India real estate: The long game

"I believe that if one wants to bet on the Indian long-term macro growth story, real estate is the better option to go with," says Subhash Bedi, managing director at Red Fort Capital, comparing real estate to stock market-driven private equity investing.

"The real estate market is more closely tied to the core macro fundamentals of India than the stock markets, which for the most part are driven by global sentiment on emerging markets. When emerging markets are out of fashion, as is the case today, stocks crash; real estate, on the other hand, is local consumers so it's more closely aligned with India's long-term growth story."

Investors in residential projects might agree with him. A shortage of housing and rising urbanisation has provided steady returns over the last 4-5 years. Bangalore has been one of the most productive markets, with a total of 19.14 million square feet of residential space sold in the city during the 2013 financial year. Average per square foot prices of units grew between 3-7%, ending the year at a INR3,954 per sq ft.

Once construction has started, a residential project is self-financed by way of sales to customers and their payments. As and when people buy homes, GPs can take profits out and return capital to investors - so there is no reliance on external events like IPOs and M&A deals.

Red Fort targets the affordable middle class housing segment in its development strategy. Bedi estimates this covers 33 million people, each making $5,000-25,000 a year, and the segment is growing at about 12% a year, which equates to approximately 3.5 million additional households. 

"Over a fund cycle of 10 years, people eventually need to buy a house. So forget inflation, the rupee depreciation, forget what's going on in the world. The question is can you build homes affordable enough for people in this segment to be able to buy them?" he adds.

Mixed bag

However, the returns have not been the same for foreign investors. When Indian real estate was first opened to overseas investors in 2005, foreign direct investment rose from $38 million that year to $2.8 billion in 2008. Funds that have invested when the rupee was trading at 40-45 to a US dollar are likely to exit at more than INR60, which is a loss of around 30% in the currency itself.

"If you'd invested in rupee terms, via a rupee fund raised domestically, you're fine. But from a global investor's perspective, if you had put in this money in 2006 through a dollar fund, the investments have done well at the property level but returns in hand are almost negligible," says Shobhit Agarwal, managing director at Jones Lang LaSalle.

Domestic funds can be far more flexible on the RE side as regulations are easier than for an offshore one. "A domestic GP can structure the investment in any manner that he wants to, but for offshore it has to be an equity. Domestics also do not have a timeline restriction that the investment has to be for a minimum period of 3 years, which is the case on the offshore side," explains Vishal Tulsyan, managing director and CEO at Motilal Oswal Private Equity.

There are foreign investors who claim not to have suffered. Partners Group says it has seen good returns even in US dollar terms in the residential sector. The group recently made a direct investment in the second phase of a project in the National Capital Region in 2011. The first phase is over 90% sold and construction is underway on phase two.

"We're going into much more established product on the residential side where pre-sales have been generated and demand is established at a particular price point, but the local developer needs capital to build out the second or third phase," says Bastian Wolff, senior vice president at Partners Group. "In these situations you mitigate land aggregation and zoning risks and timing doesn't become as big of an issue."
There is demand for real estate investment, but the supply of capital and credit has been constrained. Banks can only provide construction financing to real estate developers, not capital for land acquisition, and the Reserve Bank of India (RBI) continually monitors how much money is entering the sector.

Non-banking finance companies (NBFCs) are another source of capital for real estate developers as they are not subject to the same lending restrictions as banks. NBFCs have done well in terms of doing take-out financing, facilitating the purchase of more land.

These institutions can be fully foreign-owned and IndoStar Capital, which is controlled by Everstone Capital, and Warburg Pincus' Future Capital are some of the PE-backed lenders in the sector. KKR is planning to launch a $150 million real estate NBFC in collaboration with GIC Private that will primarily back residential projects.

Room for negotiation

The capital crunch has also allowed investors to negotiate preferred return structures, which hasn't always been the case.

"In the bull market a lot of investors went into straight joint ventures, but preferred returns mean developers bear the risk of rising construction costs or project delays. The margins are fairly attractive, with IRRs of 25%-plus on investments made a few years back," says Wolff.

Partners Group prefers to invest in smaller residential developments to keep construction and development time down, using preferred return structures that, for example, might deliver a 2x cost multiple even if the portfolio was to be sold at 0.74x cost.

Motilal Oswal has a slightly different strategy, but one that still leverages the capital crunch. Tulsyan says the firm will launch a domestic fund, largely doing mezzanine investments in residential projects in a sector starved of liquidity.

Secondaries are another success story in real estate. Partners Group has invested in these at discounts to net asset value, which in many cases was original cost. These properties, typically a mix of residential and commercial, have made significant progress in their business plans and value has been created, says Wolff.

"People have become much more realistic about their assumptions so it could be quite a good vintage for real estate investment in India over the next 2-3 years," he adds, "because it's just not that hyped."

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• Topics
• South Asia
• Real estate
• India
• Real estate
• Motilal Oswal Private Equity
• Partners Group
• KKR
• Warburg Pincus Asia