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Real estate developers looking at newer financing options
October, 04th 2007
The FDI guidelines have created a lot of interest among foreign investors. But the real attraction for them is potential investment returns of 25 per cent and more in Indian projects that might be hard to come by in the US and Western Europe today.

Major factors other than return that govern decisions of investors include valuation, exit route, time horizon of 3-5 years, regulatory compliances and clear land titles.


Big residential townships, SEZs (special economic zones) and mega retail malls are prominent among the recent trends in the real estate landscape. To cope with these mega developments, the developers are looking at various options of financing, says Mr R. Venkatesh, Regional Director, Transaction Advisory Services, Ernst & Young, Chennai.

"While debt funding, private equity (PE), IPO (initial public offer) route shall continue to happen, though at realistic and reasonable valuations, new avenues such as listing of REITs (real estate investment trusts) at overseas exchanges are expected to attract developers' attention to plan their fund raising exercise," he adds, during an email interaction with Business Line.

Major challenges, however, can be RBI (Reserve Bank of India) guidelines on housing loan interest rates and FDI (foreign direct investment), valuations, dynamic SEZ regulations, land acquisition/title issues, and developer's transparency in operations.

Mr Venkatesh has over 15 years of experience in dealing with M&A (mergers and acquisitions), PE funding, capital markets, and corporate restructuring. He has advised companies on financing and acquisitions, in industries such as automobile and industrial products manufacturing, real estate, banking and financial services, and retail/FMCG (fast moving consumer goods).

Excerpts from the interview:

What are the financing options of the different segments of the real estate industry?

The real estate industry can broadly be classified into three segments, namely residential, commercial and retail. While the major portion of the residential projects is funded by advances from customers, commercial and retail projects need significant external funding (both debt and equity) to develop the project.

Currently, the equity options prevalent in the market include PE, primary and secondary market, listing at AIM (Alternative Investment Market), etc. Developers also continue their strategy of looking at joint development opportunities to minimise their investment on land cost.

Why are new avenues of funding becoming necessary?

Traditionally, developers confined themselves to banks and financial institutions to fund their projects, including land acquisition costs. In the last 3-4 years, with the real estate markets witnessing buoyant activity, developers leveraged their balance sheet to the maximum extent possible to create land banks and fund major projects.

In the process, most of the banks have hit the sectoral exposure caps; and the RBI brought in stringent norms (such as, restriction on funding land acquisition, etc) to regulate new sanctions in the real estate sector. Thus, developers were compelled to look at alternative options to raise funds to continue with their developments plans.

Our FDI policy has room for real estate, hasn't it?

Yes, it has. For instance, when in February 2005, the Government relaxed the regulations governing foreign investment in real estate, it paved the way for capital infusion into the market. As a result, a significant amount of foreign capital is now chasing Indian real estate.

What are the norms? And the restrictions.

Foreign investors can now invest in commercial development projects (under construction) over 50,000 sq metres (5,40,000 sq feet), or plotted residential developments with a minimum size of 10 hectares with a minimum capitalisation of $10 million for wholly-owned subsidiaries and $5 million for joint ventures with Indian partners.

Funds have to be brought in within six months of the commencement of business of the company. The original investment cannot be repatriated before a period of three years from completion of minimum capitalisation. However, the investor may be permitted to exit earlier with prior approval of the Government through the Foreign Investment Promotion Board (FIPB).

Furthermore, foreign investors are not permitted to sell or trade in undeveloped plots or raw land. Recently, the RBI came out with revised guidelines for foreign investment, clarifying that investments made post May 2007 as preference shares (non-convertible/optionally convertible/partially convertible) shall be considered as debt and shall conform to ECB (external commercial borrowing) Guidelines or ECB caps. This has become a major challenge for investors in structuring a deal, leaving very few options for the exit route.

How enthusiastic have the real estate funds and PE investors been in entering this sector?

