Last-mile funding is a good option for PE investors
Traditionally and typically, most investors have accessed real estate by means of direct purchases, i.e. buying, owning and trading in physical units whether land, building, apartments, shops or offices. However, as the domestic capital market evolves, real estate investors can now access indirect investment options as well.
One such route is through private equity funds. To set the context for private equity funds acting as an alternate means of gaining real estate exposure, it would be appropriate to lay out a preamble. One, brick and mortar real estate is a high-value investment and not divisible into smaller tickets. Given the current market where prices have been running up consistently, the relative “ask” for a typical unit translates into a sizeable cheque. Also, real estate assets tend to be illiquid and to believe that you will be able to monetize quickly would be wrong. While direct real estate serves as a storehouse of value, the realization of the value is time bound (and also involves a degree of transaction cost in the form of stamp duty and taxes). These limitations have made real estate funds an attractive option. But you must remember that you will still be investing in the same asset and hence, the risks inherent to buying real estate such as failure to complete, devaluation of property price and so on will remain.
Before we get into the details, here is a quick look at the platform these funds operate through. The Securities and Exchange Board of India has recently prescribed guidelines for alternate investment funds that replace the earlier venture capital funds guidelines for enabling indirect investments into real estate. Simply put, this enables investors to commit smaller amounts (minimum Rs.1 crore) to a “fund” vehicle that has both a stated purpose and strategy and is “sponsored” by a fund manager that has a track record in delivering returns across earlier funds.
Investors can, therefore, self-select and gain exposure based on where they believe their money will be earning the most appropriate risk-adjusted returns. Moreover, the amount that an investor commits is “drawn down” over a communicated investment period, which helps an investor as the disbursement takes place in tranches. The money is deployed across several transactions reducing the risk of concentration and creating a diversified portfolio within the fund vehicle itself. The returns are earned as the manager deploys, monitors and then finally exits the various investments over the life of the fund.
Much like relying on a developer when booking an under-construction project, investing in a private equity fund also assumes a certain degree of reliance on the fund manager. How should one then approach this investing decision? An investor must choose to invest the capital with established fund managers in the industry. Ideally, the fund manager you choose should have some of the following attributes—multiple funds under management, a track record of successfully exiting previous investments at an appropriate return, a team structure to facilitate origination and active asset management of investments, a dedicated investor relations function, and general reputation and corporate governance. Quality is important and a lot depends on what the fund manager has delivered so far.
Unlike mutual funds where performance is in the public domain, real estate funds don’t have to publish performance, so you should try and speak to existing investors about returns they have made.
Investment opportunities and structures carry increasing complexity, which makes execution difficult for individual investors. Investing with a manager means that the due diligence process is taken care of for each investment and also, the negotiations are better dealt with between a developer and a manager. Moreover, its your fund manager’s job to track the progress of a property that is under development to ensure it gets delivered on time, which is hard to do if you invest independently. The caveat here is that the presence of a manager will not ensure safety of the investment, which means delays in project delivery, lower capital appreciation are still potential outcomes. To protect against these eventualities, more often than not private equity funds invest by means of “structured” instruments to balance risk and reward. Investing in real estate through this route is for those investors looking for medium- to long-term returns without the hassle of having to go around looking at properties, and also for those who want a relatively lower ticket size.
Let’s now move to talking about the market that exists today. Many successful developers are faced with operating in an environment where capital is scarce. At times the market environment turns sour and the lifeline for developers—funding—gets expensive. Moreover, if the end-user demand slows down at the same time and the developers’ natural funding source is not working efficiently, timelines can get stretched. Due to the excesses of the past, banks have closed their books for acquisition funding, capital markets are not supportive and external commercial borrowings are heavily regulated. The developer, therefore, is starved of flexible growth capital to both continue and scale up his business. It is important to realize that a rational and well-intentioned developer has no interest in delaying delivery; units get sold at an established price and extended timelines merely increase the risk of escalated costs while at the same time postponing the developer’s milestone-based cash flows and ultimate realization of profits.
The issue then is not one of ultimate delivery but the ability to complete, for which funding is required. It is exactly this last-mile funding that presents perhaps the best buying opportunity for private equity participation, mostly from high net worth individuals though given the high entry level into such funds.
Khushru Jijina is managing director, Piramal Fund Management Pvt. Ltd.