Real Estate Defined
The term real estate is defined as land, including the air above it and the ground below it and any buildings or structures on it that are intended to be of a permanent nature. It covers residential housing, commercial offices, trading spaces such as theatres, hotels and restaurants, retail outlets, industrial building such as factories and government buildings. real Estate involves the purchase, sale and development of land, residential and non-residential buildings. the main players in the real estate market are the landlords, developers, builders, real estate agents, tenants, buyers, etc. the activities of the real estate sector encompass the housing and construction sectors also.
Real estate fund
Real estate fund is a fund that buys, develops, manages and shells real estate assets and allows various participants small and large to invest in a professionally managed portfolio of real estate properties. This concept is still in its infancy in India as it is ion Much of Asia. But like most other novel financial instruments, there should be no problems for this new concept to be accepted. Real estate funds are one of the hottest things in the developed world as an investment tool. They have become a rage in the developed world mainly because it does not have any correlation with the movements in the equity markets and thus providing diversification benefits to the investors along with stable returns.
Reasons for investing in Real Estate Sector in India via Mutual Funds
There are many reasons why one should invest in real estate, the following are the reasons:
To be part of the India story since the real estate prices generally have a correlation with the country’s growth rate.
Real estate investment provides the investor a chance of portfolio diversification and thereby reducing the risk associated with investing in single asset class.
Monthly Correlation of REIT Total Returns and Other types of Investments
Real Estate generally provides for steady returns. This is shown by the graph given below which shows the performance of Dow Jones Industrial Average (DJIA) an equity index and Dow Jones REIT Index (DJREIT) a real estate index over the period of 2000 to 2004.
Real estate investments can provide for an effective inflation hedge as investing in real estate involves investing in a real asset and thus the property prices tend to increase with increase in inflation and also the rent or lease payments can be increased with increase in inflation.
Protection from legalities: With legal expertise in the hands of REMF, it can save investors from legal hassles, such as duties, documentation, etc. and going through the nitty-gritty of real estate.
Affordability: Individual investor may not have the financial strength to invest in real estate properties. REMF will allow investor to invest in real estate property by holding units of REMF.
Liquidity: When an investor invests directly in an individual property, buying and selling is a complex, time-consuming and lengthy process. By contrast, his invest in a real estate mutual funds can be brought or sold just like any other mutual fund. Because many REMF shares would have traded on the major stock exchanges and they would be more readily converted into cash than direct investments in properties.
The introduction of Real Estate Investment Schemes in Indian seems to be pliable option, which would result in increase in rental housing generation.
In India these schemes would provide enough support to the local corporations and municipalities through the payment of the house tax and water tax.
Benefits to the real estate sector
Flow of funds in the sector
Sector will become more organized
REIS will also help to tap the investments from larger section of Indian Market
More credibility to the sector
Availability of foreign investments
Economic and social benefits
Growth of real estate sector can boost the GDP
Opportunities of employment
Growth of ancillary industries
Help in the process of slum development
Availability of funds to the government for infrastructure development
It can also help in improving the penetration of mutual funds in India. There is a general acceptance in India for investment in Real Estate
Help in development of tourism
Funds for the development of B & C grade cities
Now since we are sure of the attractiveness of the real estate markets let us now look at the framework under which a real estate mutual fund (REMF) is likely to operate.
Investor is one who has an affinity towards realty investments. Investor profile can range from Insurance Companies, Corporate bodies to retail investors. The investors are the source of funds in the whole framework.
Real Estate Mutual Fund or the REMF acts as a conduit or a link between an investor and real estate and helps manage the funds of the investors and invest them in the real estate sector.
Investments: REMF can invest in a developed property, and as the value appreciates over a period of time, it can offload its investment to make capital gains. It also has an option of developing the property on its own and then selling it at an appropriate time ensure adequate returns. Furthermore, it can realize regular stream of returns through leasing, financing to developers and mortgage backed financing. The investment avenues are the users of funds in the whole framework.
The functions, which REMF performs, includes entering into real estate transactions on behalf of its investors, performing valuations of the properties either internally or through external agencies. The REMF is also responsible in maintaining liquidity in case of any redemption pressures or to fulfil any financial obligations or to undertake trades. The REMF is also responsible for maintaining the properties, which it has bought or are under its control.
The regulatory bodies involved in the working of the REMF include the finance ministry, the SEBI, the RBI and any other body as per the rules formed by the concerned authority.
After understanding the framework under which one can expect a potential Real Estate Fund to work we now need to determine the structure under which such a fund might follow.
Internationally there are two structures, which real estate funds follow. These two structures are:
Real Estate Investment Trust (REIT) structured followed in America and Canada.
