Indian real estate: Busy work on the foundations of a mighty edifice

A guide to foreign direct investment in India

Buyer beware!

The potential in India’s largely unexplored, underfunded and undercapitalized real estate sector is staggering. Mere statistics scarcely do it justice. In 2006, Merrill Lynch predicted that the property market would balloon in value to $90 billion by 2015, from $15 billion in 2005. The country’s seven largest real estate firms plan to construct 320 million square feet of residential, commercial and retail space over the next three years. This year, many of those firms went public. In the year to end-August 2007, seven Indian firms went public on the Bombay Stock Exchange, raising Rs133 billion ($3.5 billion), including a Rs92 billion domestic initial public offering by the country’s biggest real estate firm, DLF.

Foreign and domestic investors meanwhile continue to grab any real estate-related Indian stock they can lay their hands on: most listed Indian property firms’ securities have soared in value (partly boosted by the domestic Sensex market’s recent unparalleled bull run) by more than 40% in 2007 year-to-date. DLF’s Mumbai-listed stock alone has rose 47% in the two months to November 11.

Three big changes have shaken up the property market over the past couple of years. The first has been the somewhat surprising ability of leading domestic players, notably DLF and its Delhi neighbour, Unitech, to rapidly become pan-national industry players with group valuations (at least in DLF’s case) far exceeding even the market caps of Hong Kong’s largest industry players.

Next there is the emergence of several smaller domestic firms, such as Mumbai’s Lodha Group, or non-industry players that saw the property trend early and simply bought a lot of land. One example is Mumbai-based financial services firm Indiabulls, which in the space of three years went from nowhere to become India’s third-largest property firm, with a land bank of 4,000 acres, much of it prime land in the centre of its native city.

Gagan Banga, the Mumbai-based chief executive of Indiabulls Credit Services, says that people were initially scared of investing in property in India: the idea of taking on debt to buy land, or taking a risk on something, was even two years ago still a novel concept. "That’s the nature of India," says Banga. "People are scared of making big bets. We decided that instead of making a tiny bet of $10 million, we would buy $120 million-worth of land."

The final influence on Indian real estate has been foreign capital. Private equity firms, foreign institutional investors (FIIs) and pure India-focused real estate funds have pumped billions of dollars into India in recent years, and few investors or company owners in India begrudge the attention and the capital.

"People are scared of making big bets. We decided that instead of making a tiny bet of $10 million, we would buy $120 million-worth of land" Gagan Banga, Indiabulls Credit Services

Sameer Gehlaut, the chairman and chief executive of Indiabulls Financial Services, which is 45% owned by FIIs, says that overseas investors are his preferred financial partners. "Foreign investors are best," Gehlaut says. "We prefer them as good long-term shareholders. Their participation in the market is a win-win for everyone." In its 2006 study entitled India: A Real Estate Investment Future, global real estate services firm Jones Lang LaSalle noted that recent regulatory changes, the opening up of the market to foreign investors, the growth of private equity and the rising demand for higher-quality real estate were "transforming Indian real estate into a more transparent and accessible market". It’s not all roses, of course. Indian property is not just a new asset class but a new everything. Even long-in-the-tooth Indian real estate developers are largely in the dark – about how much they should build, what they should be building, and where it should be built. Vincent Lottefier, the chief executive of real estate services firm Jones Lang LaSalle Meghraj, says that Indian property companies haven’t yet reached the phase of maturity where they have decided to be commercial real estate specialists, or to build only high-end flats or shopping malls. "They’re trying to be across everything," he says.

Most high-quality modern property in India is also anything but real. Most construction sites are just that – either half-developed projects or unbroken land. That in turn makes any projections on Indian property by both domestic and foreign investors exactly that – projections. "No one is making money yet," says Lottefier, "they’re all spending it. In most cases they won’t see any yield coming in until 2009 and beyond." And while it would foolhardy to be anything but long-term bullish on an industry crying out for capital in an economy growing at just shy of 10% a year, there are overproduction concerns already, notably in the retail sector, with thousands of malls being cranked out nationwide without regard to whether they are needed or correctly positioned.

"It’s a very challenging environment, and there’s an enormous amount of work that needs to placed. Things are improving, and faster than we expected but it’s still a bit of a problem" Vincent Lottefier, Jones Lang LaSalle Meghraj

Transparency also remains a big issue. Foreign investors have removed only a small slice of the market’s opacity. As Lottefier notes: "It’s a very challenging environment, and there’s an enormous amount of work that needs to placed. Things are improving, and they are improving faster than we expected but it’s still a bit of a problem. There’s a lack of reliable data, uniformity or standards. What is determined as being a square foot, or net growth, what does ‘management’ mean? We don’t know – we never see open books." Yet having been denied capital for so long, India’s real estate firms are trying to make up for lost time. Emaar MGF, a joint venture between Emaar Properties PJSC of Dubai and MGF Development of India, is planning a Rs60 billion ($1.5 billion) Bombay IPO, with Pune-based Kolte Patil Developers set to launch its own Rs250 million initial stock sale. Other IPOs are expected in 2008 from the likes of Bangalore-based Empire Land Construction and the Lodha Group.

