It is as if the real estate domain is set to experience everything except waning in interest of both investors and sector players. Thanks to the infrequent but noticeable and impact-creating developments, which have fostered and sustained interest in the sector. The action has gained heat with the launch of two real estate funds (with global focus), ING Investment Management India’s Global Real Estate Fund and ICICI Prudential AMC’s ICICI Prudential Real Estate Securities Fund, and the scrapping of Urban Land Ceilings Regulation Act (ULCRA), which would unlock substantial land bank for players and investors alike.

Though the latter development has been a significant one, the former has been worth pondering over considering the focus of the funds, and this points out to two important points: one, the sub-prime crisis has not deterred the spirits of the influential fund houses to come out with a global realty fund and two, that there has been a slow but noticeable increase in the number of real estate mutual funds. The subprime crisis, considering incessant attribution to it for any dip in the markets, has become a constant refrain, though its comprehensive impact on the markets cannot be understated. However, what is interesting is the increasing real estate funds launches, which have given investors an additional means to make money. And if observations are to be believed, it is said that real estate is fast replacing traditional investment options such as RBI bonds, mutual funds, gold, jewellery, and fixed deposits. Hence, it is equally important to gauge the viability; key things to be aware of and suitability of the real estate mutual funds, considering these funds are branches emanating from the same mammoth tree.

Mind the roof

Direct investments in real estate are quite often a time consuming or expensive affair. As a result, investors intending to enhance their portfolio performance with real estate usually prefer to invest in real estate indirectly. This is achieved through investing in either a Real Estate Investment Trust (REIT) or real estate mutual funds.

A REIT is a closed-ended investment company that offers investors the opportunity to invest in real estate related assets (i.e. income producing real estate properties and mortgages). REITs are usually categorised into different types.

Equity REITs invest at least 75% of their total assets in real estate properties. Mortgage REITs invest at least 75% of their assets in residential mortgages, short- and long-term construction loans and mortgages on commercial properties. On the other hand, real estate mutual funds are open-ended investment funds that bear the same characteristics of most of the open-ended mutual funds.

? Returns, risk and safety

Points out Anuj Puri, country head, property consultants Jones Lang LaSalle Meghraj, “Conservatively, real estate mutual funds can offer returns in the range of 20-30% pa – depending on their portfolios.” However, he states, “The risk/safety ratio must be evenly balanced at 50:50, since you need to study the net present value (NPV) of such funds carefully.”

? The difference

Considering the diversity of locations and funds’ objectives, real estate mutual funds call for a longer investment horizon. Says Navendra Singh, a property consultant, “Ideally, as an investor you must look for three to five years of maturity. The reason being this period factors in most inconsistency created by factors, both micro and macro, impacting the sector.”

With regard to the funds’ technicalities-overseas and domestic, there are differences in their operations and constitution. Domestic funds can invest in any number, variety and size of land parcels and property holdings, while overseas funds are limited to greenfield projects consisting of 10 lakh square feet and above, or under-construction projects of these dimensions that have yet to reach completion. But considering the acceptance and investment frequency, overseas funds will take time to get an accurate feel of the Indian market. Advises Puri of Jones Lang LaSalle Meghraj, “It makes sense to focus on domestic funds that have been around for at least 2-3 years and have a consistent performance record than to opt for funds having overseas real estate exposure, which are yet to demonstrate their potential.”

Performance

Considering the performance aspect being an important factor that determines investment in funds, it is observed that real estate funds move more or less in tandem with the markets. Observes Muthuraman Iyer, a property consultant, “The general conclusion of the performance of real mutual funds in the US and other markets is that these funds don’t give extraordinary returns. On fund performance, the results indicate that real estate mutual funds, individual or on average, do not outperform the market no matter whether the benchmark is the whole stock market portfolio or the real estate sector market portfolio. This result is robust with various versions of evaluation models.”

It is also observed that the performance of the whole real estate sector, to a large extent, determines the performance of real estate mutual funds. Risk factors related to size and book-to-market ratio and market momentum are immaterial in explaining the performance of real estate mutual funds when the real estate market index is also included in the evaluation model. Also, the issue of persistence of performance is only for the short term.

And this short-term consistency is observed across the board, both in the better-performing real estate funds as well as the under-performing funds. In addition to this, fund size is also related to risk-adjusted real estate fund performance. However, there is not a single, right and comprehensive parameter, which when applied, gives an accurate picture of the performance of real estate mutual funds. The reason being there are various other factors that impact the performance of these funds.

Impact makers

Says a fund manager with a mutual fund, “One of the crucial things investors need to be aware of while investing in these funds is the high transaction costs involved. Also, the inconsistency followed in calculating the net asset value (NAV) is an important issue.” You, as an investor, should understand how well-balanced the supply of new buildings is with the demand for new space. When construction adds new space into a market more rapidly than it can be absorbed, building vacancy rates increase, rents can weaken and property values decline, thereby depressing net asset values.

Also, market purists argue that there is lesser liquidity in these funds, especially when compared to equity markets. Some sector experts argue about the industry being a victim of pricing manipulation or fraud, the inadequate documentation of history of prices at which deals are struck, relatively lower regulation and more importantly about the lack of transparency in deals. Factors such as growing awareness, appreciation potential and a movement in property prices all have a combined impact on the returns on property and, in a way, the returns of the funds.

What is expected of you

As an investor, you need to gauge the advantage of reducing risk of investing in a single property vis-?-vis a portfolio of properties. Not to mention an opportunity of investing in smaller amounts and getting a good exposure to a portfolio of properties, that has a potential for appreciation.

And also ‘diversification’. The advantage of investing in a real estate mutual fund cannot be ruled out and in time when the markets demonstrate a bearish trend, it is diversification of this sort that helps you minimise your losses. For savvy investors with good investible surplus and a high-risk appetite, the returns from a direct investment in property could be higher. However, such a savvy class is in minority and a major chunk prefers funds. Another key design feature of real estate funds is the elimination or reduction of the taxation differential between directly-owned property and property owned through a corporation.

Nevertheless, as India’s real estate market grows and opens up, REITs also can play a major part in its development. More broadly, REITs could provide many benefits to India’s economic development, just as they have in other countries such as Australia, Singapore, Japan, the UK and France. For instance, REITs can boost capital access and reduce capital costs for property owners, managers and developers.

Moreover, in many markets REITs have successfully helped the commercial property business better access the four quadrants of capital: debt and equity, public and private. REITs also help create conditions for building integrated property businesses, and are well positioned to appeal to foreign capital, thereby helping develop the Indian economy.

However, the road to establishing an Indian REIT sector could be challenging. Not least, the authorities will need to change parts of India’s legal and tax frameworks to suit the smooth functioning of these funds. Furthermore, the real estate transaction process is cumbersome, and the property industry’s transparency and disclosure levels could be an important factor to watch out for.