securities and Exchange Board of India (SEBI). The guidelines require the Finance Minister’s approval for tax concessions to make REIT attractive and at par with similar norms in the rest of the world. Several developers are waiting on the sidelines to list their commercial space stock. According to industry estimates, India has 200 million square feet “REIT-ready” space. REIT will provide an alternative route of finance. REIT is currently open for office space, but developers of malls are anticipating extending of REITs to shopping centers, which will boost development of malls in the country. Furthermore, relaxation of FDI norms may encourage foreign single- and multi-brand retailers to set up shop in India and create a significant demand for retail space.
FDI in real estate: FDI inflows in construction (townships, housing and construction development) have been declining since FY12 due to India’s weak economy and regulatory concerns. FDI in construction development has declined to US$1,226 million in FY14 from US$1,332 million in FY12. The Union Cabinet has approved the proposal of the Department of Industrial Policy and Promotion to relax existing performance-linked conditions relating to FDI. These include the following: ► Built-up area to be reduced from the existing 50,000 sq., m. to 20,000 sq. m. ► Minimum capitalization reduced from US$10 million to US$5 million, with a three-year post- completion lock-in period ► Projects with a commitment of at least 30% of the total cost toward low-cost affordable housing exempted from requirements relating to minimum built-up area and capitalization, with a three-year lock-in period The potential of and the challenges faced in investing in real estate as well as the investment philosophy of available pools of capital have led to the evolution of this new form of investment in real estate in the country.
Market opportunity — the need gap
The global financial downturn in 2008 resulted in a significant shift in the funding scenario with investors becoming increasingly cautious. Along with a decline in the total quantum of investment, the average ticket size of deals in real estate trickled down from US$140 million in 2008 to US$30–US$40 million after the financial downturn. Another notable trend was that investments became skewed towards the project level rather than the entity level. Developers have been looking for other sources of funding due to the decline in gross bank credit deployment to the commercial real estate and housing sector from 10% in FY10 to 8.3% in FY14. However, with learning derived from the global meltdown and past investments in India, investors have begun looking at more secure funding options such as mezzanine and structured equity instruments. Non-Banking Finance Companies (NBFCs) have been actively looking at “last mile funding” opportunities, where projects in which substantial investment have been made are delayed due to tempo- rary mismatches in cash flows. Therefore, there is a large need (created over time) for equity funding from institutional sources. It is this gap that is being filled by platform-level deals between PFs/ SWFs and developers.
Since April 2012, there have been seven such large platform-level deals by Provident Funds (PF)/Sovereign wealth funds (WFs) that we have tracked. Total investment in these deals amounts to US$1.9 billion with an average deal size of US$270 million. The trend has increased in the last year (since July 2013) when the number and size of these deals increased significantly. In terms of asset classes, while 74% of this investment is for office space assets, 20% is in the residential segment and 6% in the hospitality segment. In terms of the number of transactions, the share of office space is 57%, residential 29% and hospitality 14%. During the period April 2012 to September 2014, investment in such deals amounted to.US$3.9 billion vis-à-vis invested capital from private equity deals worth US$2.7 billion. Although capital
Randhir Kochhar, Partner, EY, says: “High office space yields, coupled with an ever-increasing visibility on Indian REITs, have led to investors building sizeable portfolios of high-quality rentable commercial spaces. This has led to PFs/ SWFs partnering with developers, operators and managers to create/acquire such assets. Direct investment in the Indian Real Estate industry has evolved due to increased allocations to real estate as an asset class by SWFs and PFs on
account of increasing real estate and sovereign debt yields.”
from platform-level deals will be invested over a longer period in portfolios of projects, the increasing number of such deals as well as the higher quantum of capital commitment indicates the confidence of global funds in the Indian real estate sector. Increasing investment flows from Sovereign Wealth Funds (SWFs)/ Provident fund (PFs) indicate their confidence in the potential of the Indian real estate sector. The nature of this pool of capital as well as the form of investments — directly in platform level deals — overcomes some of the challenges faced by foreign investors in the past. Given the nature of the sector, long-term capital has a better chance of generating expected returns, and therefore, this form of patient capital can address the needs of developers and investors by offering them enhanced flexibility to tide over market cycles and project gestation periods. Gaurav adds, “Reduction in the development size of projects for which FDI can be tapped will also open up additional opportunities with shorter project development time frames.” There has been an upward revision in growth forecasts with the formation of a new Government with a clear majority at the Centre. Some policy changes with respect to real estate have already been initiated (e.g., relating to project size and minimum capitalization for FDI, REIT-related regulations, finance for affordable housing, etc.). These, along with the expected improvement in the macroeconomic environment, can give further momentum to investment flows from SWFs and PFs as well as to platform-level deals in India.
REIT— the new investment vehicle in Indian real estate market
The introduction of REITs in India marks the coming of age of the country’s real estate sector and recognizes the fact that there is adequate stock of real estate assets that are REIT-able in the country. Ideally, REITs should offer a structured and perpetual source of capital and exit opportunities for developers and financial investors, allowing them to unlock capital employed in completed real estate assets by including such assets in the REIT structure. Introduction of REITs that are pure equity capital will help to improve the debt-equity balance in the real estate market by providing equity financing and thereby facilitate the growth of a stable and mature real estate market. It is also expected that REITs will help in streamlining the real estate sector by creating a transparent mechanism for raising finance in the market. For REITs to become a reality in India there are certain key issues that need to be resolved first. • Indian pension funds and insurance companies should be permitted to invest in such securities while permitting FDI in REITs up to 100% under the automatic route. • Indian sponsors of real estate will either be real estate owners or developers. However, SEBI’s regulations require sponsors to have a “real estate experience” of five years, which makes it impossible for corporate real estate owners sell and leaseback their real estate assets to REITs sponsored by them. A special dispensation should be made in relation to “sale and leaseback transactions” to open up avenues for businesses in the service and manufacturing sectors and enable them to raise equity capital by monetizing their non-core (but valuable) assets, e.g., factory premises, warehouses, corporate offices, etc. • Currently, the proposed tax treatment of REITs differentiates between a resident unit holder and a non-resident unit holder in relation to their income from interest through a reduced rate of tax (5%) for non-residents. This discrimination makes the structure unviable, since a sponsor, being a resident, does not benefit from the effective tax impact. Moreover, this will influence the capitalization structure of the REIT and its SPVs. To address this, it is imperative for the Government to exempt Dividend Distri-