Pooled Managed Vehicle (PMV) or the Mutual Fund Structure Followed in United Kingdom.
But these structures are explained below:
REIT Structure: REIT is a corporate structure, which collects money from the investors and invests in real estate assets to earn money in the form of rentals and lease. It also earns money on the profit from the sale of any assets. In the USA, by law REITs need to give at least 90% of their net income as dividend to its investors every year. An REIT is a closed ended fund, which does not accept fresh investment after its Public Offering, is over and also does not allow everyday redemption. To provide for liquidity to its investors it gets itself listed to an exchange and the REIT certificates are then freely traded on the exchange. To fund fresh investment REIT can raise debt from banks and financial institutions just like any other corporate.
PMV or mutual fund structure: In this structure, which is prevalent in UK, the funds is in the form of a trust and operates just like an open ended mutual fund. Such funds are not allowed to use leverage in the form of institutional loans or bank loans. The fact that they are open ended helps them provide liquidity to the investors as redemptions are possible but at the time of the heavy redemption pressure they have the power to suspend redemption till the next valuation of properties it holds takes place. Since it provides for liquidity there is no need to list them on exchanges and that’s why most of them are not listed on the exchanges.
Thus we see that there are three fundamental differences between these two structures, which are listed in the table given below:
REIT Structure (USA)
Mutual fund structure (UK)
Close ended fund
Open ended fund
Does not use leverage
Are listed on the exchanges
Not listed on the exchanges
Real estate mutual fund in India
There is a hot discussion floating in India about which model the Indian market should adopt. Should it adopt the Us structure or the UK structure or follow an altogether new structure for a fund, which invest in Real Estate. There are proponents of close ended mutual fund and of open ended mutual funds.
The proponents of close ended mutual funds argue that the Indian real estate markets is highly illiquid and require long term investment horizon which might create a problem for open ended mutual funds are there wont be enough liquidity to enable smooth redemption as in the case with equity investments.
The proponents of open ended mutual funds state that the fund is not project specific and thus it cannot be a close ended fund and they feel that it is easier for an open ended fund to get funds for investing in new properties in the absence of ability to raise debt, which could be dangerous for the investors. They also feel that the problem of heavy redemption can be over come by the ability of the fund to suspend redemption till the next valuation date.
A study conducted by the sub-committee called Satwalekar Committee constituted by AMFI to appraise SEBI about the product studied the two structures and recommended using the open ended mutual fund route which is prevalent in UK. This structure they noted needed certain modification based on the prevailing market condition in India.
Real estate index
In USA there are funds, which invest in different REITs based on certain Index, which are formed as a benchmark. US has a few of these indices based on the REIT prices in the stock exchanges in which these REITs are listed. The index weightage of those REITs is based on the total market capitalization of each REITs. Some of the examples of such indices are Dow Jones Composite all REIT index, Morgan Stanley REIT index, S &P/TSX Capped REIT Index.
The mutual funds, which invest, based on this strategy aim to match these benchmark indices if not outperform them. Such indices are non-existent in the UK market because there are no listed Real Estate Funds. this might also be the case in India few years from now.
Investment Avenues for the Fund
It is important for us to know what are the investment avenues, which an Indian fund can look at while investing in real estate assets. Some of the avenues are given below:
Equity Shares / Bonds / Debentures of the listed companies which deal in properties and also undertake property development. however, at present, in India there are very few such companies, which are listed.
Mortgage backed securities i.e. the securitisation of housing loans. At present, these are not yet available. However, one expects that this avenue will be open once the bill seeking amendment is passed in the next budget session.
The real estate investment schemes can undertake or finance the properties i.e. ready buildings with a view to lease where the lease rentals will be a regular income to such mutual funds, which can then be distributed as dividends to the investors in the fund.
Direct estate project finance, construction finance, purchase / option to purchase of buildings under construction with a view to sell it again; investment in debt securities issued by development and construction companies (placed privately).
Along with other avenues a part of the funds assets should be invested in call and money market instruments to ensure required liquidity.
Risk associated with property investments
There are certain risks associated with investing in Real Estate, given below:
Risk because of high maintenance burden
Risk due to high government controls
Risk due to real estate cycles
Risk due to legal hurdles and complexity
Risk due to high transaction cost thus forming barriers to entry and exit.
Risk due to lack of information.
Some of these risks are natural and inevitable but a lot of these risks can be controlled to some extent. A real estate mutual fund should work in such a way that the overall risk is optimized and matched to the investors needs. Regulations in this direction will go a long way in reducing the risk levels.
