Indian realty GPs show their distress

Distressed sales in India's real estate sector were first witnessed following the global financial crisis. In 2010, several foreign private equity funds - predominately based in the US - were forced to liquidate their investments and distribute returns, under pressure as they were from LPs.

That year PE firms registered 10 losses from exits in India - more than they had in the previous two years put together - and it seems as if real estate deals were primarily to blame.

Nevertheless, two years ago, distressed investment was still a novel concept. Few real estate developers would have been willing to suffer the embarrassment of launching a distressed sale due to a shortage of capital, so it is fortunate that, despite paying high interest rates, most were able to avoid selling under duress by restructuring their loans. In cases where debt financing was unavailable, such situations were usually averted by accessing private funding.

According to Balaji Rao, the former managing director of Starwood Capital India Advisors, little has changed on this front over the past two years. Rao, who is currently raising a $200 million fund on behalf of new firm Indic Capital Advisors to tap distressed opportunities in the hospitality space, says that the whereas in most markets distress refers to the circumstances surrounding a particular asset, in India the distress is experienced by the GPs themselves.

"Most people thought that the distress would be in the investments, and the developers would be trying to sell cheap. That has not happened. The distress is coming more from the investors," he tells AVCJ. "The investors who do get distressed are usually foreign because they get tripped up by the inordinate delays in getting approvals, or some sort of problem in the title documents, which tend to worry them."

Exit anxiety

Another source of distress is the desperate need that many have to exit holdings via secondary sales, which is largely motivated by the imminent culmination of funds raised in 2005. It was predicted that GPs could sell off up to 130 projects this year, but it is proving challenging due to the sheer volume of firms that are trying to offload assets. The situations is not helped by a dynamic in which the few firms looking to enter the market are seeking fully-leased assets - which are in short supply - with little to no demand apparent for positions in half-completed projects.

Rising borrowing costs and reduced access to credit are also playing their part by causing delays in project completions. After the Reserve Bank of India (RBI) expressed concern last year about rising real estate prices, and cautioned banks to introduce stricter terms for loans to commercial developers, a number of banks are said to have increased the risk weightage on financing for projects in this segment. This has forced companies to seek high-cost debt alternatives to overcome cash flow pressures.

"The borrowing costs are increasing, and there's a lack of credit availability in the market," says Neeraj Sharma, a director at Grant Thornton India. "The real estate community is really finding it difficult to complete their current projects in time.There were very few funding options available, so that's where they started looking at their current land parcels to see if they're able to sell them, and that's being called a distressed sale."

Poor location has been cited as another factor contributing to struggles in the commercial real estate sector. A number of properties were constructed before the financial crisis in suburban districts, at a radius of 10 kilometers away from city centers. While these previously proved popular with cost-conscious occupiers - who were willing to go off-location to save on rental prices - city center buildings have now become more affordable, meaning there is little benefit to venturing further afield.

This lack of cost arbitrage is particularly pronounced in the cities of Hyderabad, Chennaiand Kolkata, where there's great price similarity between city center locations and suburban office complexes. "If I'm paying $1 for my city center office, the suburban place is $0.80. The $0.20 you save, you end up spending on commuting," explains Shobhit Agarwal, Capital Markets managing director for Jones Lang LaSalle India. "If my city center place was more expensive, then it would make sense for me to go into that kind of location, but here I end up losing time and I don't really save money."
Grade-A office buildings located off-center are therefore finding it extremely difficult to attract tenants.

Some developers have backed themselves into even more of a corner by placing bets on buildings that are too large. In 2006, real estate companies had to build projects of 50,000 square meters in size in order to be eligible for foreign direct investment (FDI). Located predominantly in suburban areas, most of these far-flung buildings are in trouble due to a lack of occupiers.

