No Exit

The year was 2005. Massive growth in IT services in the late 1990s had pushed up demand for residential and commercial real estate. While the demand was rising, there wasn't enough capital to meet the realty requirements of residential and corporate users. The government decided to open real estate to foreign direct investment (FDI) to help the capital-starved sector.

Alongside, in 2006, the banking regulator, the Reserve Bank of India (RBI), prohibited banks and housing finance companies from funding land purchase transactions of developers. Real estate players did not feel the pinch immediately as the gap was bridged by global private equity players, which were using the FDI window to pump in money.

Not surprisingly, between 2005 and 2008, close to $12 billion came into real estate from marquee global investors and went into futuristic projects like Special Economic Zones and luxury hotels. But the global meltdown in 2008 brought this capital inflow to a grinding halt. And the RBI's direction to banks not to fund land hit developers hard.

It was at this time, when both banks and global investors had pulled out of Indian realty, that a new breed of funds came up to meet early stage capital requirements of developers - domestic real estate funds. This regulatory arbitrage, where banks stayed away from lending for land, led to the birth of about 20 domestic real estate funds between 2009 and 2013.

With global investors focusing on the more steady commercial real estate segment, domestic funds became the saviour for residential realty developers, which make up for 80 per cent of the market.

As per Anarock Research, domestic real estate funds pumped in close to $10 billion into the sector between 2015 and third quarter of 2019, of which nearly 70 per cent was in the residential segment while the remaining was across commercial, logistics, warehousing and retail.

"Most of these funds raised domestic money to fund developers," says Sharad Mittal, Director and CEO of Motilal Oswal Real Estate (MORE). These include funds raised by ASK Property, MORE, ICICI Prudential, IIFL, Piramal Group's India REIT, Reliance Capital and Aditya Birla group. The money was raised primarily from high net worth individuals, family offices and institutions and all these funds are of the 2008-14 vintage.

But 10 years from then, most real estate funds are either staring at negative returns for investors, have exited their investments at a loss or continue to extend the exit deadline hoping to close at a better valuation.

Funds in the Red

The Piramal group's Indiareit Fund Scheme IV, Indiareit Fund Scheme V and Indiareit Mumbai Redevelopment Fund have all extended their original closure dates due to the inability to exit fully from all investments. The same is true of Reliance Yield Maximiser AIF Scheme I and II.

"Exit risk is the biggest concern for us. Our returns are adversely affected if we can't exit in a timely manner," says a Mumbai-based fund manager (anonymity requested).

Real estate is a cyclical industry and if investors are not able to exit a project, due to delays or other reasons, then it gets tougher to get good returns as troughs follow peaks.

There are many factors behind why most funds have not been able to give positive returns. "One of the critical factors is the fund manager and the key team personnel," says Amit Bhagat, CEO and Managing Director, ASK Property Investment Advisors.

MORE's Mittal agrees that the team is the most important ingredient in the investing business. "Globally, too, there is a strong focus on getting the right team and retaining them for a long period. Unlike cases where there is yearly gratification, the results here are out only over a long period of seven to eight years. So, you need the same people, who had raised the capital, to deploy and monitor it continuously and see it through the exit. That's where our domestic industry has failed terribly," he says.

There are two main reasons why any professional will put in a 10-year-cycle at a fund. "One is independence and second is alignment of interest. Globally, performance fee is shared with the team, but in India, the practice is selective," adds Mittal.

Fund managers of all successful funds have seen the investments pass through all the three stages. Vipul Roongta, MD and CEO of HDFC Capital Advisors; MORE's Mittal; and ASK's Bhagat, for instance, have been around since the funds were raised. This kind of stability at the helm partly explains the 20 per cent-plus returns that these funds have generated.

This stability was, however, missing in the case of Aditya Birla Real Estate (ABRE) Fund, a six-year closed-ended fund which was due to mature in August 2016. It wound up in August 2019 after extension of the tenure by three years and gave a return of -2.66 per cent over the nine-year period. The fund was overseen by three portfolio managers during its tenure.

Shobhit Agarwal, Managing Director and CEO, Anarock Capital, says one of the key reasons behind domestic funds not being able to generate good returns is that their focus has been on residential projects. "This segment has been under severe stress due to issues like delayed or stalled units, low sales and fairly low yields, thereby making it difficult for investors to exit with any substantial gain," he says.