Having been (thus far) denied the right to Reit, Indian real estate firms are seeking to launch real estate investment trusts abroad. Ascendas in August listed its India Trust in Singapore, the first listed India-related Reit anywhere in the world. DLF and Unitech, the two Delhi-based market leaders, are both planning to launch Reits or Reit-like structures in Singapore in 2008. India’s finance ministry, which oversees the development of the Reit market, doesn’t like seeing the market develop overseas, outside its jurisdiction, and is expected to set up a new body to regulate the expected new domestic market, in 2008.

The need for capital to build India is staggering. Property and working infrastructure go hand in hand – and India’s government plans to channel up to $400 billion into developing its ramshackle physical infrastructure over the next five years. Into this mix sits, rather uneasily, the rather controversial issue of special economic zones (SEZs). Essentially huge new cities, some residential, some commercial (mostly IT-focused), some industrial (notably electronics, chemicals, textiles or refining), India has approved the construction of 74 SEZs, to be built over the next decade or more. Each will require billions of dollars of capital; each is likely to be at least partly funded by foreign investors, particularly in the private equity sphere.

Yet despite its thirst for capital, India’s property market remains remarkably underdeveloped when it comes to the most basic debt and equity issuances. A very basic market for direct capital-raising exists but more developed financial instruments, such as Reits, property derivatives and the now rather out-of-favour commercial mortgage-backed securities are non-existent, hampering capital flows and the development of the market. Nonetheless, foreign investors are increasingly muscling into India’s property market, bringing with them new financing techniques, greater transparency and better management.

Many foreign investors have taken the private equity route, buying real estate alongside a clutch of domestic and overseas partners. Naveen Jain, a real estate analyst at Mumbai-based brokerage Emkay, says returns on equity for foreign private equity firms can be compellingly high. "Projects do move a little slowly [in India]," she says, "but as returns go in the private equity space they are phenomenally high, so once they take off they can be 60% to 70%."

Another way in is through foreign investors (usually investment banks) providing loans as external commercial borrowing to Indian landowners, which at a later stage gets converted into equity. Goldman Sachs, Morgan Stanley and Lehman Brothers have each taken this approach, which acts as a form of debenture and enables overseas investors to take direct parcels of Indian land, in the form of debt, which is later on converted into pre-IPO equity. It’s another way of getting around the onerous restrictions placed on the direct foreign ownership of Indian land (see box).

Another basic route into India is via simple equity purchases as an FII. About $18 billion-worth of FII capital flowed into India in the first 10 months of 2007, much of which swept into the real estate sector. It’s notable that FIIs hold on average 15% of the listed equity of India-listed real estate firms, compared with an average of just 2% FII holding at other domestically listed corporates. At two firms, IBRL and Mumbai-based Phoenix Mills, FIIs hold 45% and 22.6% respectively. The real estate arm of rising Indian financial services firm Indiabulls is also 45% owned by FIIs, led by such banks as HSBC and Deutsche Bank.

Still foreign capital continues to surge into the market. Over the past couple of years, foreign investors have raised funds dedicated to Indian property investments, among them Tishman Speyer, Vornado Realty, GE Capital, Warburg Pincus and Apollo Real estate.

Over the next four or five years foreign buyout and investment banking firms including UBS, HSBC, Goldman Sachs, Blackstone Group and Carlyle, will pump a combined $5 billion of capital into Indian property via new, pure real estate-focused funds. Even that pales in comparison with ICICI’s $5 billion fund, the second one of its kind launched by the privately- owned Indian bank to invest solely in local property. That fund, launched in late 2007, will be fully invested by 2012.

Not that the government is necessarily joyous at the sudden spike in foreign ownership of Indian land. This is a contentious issue in a still-socialist country in which 75% of the population scratches a living directly from the land. India’s key financial regulators – the finance ministry, the Reserve Bank of India (RBI) and the Securities and Exchange Board of India – recently moved to scrap the divisive use of participatory notes (derivative products used largely by foreign hedge funds to buy underlying Indian shares from outside the market). Likewise, many bankers and analysts believe that the RBI will move to halt, or even scale back, however temporarily, foreign investment in real estate, as and when it sees fit. "There’s been a lot of talk about this recently," says Emkay’s Jain. "The government isn’t happy with the flood of foreign money coming into real estate, and it isn’t keen on the recent price rises. It may cut foreign investors off soon – there may be temporary restrictions."

Yet such grumblings from a government irritated at its own inability to control an inrush of foreign capital are relatively insignificant. The country’s real estate industry has fast become one of the world’s most vibrant property markets. As it grows, it will force regulators to increasingly open up the market to more domestic and foreign capital. That in turn will create a pressing need for new financial instruments, notably the creation of a working Reit market. India’s real estate story has only just started, but it has already come a long way.