It's slow going for real estate funds

The housing start-up index, which is now at a pilot stage, shows that new housing units in cities such as Kolkata, Chennai and Bangalore are showing a declining trend. A January 2014 consumer outlook index by ZyFin Research shows that only consumers in Bangalore and Hyderabad are optimistic about purchasing real estate. However, despite this stagnation or fall in demand, many real estate funds, both in residential and commercial properties, are entering the market.

The latest among these is real estate services company Jones Lang LaSalle India, which has raised 160.75 crore through its Segregated Funds Group for Residential Opportunities Fund-I. The fund will invest in residential projects mainly in tier-I cities.

For investors, according to Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, a minimum of 1 crore investment is required. This makes the instrument suitable only for high net worth individuals and institutional investors. But it is worth looking at the progress they have made in India despite a depressed real estate market.

The design

Real estate funds are typically closed-end funds that invest pooled funds as per the mandate for a given period called the life of the fund. “They invest in residential developments, or commercial assets if the fund has a mandate, to do yield transactions on behalf of investors, and then undertake active asset management and monitoring to create and realize value,” said Khushru Jijina, managing director, Indiareit, Piramal Enterprises Ltd.

Investors bear two types of costs—management fee and performance fee. Returns are also of two types: rental return (usually in commercial real estate funds, which have a mandate for yield transaction) and capital returns (both in residential and commercial funds; paid to investors on exiting the fund when the fund life ends).

“The funds that were launched initially (2005-06) have not seen the kind of returns that were expected,” said Chintan Patel, director, real estate and hospitality practice, EY, a consultancy firm.

Taxation of the returns is also not clear. “There is some litigation and further clarity is required in terms of whether these returns should be taxed in the hands of the fund or in the hands of the investors,” said Gautam Nayak, a Mumbai-based chartered accountant. The method of taxation is usually mentioned in fund documents. Income in the investors’ hands will be treated in the same manner as it accrues to the fund. So, a rental yield fund’s periodic returns will be deemed to be income from rent, and once the fund sells the property, capital gains tax will be applicable.

Real estate funds are still new in India and do not have much of a track record. However, the space has seen one full cycle of fund life and investors can validate a fund manager’s performance before putting in money again. “As most funds raised back in 2006 are not performing well, there has been dislocation in the fund manager space. Only a handful of managers have performed. But then only those who have been successful are able to return to raise further funds,” added Jijina.

These funds also carry risks associated with markets, regulations, and timing, among others. “Keep things such as return history, investment mandate, where is the fund deployed, etc., in mind,” said Patel. Investors should also note that being closed-end in nature, one cannot pull out money mid-way from the fund. So, one’s investment horizon should match the life of a fund.

Investors should also take into account the quality of the sponsor and the current market environment.

Staying afloat

Real estate funds have evolved in the recent years from having complete equity exposure earlier to structured product investments. “Of late, most fund managers have been following a ‘mezzanine’ strategy—investing on a structured basis for a preferred internal rate of returns even as downside risks are capped through various mechanisms such as escrow accounts, negative consent rights, put options, and others,” said Jijina.

According to Patel, these structured products have seen point-to-point returns from mid-teens to 20%-plus.

Timing is a concern as at the time of exit, capital returns may not be high. However, Mridul Upreti, chief executive officer, Segregated Funds Group, believes that with bank non-performing assets going up, many distressed assets that can give high risk-adjusted returns may be available.

Once real estate investment trusts (Reits) are introduced, even smaller investors can participate. But for now, these funds are for high net worth individuals with a high risk appetite.