Over 1.3 million flats are lying unsold across the country, an inventory that will take over 40 months just to clear up.

In contrast, the commercial segment has been doing significantly well, giving positive returns to foreign investors, who invested close to $13.7 billion in Indian real estate between 2015 and the third quarter of 2019. Of this, nearly 64 per cent was in the commercial segment.

Strategy Reboot

Another major factor behind the low returns of some funds has been the choice of projects, which were either in far-flung locations with low job and growth prospects or were with developers that could not deliver. ABRE Fund I, for example, could not exit from some projects - bankrupt builder Amrapali's Noida Golf Homes is one of them. It is time that funds tweak their investment strategies in line with market demand.

Bhagat says poor partner selection and investment in long gestation projects pulls down returns. "The location should be in proximity to job growth corridors," he says.

Mittal says: "We decided to stay out of Delhi and Mumbai as these markets are frothy and speculative. We always ensured that we do business with large developers because we knew that whenever the Real Estate (Regulation and Development) Act or RERA is implemented, it would clean up the bottom 70 per cent of developers."

Besides, all the successful funds have been focused on mid-income and affordable housing. "That is what sells in India - a house between Rs 40 lakh and Rs 80 lakh - and that's where the bulk of the housing market is," adds Mittal. MORE has executed 52 transactions so far and the average selling price of its portfolio is Rs 5,200 per sq. foot.

While ASK focuses on equity structures for investment, MORE is focused on mezzanine debt structures wherein the investment carries a fixed coupon rate like debt but also has an upside earned through superior project performance. These strategies can help funds keep risks in check.

Investor Options

While fund managers are expected to invest in projects that can maximise returns, investments are always fraught with risks. And investors, who need a minimum of Rs 1 crore to participate in a real estate fund, do not have many options if a fund is unable to keep its promise.

The CEO of a wealth management service provider (anonymity requested) says he stopped recommending real estate funds about five years back due to lack of transparency in sharing data by most funds. "We observed that barring a few funds, there was no way to access critical information about portfolios and investments. It is a black box. And the sector itself was in the bubble zone with highly leveraged players. We stayed away due to opacity of many of these funds," he says.

While the funds are monitored by the Securities and Exchange Board of India (Sebi), the market regulator is yet to standardise disclosure norms for real estate funds.

Once an investment is in the loss zone, investors don't have many options. There is a provision for in-specie distribution, which means the instrument of investment at the project level can be distributed physically on a proportionate basis to investors.

Bhagat, however, says that despite this provision, the most viable alternative for investors is to extend the term of the fund. "This is needed so that the fund manager, who has an understanding of the assets and inherent risks, can find the most viable exit option in the extended period," he says.

The individual negotiation of investors with developers will only erode their bargaining power, making extension a better option.

Anarock's Agarwal says the residential segment, which is in dire need of funds, is seeing minimal investments, particularly from foreign investors. "Several delayed projects need to see completions. It has become more of a chicken and egg situation, where funds are not available to complete projects, making it difficult for investors to make an exit."

The result of all this is that investors for residential real estate funds are diminishing. "The sector is still reeling under a severe liquidity crisis. Amid low yields, most investors are shying away from it," he adds.

As per Anarock data, residential segment received only $295 million private funding in the first three quarters of 2019 as against $210 million during the corresponding period last year. Though it saw nearly 40 per cent yearly gain, it is much lower than its earlier peak levels.

In the last one year, there has not been any new major fund launch. "There is now almost no appetite among investors for real estate funds as they have not done justice to all investors," says Mittal.

With liquidity drying up for most developers and some others saddled with excessive unsold inventory, the sector now requires curated solutions. "They are not operating under stringent regulations like non-banking financial companies. The cash flows are not predictable and binary and so there is a large scope for structured credit or structured equity deals," says Mittal.

An investment strategy for real estate funds can no more be one-size-fits-all, says Bhagat. "It is about location, buying at a value that has a margin of safety, monitoring cash flows, ensuring compliance with RERA and then making a margin on it," he explains.

With increasing regulations as well as uncertainties, investors would be better off trusting their money with professional fund managers who have a proven track record rather than going by fancy brochures. And real estate funds should take a cue from their successful counterparts to realign their focus towards investing in mid-income housing projects of marquee developers at accessible locations. They must also stay involved at various stages of every project they invest in.