Will Nuvama’s PRIME plan to flip office buildings work?

Can flipping commercial real estate generate returns?
Can flipping commercial real estate generate returns?

Summary

  • The alternate investment fund will buy and sell office buildings to generate capital gains

The tide seems to have finally turned in favour of real estate, an asset class that Indian investors

prefer to have in their portfolios. Realty prices, albeit for residential real estate, are soaring across the country after the lull witnessed during the pandemic. The commercial real estate market is set to follow suit. And, Nuvama Asset Management, an arm of Nuvama Wealth Management (the company that was spun off from Edelweiss Financial Services in June), is looking to benefit from this.

Nuvama has launched a real estate investment platform through a joint venture (JV) with Cushman & Wakefield, a global commercial real estate services firm. The venture—Nuvama and Cushman & Wakefield Management—has launched the first of its funds, PRIME Offices Fund, from this real estate platform.

Graphic: Paras Jain
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Graphic: Paras Jain

This alternative investment fund (AIF) aims to employ a real estate strategy called flip—buy homes and sell them for a profit within a short period. In this case, the product involved will be office buildings and the tenure is a mere six years.

Financial experts consider this a tough proposition, given the notoriously illiquid nature of the asset class. But, Anshu Kapoor, president and head of Nuvama Asset Management, is confident that the fund will be able to exit its investments in time.

The flip factor

The fund is not a yield-product like real estate investment trusts (Reits) that aim to distribute rentals to investors, but one that looks to generate capital gains from buying and selling office buildings . The exits could be by selling the properties to Reits or other funds.

According to Kapoor, the fund will invest in a mix of completed and soon-to-be completed real estate projects. These will be around five-seven in total. The completed ones may be fully or partially leased. These will be grade ‘A’ plus assets—properties that check all the boxes in terms of meeting highest standards of construction quality, amenities, environmental impact, etc. The fund, says Kapoor, has several parameters in its internal checklist to ensure the standards are met.

The fund will also consider putting in some additional capital in the property to improve the tenant profile. “One type of property may be ready properties that are fully leased out, but there could be a possibility to enhance the building’s profile by putting in some capital," Kapoor says.

In under-construction properties, the fund will enter at late-stage, but can influence experiential part of the office such as services, parking experience, green certification, tenant profile, etc.

Kapoor says tenant profile and occupancy are key for a commercial real estate investment. “If your occupancy is not there, your IRR (internal rate of return) doesn’t come. So, we should be confident that the property has the potential to be leased out with the right tenant profile. This (the profile) has a major impact on rentals, and thereby on the property’s future value. You also need right operating management that can constantly bring down the cost and keep improving the services and profile of the building," he says. Each investee building is likely to account for 10-15% of the fund’s corpus.

Exit plan

The commercial real estate market in India is currently sluggish and valuations are depressed due to high interest rates, say real estate experts. Kapoor and his team, however, are betting that this environment will change in the next three years. 

If they are able to exit, investors will get the profits in the form of long-term capital gains (LTCG) because the holding period for long term in real estate is just two years. Since category II AIFs are pass-through vehicles, investors in the fund will also be taxed at the LTCG rate which is 20%, along with the benefit of indexation. This is what makes the fund different from existing real estate funds which are mainly credit funds that lend money to builders. 

The key question remains: can the fund make an exit within the given timeframe?

According to a senior fund manager at a real estate fund who declined to be named, there are very few buyers of commercial real estate in India because of the extremely high-ticket size. Residential real estate, by comparison, sells quickly. This gives Nuvama just a few options. One possibility is that existing Reits buy it. But there are just three Reits in India— Embassy Office Parks, Brookfield and Mindspace REIT. A second option is to do a ‘strata sale’. This involves selling bits of the office buildings to high-net worth individuals or institutions. However, the fund manager mentioned earlier said this could be difficult as well.

But there are others who beg to differ. “A fund tenure of six years should be enough if the AIF has a decent pipeline of projects lined up and can make the initial investments without much delay. The office investing environment is currently soft, and reasonably good quality assets are available. It will offer a window for opportunistic investors like Nuvama and Cushman to acquire office assets. While valuations have not heated up, assets will be available at a fair market value. Owners of Grade A front-office assets, in particular, are not distressed and won’t sell at a discount. Office leasing has picked up, but rentals are still under some pressure in certain micro-markets. But assuming the office market heats up in the next two-three years, and rentals rise, exits should not be a major issue," said an industry expert who did not want to be named.

According to industry-based estimates, the fund may be able to generate a pre-tax internal rate of return of 18-20% if all goes as planned. Since Nuvama has not yet decided the exact fee, it is difficult to determine what it could come to net of fees and charges. However, assuming a standard 2% fee, one can assume a post-fee return of 16-18%. Accounting for a 20% LTCG, this comes to a 13-14% post tax return. This also assumes that the fund is able to exit the projects in time.

To flip or not?

According to Nuvama’s presentation, office stock worth 8.3 trillion will get added by 2033. The growth in employee base in global capability centers (GCC), which is driven by IT (information technology) companies is matched by growth in GCC offices. India accounted for 50% of office space available in Asia-Pacific region. 

However, domestic investors only have 18% share in Indian office investments. Almost 82% of these investments are made by foreign entities.

The fund is aimed at high networth (HNIs) and ultra-high networth investors (UHNIs), that have the right risk-return profile to invest in such a product. As an AIF, the fund will require minimum investment of 1 crore. The fund has a six-year term and intends to start returning cash to investors from the fourth year onwards upon exiting investments.

However, the fund also has built-in provision of two extensions of one year each, which it can trigger by seeking approval from investors. In cases of extreme market conditions, the fund may need such an extension to hold certain assets longer to get better value.

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