Risk management would be addressed in the following way:
Amendment in SEBI – As recommended by the Satwalekar Committee, a amendment in SEBI regulations is suggested enabling the SEBI to regulate the establishment and functioning of the real estate mutual fund schemes with all the existing regulations applicable to such mutual funds pertaining to net worth of AMC; existing fee structure; initial launch expenses restricted at 6%; maximum limit of expenses; etc. as already provided in the mutual fund regulations.
Investment restriction – That present regulations have a restriction on investment where any investment in one corporate should be restricted upto 10% of the corpus and similarly, any investment in the properties and owned and managed by sponsor should be restricted upto 25% of the corpus.
Restriction based on project, Promoter Group and geographical area – The Satwalekar Committee has recommended investment restrictions based on a project, a promoter group and a geographical area. With these restrictions appropriate to mitigate the concentration risk of the investment portfolio of real estate scheme. Details of the investment restrictions proposed in the report of the Satwalekar Committee can be found on Page 24 of that report.
Valuation – At present, we have registered valuers as approved by government of India / Income tax departments / insurance regulatory development authority. Thus it becomes imperative for SEBI to use them and approve these registered valuers for the purpose of valuing properties held by real estate investment schemes. the funds should appoint two valuers to value the properties and if the difference in the valued price is more than 10% then a third valuers should be appointed and his valuation should be considered.
Legal aspects that need change
Along with the regulatory issues, there are some legal issues that are caused by our antiquated laws and which will hamper the smooth and profitable functioning of the real estate mutual funds. thus these laws need to be reformed since they also increase the risk level of a real estate investment. Some of these laws and proposed changes are given below:
Stamp Duty – This a state subject and unless the central government decides to make it uniform, it will be difficult and time consuming to expect any changes in the stamp duty framework. It is recommended that either there should be no stamp duty for a SEBI registered REMF or even if a minor stamp duty is imposed it should take the form of value added stamp duty structure and thus double stamp duty will be avoided in case of frequent transfers of the properties.
Property taxes – This is a state/city subject. It is recommended that the relevant authorities provide exemption from annual property taxes to real estate investment schemes. This would help real estate schemes to provide better returns to investors.
Records – A significant issue in dealing with properties is the custody of title and paper form of transaction. It would be very helpful to the REMF if all the property records are computerised and the properties be transacted in a dematerialised format, exactly how the securities are traded right now.
Rent control act – The provisions of the rent control act have been amended in some of the states. since, several states continue with the ancient rent control provisions and it is believed that the rent control act is one of the main reasons why people are not very enthusiastic in building a house and giving it on rent.
Urban land ceilings and regulations act – This act lays a ceiling (generally around 500 to 2000 square meter) on the land which a person can hold in an urban area, the access land is either to be handed over to a competent authority or is to be developed by the owner for a specified purposes only. Here a person stands for an individual, corporation, firm, association or body of individuals etc. thus if the REIT has to come to any meaningful existence this law has to be scrapped.
Another serious malaise affecting investment in the real estate sector and housing development in the tardy process of planning approvals. A system of deemed approvals for all planning permissions by registered architects operating on the basis of self-regulation much like chartered accountants do, would enormously speed up the entire plan approval process. This will ensure that far larger quantum of housing stock is supplied every year, at more reasonable prices than is the case presently.
All these issues are major hindrance to the real estate investment schemes in India. A country like India having ample of land and set of huge investors requires attention on these problems. A major step in these directions will benefit the society.
India has very few listed companies that operate in the real estate sector in Indian context for the success of these schemes it needs the participation and willingness on the part of reputed construction groups as well as asset management companies. this combination of professional fund management and expertise in real estate will be an appropriate model for Indian market.
It can be concluded that there is a tremendous potential for a real estate mutual fund to be introduced in India. The proposed fund will mainly follow the structure already being followed in UK, which is that of a mutual fund with some changes. Though the demand for such a fund is huge there are lot of concerns, which are still to be answered in terms of the antiquated laws, which govern the real estate business, the existing laws of SEBI and regulatory mechanisms to be used. If these concerns are taken care off by the government then the proposed real estate funds are poised to have an exponential growth in India and thereby lead to greater economic growth and overall progress of the country. mutual fund houses should take an active interest in such a fund, as it can be a big money earner for it. but introducing such a fund and ensuring stable returns to the investors will be only possible after the regulations are more favourable for real estate mutual funds.
C.B. Richard Ellis
The Economic Times
Value investing in real estate by Gary W Eldred
Investing in REIT’s by Ralph L Block
Real Estate Investment Trusts by Richard T Garrigan, John F Parsons