Experts say funds are unwilling to take major risk on projects
Private equity (PE) investors continue to be cautious while investing in real estate assets, evident from the astronomical rise of mezzanine finance, or what is also known as structured debt. According to Cushman and Wakefield, five years back in 2010, 29% deals in the private equity real estate (PERE) space were in the form of structured debt, whereas in 2015, 72% transactions were made via mezzanine or structured finance. During 2015, total PE investments made to the sector stood at $3.96 billion. Since 2010, PERE investments have grown by 30% in the past five years.
As much as the sector is strapped for cash at the moment, industry experts say the rise of mezzanine debt indicates funds are unwilling to take major risk on projects and are weighing in on risk reward ratios more cautiously than before. Unlike equity, structured debt allows investors to exit investments with a predetermined rate of return.
While companies would need to fork out 13-14% as interest on loans, PE funds demand a return of between 16% and 18%, which are lower than the returns of 27-30% they can make from equity investments in residential properties.
But the risks of buying an equity stake are too high now, given the real estate companies are not in the best of financial health. “Structured debt has the advantage that developers do not have to attach projects as a collateral to raise capital,” says Sumeet Abrol, partner at Grant Thornton. The sector, in recent years, has underperformed and returns on equity investments have dropped, making funds more cautious, Abrol adds.
Now that PE deals in the office space have picked up pace, it is not surprising much of it is anticipated in the form of debt. So far it is only institutional funds that have ploughed equity money into marquee income-generating assets, but now domestic players are also gearing up to take position in under-construction projects.
“We will primarily fund projects through construction financing and senior secured debt,” said Khushru Jijina, managing director at Piramal Fund Management. Typically, these projects are funded by banks, with interest rates in early teens. “We feel we can be more competitive than banks — with the difference mainly coming through customised repayment schedules, staggering payments, working around COD requirements that most banks are forced to to adhere to, flexibility in interim interest servicing, etc,” Jijina added.