Mumbai: Even as equity markets have decisively come out of a long downturn, real estate continues to suffer. Residential prices in major cities are falling or, at best, stagnating. In the National Capital Region (NCR), for example, residential property prices have fallen 6.5% in the past 12 months. In Bengaluru, it’s more pronounced at 14.6%. Mumbai has seen a rise, but of just 4.5%, according to realty portal Makaan.com.
Deal volumes for brokers, too, have fallen sharply. If you bought an under-construction property in 2010-11 with a horizon of one to two years to book profits, you may be in a position where you have paid in full but don’t have possession as the secondary market has slumped. In NCR, for instance, there are locations such as Dwarka Expressway where currently the per sq. ft prices for apartments is 12-15% below their launch price in 2011.
This shows that like other assets, real estate, too, is prone to market cycles, which can alter long-term returns, for individuals and real estate funds.
Dispersed gains and the lack of an efficient market-making mechanism are inherent issues that affect long-term returns in real estate. The troubles that long-term real estate-oriented private equity (PE) funds face also makes this apparent.
What plagues real estate?
In the past couple of years, a slowing economy led to lower real estate purchases and a slow resale market. High interest rates and property prices scared away end-users. Poor sales and cash flow troubles for builders led to delay in giving possession.
“The slowdown in the number of transactions is in line with the overall sluggish market cycle. The industry is driven, to a large extent, by market sentiments. A prolonged economic slowdown led to weakening in sentiment, which led to a slowdown in demand offtake and transactions,” said Rajeev Bairathi, executive director-capital markets, Knight Frank India Pvt. Ltd.
Real estate funds struggle
Due to the granular and cumbersome nature of real estate transactions, some investors prefer to take the fund route. Real estate funds pool assets from investors and deploy it across projects. These are both domestic and off-shore (money raised by foreign investment funds or through overseas investors), and are regulated by the Securities and Exchange Board of India (Sebi).
Domestic funds primarily target high net worth investors who are considered to be aware of the risks involved.
But so far, the majority’s experience hasn’t been rewarding. “Since 2005, $15-16 billion has been invested through real estate PE funds across about 750 transactions, but exits worth only $5 billion have happened. Out of the 125 funds that were active in 2007, only 25 are active today,” said Ramesh Nair, chief operating officer-business, and international director, JLL India.
Real estate funds don’t publish returns, assets under management and other such details. But they do give newsletters and periodic updates on performance and portfolio to investors.
Some newsletters, which Mint has reviewed, clearly demonstrate the funds’ inability to deliver the expected returns within the specified timeframe. For example, some of these funds, which have been around for 8-9 years, haven’t posted the indicated 24-25% returns (on total capital invested within the specified time). (This is internal rate of return, or IRR, which is the rate at which a project grows to recover all cash flows. Higher the IRR, more attractive is the investment.) In most cases, the capital is yet to be returned though maturity is only a few months away (projected valuation for remaining projects does, however, cover capital).
The first real estate fund launched by a Mumbai-based fund management company (promoted by a conglomerate which also has a realty business) in April 2006 hasn’t been able to sell all its assets and projects; final maturity was in March 2015. This means its investors haven’t got their capital even after nine years.
“Before 2009, (real estate) funds had bought highly priced assets. Now returns projections have gone awry. Some are stuck with land parcels that are difficult to exit from or to develop. The focus has now shifted to more structured deals with a focus on protecting capital,” said Nishant Agarwal, head-investment advisory, ASK Wealth Management Pvt. Ltd.
The inability to exit has made it difficult for funds to return money. Some of the earlier funds that were structured as equity investments deployed money in projects at very high valuations; exit at a good price is now an issue.
There were other issues as well. “Only a few funds have been able to meet the target IRRs. Not only did fund managers overestimate developers’ execution skills but also underestimated time needed for regulatory approvals. For offshore funds, currency played spoilsport as the rupee depreciated against the dollar over the period,” said Nair.
It must also be noted that developers and builders themselves promoted many of these funds. “A real estate fund launched nearly nine years ago, promoted by a Gurgaon-based developer, is yet to exit even one project. The conflict of interest is clear,” said a senior executive of a private bank, who preferred not to be named. Many funds have lost money and shut shop.
Ruby Arya, vice-chairman and director, Milestone Capital Advisors Ltd, said, “Our learning has been that it’s better to partner with the established national and regional developers and focus on middle to upper-middle housing rather than luxury housing. Moreover, getting stuck in a single large project can be an issue; it’s better to focus on multiple projects with smaller ticket sizes.” Milestone Capital has so far returned 76% of the capital raised across seven real estate funds and a bullion fund which were launched between 2008 and 2012 and are ongoing.
This is not to say that there aren’t any funds that have done well. “Funds that stand out include HDFC India Real Estate Fund and ASK Property Investment Advisors,” said Nair. Investors in these have been able to earn well on the projects from which exit was possible, although all exits haven’t happened yet. “In the past two years. many large foreign funds such as Blackstone Group, KKR (Kohlberg Kravis Roberts), ADIA (Abu Dhabi Investment Authority), and APG Asset Management among others have invested or committed to investing significantly in India. This is patient capital, and not for just 4-5 years,” added Nair.
Changing the tone
Keeping the various factors in mind, most real estate funds are changing their overall strategy and approach. Earlier, a typical fund’s life was 5-7 years with a year or two of extension. But the more recent launches are seeing reduced tenors of three-and-a-half to four-and-a-half years. Also, rather than investing across cities, funds are now focusing on projects in only the top 4-5 cities, and choosing the safer route of fixed lending for smaller projects that are near completion. Returns expectations are also lower at 16-18%, from around 25% IRR expected in the initial funds.
The onus is on the investor to evaluate the credibility and execution capability of the fund manager before investing in a real estate fund. You can’t exit if the fund manager is slacking on performance; you have to remain till maturity, and even then, you may not get your money back. “Even as exits take longer than expected, investors have to continue paying management fees every year. In some cases, this gets waived but an external performance audit is essential where multiple funds get launched,” said Prateek Pant, executive director, products and services, RBS Private Banking.
Considering the poor returns and exit troubles, are real estate funds worth the risk? Fund experiences show that investing in land or a building and holding for 5, 6 or 7 years isn’t a sure shot way to make money. But for high net worth individuals, such investments makes sense for the purposes of diversification and asset allocation of risk capital.
Secondly, real estate investments can be used for regular income if the property can generate rental income. But this means steady returns over 7-10 years rather than extraordinary capital gains.
If these funds are a way for you to invest in real estate, do the due diligence beforehand. Also remember, that long-term returns aren’t a given. And you won’t be compensated by anyone for making a wrong choice or taking too much risk.