Understanding The Real(ty) Picture

Updated: Jun 30 2002, 05:30am hrs
A real estate mutual fund (REMF) is a channel for investors to invest in commercial and residential real estate businesses with returns as in case of a mutual fund. An REMF generally invests in equity shares, bonds, debentures of listed companies dealing in properties and property development and mortgaged-backed securities like securitisation of housing loans.

Also, undertaking or financing ready buildings where the lease rentals can be a regular income to the MF and direct estate project financing, construction finance, purchase or option to purchase buildings under construction with a view to sell it again and investment in debt securities issued by development and construction companies (placed privately) are the possible investment avenues for REMFs.

Around 50-years old globally and a big success in countries like the US, the UK and Hong Kong (HK), REMFs are still a totally new concept in India with no domestic mutual fund (MF) having a real estate investment scheme.

Though, the Securities and Exchange Board of India (Sebi) regulations allow MFs to set up real estate schemes, most MFs in India are currently not very optimistic about a foray into a new territory like realty investments.

Most India fund managers are wary of investments in realty due to low realisations or gains that investments in real estate are currently fetching.

The current low realisations are in contrast to the dizzying heights that real estate prices had seen around three years ago. Illiquidity is another problem cited by fund managers, that has dampened the spirits of MFs looking at the possibility of investments in real estate.

Currently, most asset management companies in India are not very enthusiastic about launching REMFs.

The chairman of the largest mutual fund in India The Unit Trust of India M Damodaran says: As the high real estate prices witnessed earlier are unlikely to be repeated, there is a very bleak possibility of MFs launching schemes dedicated to real estate in the near future.

The same sentiment is shared by JM Mutual Fund CEO Krishnamurthy Vijayan: The amount of liquidity available in the real estate segment is poor and therefore MFs will probably hesitate to launch a scheme in a market where investors tend to be very particular about having instant liquidity.

IDBI-Principal managing director and CEO Sanjay Sachdev says: Although, people are talking about the possibility of launching REMFs in India, it is practically not possible as the infrastructure to launch and run an REMF is not in place.

Mr Sachdev further says that real estate is an immovable asset, which is not easy to buy and sell. This is a major disadvantage for launching REMFs in India.

However, REMFs are very popular abroad, especially in the US and the UK. In the UK, real estate investments are in the form of Pooled Managed Vehicles (PMV) which are in the form of Trusts and are similar to the MF schemes regulated by the Securities and Exchange Board of India (Sebi).

PMVs are different from open-ended investment companies (OICs) and the regulator for these PMVs is the Financial Services Administrator (FSA).

The PMVs have a variable capital and are similar to open-ended funds. These get tax benefits based on investor profile, with offshore funds and pension fund investors qualifying for the benefits. However, there are no tax benefits for the regular PMVs, like in case of OICs. Also, the PMVs have the ability to delay redemption if there is excessive pressure to exit the fund.

Similarly in the US, real estate investments are in the form of Real Estate Investment Trusts (REITs) which are formed as companies that have an issued share capital.

REITs also have the flexibility to raise funds through preference shares and debt and they are always close-ended and listed on the stock exchanges.

REITs were started without any tax benefits and did not do well till the US Tax Laws were amended in 1986 to provide them with tax benefits if they conform to certain requirements that have been laid down.

Currently, there are around 300 REITs operating in the US, including names like Alliance, Principal and ABN-Amro with assets in excess of $300 billion.

The tax breaks accorded to REITs and the distribution of 95 per cent of the profits as dividends to investors has made them very popular in the US, says Mr Sachdev.

Keeping in mind the success of realty MFs abroad, the Association of Mutual Funds in India (Amfi) had earlier set up a committee under Deepak Satwalekar, formerly of HDFC, to look into the issue of setting up REMFs in India.

Following this, recently a sub-committee headed by HDFC MF managing director Milind Barve filed a report on the prospects of MFs investing in real estate in India with Amfi.

In the report, the sub-committee has suggested the PMVs system followed in the UK as ideal for the Indian investment environment. The REITs structure, which allows the flexibility to raise funds by leveraging the balance sheet, was deemed in-appropriate by the sub-committee.

Further, the sub-committee report has recommended modification of the Collective Investment Schemes (CIS) Regulations 1999 part of the Sebi Regulations to include real estate as an investment objective.

Issues like a creditable track record of the sponsor, incorporation of several checks and balances for investor protection and investment restrictions will be considered when the modification of the CIS regulations come up.

Further, the sub-committee has strongly mooted that there should be no maximum limit on subscription to REMFs as it would be disadvantageous to the small investors keen on taking an exposure to the real estate sector.

In the case of PMVs, valuations of properties is done on a quarterly basis and the NAVs reported on a daily basis. The CIS regulations do not necessitate the calculations of net asset values (NAVs), but NAV calculations must form a central concept of REMFs, states the report.

The most important issue as per the sub-committee report is tax benefits to be accorded to REMFs, as they are a vital determinant of investors preferring a particular scheme.

In terms of risk management for the MF investing in real estate, the sub-committee has suggested that investment in one corporate should be restricted up to 10 per cent of the corpus and investment in properties owned and managed by sponsor should be restricted up to 25 per cent of the corpus. Investment restrictions based on a project, a promoter group and a geographical area was deemed appropriate by the sub-committee. The sub-committee also enthused the introduction of registered valuers approved by Sebi for valuing properties held by REMFs.

According to the sub-committee, legal areas which need to be considered at a later stage by Sebi were issues pertaining to levy of stamp duty, exemption from property taxes, computerisation of Land Records and dematerialisation of property transactions and uniform amendment of the Rent Control Act throughout all Indian states.

The sub-committee also has advised on the type of REMF which can be introduced in India and has suggested close-ended or interval funds for the first three years. Once the liquidity aspect in real estate in India reaches a comfortable level, then open-ended funds can be introduced.

According to the report, a typical interval fund will be close-ended for a minimum period of three years and the scheme would open at the end of every quarter for sale of fresh units based on the quarterly NAV calculation and remain open for a minimum period of 15 days. The scheme should offer redemption or repurchase at the end of three years in a staggered manner and may be listed on the stock exchange, stated the report.

India has still a long way to go in terms of setting up REMFs. Industry experts say that once the secondary market in commercial real estate picks up and increase in transparency levels and the legal framework is worked out, REMFs may be another investment avenue available to both corporates and the small investor.