Highly. The policy changes introduced by the Government in FDI guidelines have created a lot of interest among foreign investors. But the real attraction for them is potential investment returns of 25 per cent and more in Indian projects that might be hard to come by in the US and Western Europe today. A report by property consultants Jones Lang LaSalle estimates that $10 billion foreign investment is expected to be injected into the Indian real estate sector in the next 12-18 months.

Industry sources say over 90 foreign investors are already in the country tapping investment avenues. Nearly two dozen US funds are raising $3.5 billion for investments in Indian realty.

Those who have already raised or are in the process of raising the funds include Wall Street powerhouses such as the Blackstone Group ($1 billion), Goldman Sachs ($1 billion), Citigroup Property Investors ($125 million), Morgan Stanley ($70 million), apart from JP Morgan, Warburg Pincus, Merrill Lynch, Lehman Brothers, Warren Buffett's Berkshire Hathaway, Colony Capital and Starwood Capital.

And how enthusiastic is the response that the PEs elicit here?

Let's not forget that most of our real estate companies are still closely held or family run. It is therefore not uncommon to find the promoters being cautious in diluting stake at the parent company level. Instead, they are keen to look at PE participation for specific projects or assets essentially to fund the development (including land consolidation).

Depending upon the funding requirement, the promoters also prefer to cash out the excess brought in by the investor as premium on land cost. Investor's exit in this case is usually through cash out of proceeds from the project, buyback arrangement with promoters, or sale of stake to asset management companies.

What are the typical structures preferred by developers and investors for PE participation?

Investors look at any one or a mix of the following options for their investment:

Pick up stake at the parent company level and partner in its growth plans across asset classes and cities.

Choose target cities for investment and partner a developer present in each city selected for investment.

Invest in specific projects or asset class based on the developer credentials and strengths of the project.

Apart from return, what factors are important to the real estate investors?

Major factors other than return that govern decisions of investors include valuation, exit route, time horizon of 3-5 years, regulatory compliances and clear land titles. Investors generally prefer their investment to remain in the system for funding the development rather than the promoter cashing it out.

In case of a cash-out deal, they would look at prioritising their investment and minimum return in the project vis--vis the promoter's return and investment.

How big is the real estate IPO market?

Currently, real estate companies account for around 2.5-3.5 per cent of the aggregate market capitalisation. With many other companies planning to raise their money through IPOs the current share is expected to at least double by end-2007.

Do we have controls in place to ensure that valuations are right?

Yes, we have. For example, recently, SEBI (Securities and Exchange Board of India) held up many IPOs, expressing concerns over their valuations. Merchant bankers to realty companies planning IPOs have now been asked to give additional information about the land bank of their clients under different categories such as land already owned, land under development, agreed to purchase, agreement for development, etc.

SEBI is also restricting companies from including values of agreements that provide for revoking the contracts. In case real estate companies have entered into an agreement for purchase or development of land, the new rules would require disclosures such as identity of the contracting parties, agreement value, amount paid against agreement (both in terms of percentage and absolute value), if any, and sources of such funds.

Further, companies have been barred from valuing land based on discounted cash flows expected from future developments of the current land bank.

All these measures are expected to have a significant impact on the valuation expectations of companies planning IPOs and we can expect the same to be realistic.

Your views on developers aiming at AIM.

AIM was launched by the LSE (London Stock Exchange) in June 1995 as an alternative trading platform to the Official List of the LSE. AIM gives companies from all countries and sectors access to a market at an earlier stage of development, by combining the benefits of a public quotation with a more flexible and less stringent regulatory approach.

In 2006 alone, at least a dozen real estate funds had raised in excess of $2 billion through listings on the AIM. Most of them are currently trading at levels below their offer price, one of the major reasons being that the funds raised have been deployed on projects in progress which are yet to start generating income. This has to an extent slowed down the plans of some of the major real estate companies to list their assets on the AIM.

Developers are now looking at Dubai and Singapore exchanges to float REITs as an alternative strategy to raise funds.

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