A watch and wait game

Updated: Sep 29 2014, 07:27am hrs
In this first-of-a-series, we present a primer on the potential Indian REIT (Real Estate Investment Trusts) landscape and illustrate how developers and investors are likely to position themselves in anticipation of the REIT regime. Our analysis suggests that the proposed tax legislation favours debt contribution over equity and is skewed towards non-resident investors. We expect highly levered, operational commercial assets (within a REIT-able universe of ~110msf) to find REITs as an ideal means of raising perpetual capital to replace domestic debt at the SPV (company) level. We expect high-quality retail assets to command better valuations than comparable office space assets.

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* REITs in India: The need for perpetual capital in the real estate sector

Despite recent signs of a turnaround in the nature of capital coming into the real estate sector (long-term, sovereign and pension funds), there is a severe shortage of long-term risk capital. Hence, an enabling legislation for REITs will offer an avenue for replacement capital and exit opportunities for developers and investors, allowing them to unlock capital employed in completed assets.

Real estate, being a capital-intensive sector, faces a burgeoning need for funds, especially in the form of long-term institutional capital. The Indian real estate industry has witnessed exits from a few private equity (PE) investors with mixed results. A larger chunk of exits (of $2 billion) is likely over the next 2-3 years when the sector completes its first full cycle, which is where the key challenge lies. In this context, REITs will offer replacement capital and exit opportunities for developers and financial investors, allowing them to unlock capital employed in completed assets by injecting such assets into REITs.

Bank funding (direct) to the real estate sector has been sporadic. On the other hand, the NBFC channel and the private lending channel have consistently seen high levels of activity nearly every year. This is reflective of the existing regulatory arbitrage between banks and NBFCs that lend to real estate.

* NBFC lending to real estate: Capitalising on regulatory arbitrage

It is worth highlighting that since Indian banks are not allowed to lend to real estate companies for the purpose of land acquisition, developers either use internal accruals or other sources of funding for the purpose of land acquisition. Given the regulatory arbitrage (around exposure limits, extent of scrutiny and end-user classification) between banks and NBFCs that lend to real estate companies, the NBFC route is thus conveniently exploited. In fact, we argue that a significant proportion of what appears to be non-bank debt to real estate companies is also bank lending to the sector, albeit in an indirect manner.

Banks are under far greater regulatory scrutiny from the Reserve Bank of India (RBI) on exposure to the real estate sector. In fact, bank exposure to commercial real estate (CRE) is mandatorily classified under sensitive sector exposure as part of banks statutory reporting. Another area that contributes to the regulatory arbitrage between banks and NBFCs that lend to real estate companies is the prevalent laxity in end-user classification at NBFCs, where exposure to real estate is often camouflaged as MSME (medium, small and micro industries) exposure or unsecured personal lending, whereby high networth individuals (HNIs) and ultra-HNIs leverage themselves to fund special purpose vehicles.

Given this regulatory arbitrage, banks find it easier to lend to real estate companies through intermediaries like NBFCs. Also, given the NBFC dependence on bank funding (80%), a large proportion of NBFC lending is, in fact, disguised bank lending. It is worth highlighting that growth in bank lending to NBFCs has been consistently north of the headline credit growth being reported by the banking system and it also does not undergo as much regulatory scrutiny as bank lending to other end-user industries (like infrastructure).

* Private equity in real estate: Funds in exit phase

Although there are recent signs of a turnaround in the nature of capital coming into the sector (long-term, sovereign and pension funds), there is a severe shortage of risk capital in the real estate sector, implying that a bulk of the so-called risk capital in the sector is disguised mezzanine finance (quasi private equity coming in with debt-like features such as assured returns built into the contracts).

To put the nature of private equity capital in real estate in perspective, out of the $14 billion invested in the sector since 2007, Jones Lang LaSalle (JLL) believes that $5 billion has exited. More importantly, the private equity industry has seen considerable consolidation, with about 20 serious funds in existence now as compared to nearly 120 funds during the heydays in 2007. The consolidation, whilst indicative of a maturing investor community, has now begun attracting seasoned, long-term capital providers into the sector, as evidenced by the entry of sovereign and pension funds that are willing to offer the much-needed long-term risk capital to developers. Our discussions with experts in capital market teams suggest that nearly $4 billion has already been raised for the Indian real estate sector, out of which nearly $2 billion is ready for immediate deployment.

Whilst new money is being raised in anticipation of reforms in the real estate sector, existing investors are undeniably looking for an exit. Since 2005, $37 billion has been deployed in the Indian real estate sector by institutional PE funds, out of which nearly one-fifth, amounting to $6.9 billion, has been exited by PE funds. Whilst the residential sector accounted for 58% of the exits, the office sector accounted for about 24% of the exits. Our discussions with experts also suggest that private equity of $2 billion is waiting to exit office assets over the next 18-24 months and is keenly watching the REIT regime unfold in India in order to optimally time their exit.

* Proposed tax legislation and final norms: Necessary but not sufficient

Whilst the current tax proposals (proposed in the Budget) are kick-starting the REIT regime in India, the tax structure is sub-optimal for sponsors and investors alike. In fact, the proposed tax legislation is skewed towards non-resident investors and favours debt over equity and needs to be tweaked in order to make Indian REITs more palatable to sponsors and investors alike.

* Quality of investible universe will determine quality of investors

The quantum of Grade-A assets (investible stock of income-generating assets across office and retail space) available for injection into Indian REITs is limited in the Indian context. Experts suggest that the investible universe is restricted to about 30% of Grade-A office space (amounting to ~100msf) and about 20% of Indias total retail space (amounting to ~10msf).

* Developers likely to fold yield-bearing assets into SPVs (companies)

We expect developers to wait until the next Budget to see whether the tax concessions are extended to other ownership structures. In the absence of any further developments on taxation, we expect developers to fold their portfolio of yield-bearing assets into SPVs (in the form of a company). We expect sponsors and developers to lobby for further tax concessions in this structure.

* New investment vehicle will call for a new set of disclosures

We believe that current disclosures around yield-bearing assets are insufficient to arrive at a sensible valuation of such assets. We believe investors need to seek greater clarity around tenancy mix, nature of lease contracts and tenure of leases to efficiently value assets. Until then, we expect Indian assets listed in Singapore to set the upper end of the valuation band for yield-bearing assets.

* Valuation: What is an appropriate cap rate in the Indian context

Our discussion with experts and potential sponsors suggests that REIT yields at 150-200bps below base rates would be viable. Whilst yields are determined by a combination of factors such as location, tenancy mix, outlook on vacancy risk and residual lease tenures, we believe that Grade-A retail assets will command better valuations (lower cap rates) than comparable office assets.

Ambit Capital