One potential solution for developers of these projects is - instead of renting to institutional grade occupiers, such as JP Morgan, HSBC or Morgan Stanley - they could change the positioning of the buildings to more local occupiers. This would involve dividing up a building and selling it offer in small units to local buyers. However, the risk that developers run is that they'll only succeed in offloading a portion of the building. A large institution would also be deterred from renting at that stage.

SEZ issues

Projects located within India's Special Economic Zones have faced more problems than most, as the SEZ Act stipulates that land banks of at least 25 acres are needed for any real estate to be developed within them. Developers ended up doing enormous amounts of construction in these zones in the hope that the demand for office space seen before the economic crisis would continue. When 2008-2009 downturn arrived, though, demand decelerated, but the projects still needed to be completed.

"Many IT and SEZ projects have been shelved and developers have not commenced execution," adds Parry Singh, managing director at Red Fort Capital. "Some developers have taken out bridge loans to finance construction in the face of slow lease-outs."

Indeed, the capital specification of the average developer has widened. Since 2009, mezzanine finance has added to the other options available - namely equity and senior loans - in recognition of the fact that the banks can only lend so much. Though regulations prohibit private equity from providing mezzanine in India, some GPs are looking to capitalize on the opportunity to provide debt by either acquiring preferred equities or setting up their own non-banking finance companies (NBFCs), which provide loans to developers.

"There are funds which have set up NBFCs here in India," says Ashish Joshi, director and managing partner for real estate at Milestone Capital Advisors. "The returns they're expecting are in the range of 18-20%, compared with 25% for an equity owner that went in at 2007 valuations, assuming locations are good, like Mumbai or Delhi or Bangalore. The prices are high in Mumbai and Delhi."

KKR set up its own NBFC in 2009 - although this does not lend to real estate firms - while Goldman Sachs Private Equity, Ashmore Group and Everstone Capital teamed up to create Indostar Capital Finance. Warburg Pincus won approval from India's Foreign Investment Promotion Board for a $145 million investment in Future Capital Holdings earlier this month.
Specialist distressed asset investor Clearwater Capital Partners, which closed its third fund at $575 million in July, also operates in India through a NBFC.

However, there are many PE firms for whom the distress in the market is far more of a challenge than an opportunity. So far, though, few GPs appear to have made a loss on their investments, and the majority seems inclined to sit out the storm and wait for interest rates to fall and credit to become more widely available. The consensus is this will happen within a two-year window.

"While we know people are in pain, they always work out an arrangement with their bankers. So - with the exception of one or two deals - people haven't really taken a loss," says Jones Lang LaSalle's Agarwal. "We don't have the US or European style of distress in India, where if I put in $100, I'm happy to go out at 80, 60, or whatever I can get... We'd much rather wait it out and not sell at a loss."

SIDE BAR:

Distress unraveled: Investor angst

They say investors are more distressed than investments in India. But why?

Part of the reason is that all the private equity players are attempting to jettison their assets at the same time. The vast majority of firms are approaching the end of the 5-7 year lifespan on their first funds - funds which realized a large number of deals in the 2005-2008 period. These investments need to be monetized in order for any new vehicles to be raised, which explains the current rush for an exit.

Not only does this mean that supply of assets currently exceeds demand - at least in the commercial real estate market - but it means that returns are being impacted, too. "The multiples are probably not as affected but the IRRs definitely are because of the extended timeframe," says Archana Hingorani, CEO of IL&FS Investment Managers, whose firm completed partial exits from five of its Indian real estate investments in the fourth quarter of 2011.
Most managers are expected to reap IRRs of less than 20% this year, and money multiples of 1.8-2x.

"The challenge is to understand the market dynamics, because most PE players are equity partners, and have to share the profits and losses equally,"says Neeraj Sharma, a director at Grant Thornton India. "The market will divide in the next couple of years, so if they can wait until then, they should be able to recover their investments. We've seen a lot of reforms from the Indian government in this sector, so things will start moving in the right direction."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• South Asia
• Real estate
• Real estate
• India
• Milestone Capital Partners
• Real estate