Investing in real estate private equity funds

The Indian real estate sector has grown rapidly over the last few years, with its stakeholder profile evolving from locally-focused, privately-owned enterprises to increasingly corporatized, professional organizations funded with public capital and having multiple market and product strategies.

As a result, Indian real estate has seen a considerable flow of capital in recent years, both from foreign and domestic sources. The developer community is adapting to the requirements of joint venture arrangements with institutional capital sources by providing improved transparency and higher professional standards. The preferences of commercial space occupiers (particularly MNCs) as well as residential space buyers are driving improvements in design, engineering and construction quality.

Interestingly, the fragmented nature of the Indian developer community provides scope for Real Estate Private Equity (REPE) funds to source off-market investment opportunities and strategic relationships. This has led to Indian HNIs viewing domestic REPE funds as a preferred asset class for diversified investment. The demand for quality residential and commercial real estate in India is proven and sustainable; presenting investors at many levels with opportunities for income growth and capital appreciation (REPE is not suitable for small retail investors, since the minimum ticket size in most funds is Rs.25 lakhs).

There are many different strategies adopted by PE fund managers. The most common investment strategies include:

• Core investing
• Core plus investing
• Value added investing, and
• Opportunistic investing

REPE funds usually have a five-to-seven year life span. The period includes a two-year investment period where properties are acquired, followed by a 3-5 year holding period where active asset management is carried out. At the end of the whole period, the investors make an exit when the acquired properties are sold.

The typical expenses for such investor include:

• Annual management fees
• One-time setup fees, and
• A performance-based fee (also known as carried interest).

As in all other types of private equity investing, REPE investor have to review their financial condition, investment purpose, risk openness, time horizon, diversification and liquidity needs before making an investment decision. They also need to evaluate a number of aspects of the REPE fund itself. These are:

• Integrity, quality and stability: The integrity of the fund manager and the quality and stability of the management team are extremely important, as are the quality of financial and operating controls, corporate governance and reporting.
• Financial soundness: The investor also needs to evaluate the REPE fund’s overall capital structure, the soundness of the company assets and the sustainability of earnings. The due diligence should include its historical and prospective financial health and the potential returns on investment weighed against the perceived risk.
• Market responsiveness: The fund’s ability to source off-market deals also need to be studied
• Commitment to ROI: The capital commitment by the fund manager and ability to enhance returns with leverage should be evaluated, as also the fund’s cash distribution structure and management fee
• Asset focus and investment structure: The investor should look at the fund manager’s geographic and asset class focus, diversity of the investment structures, methodology for selection, management of JV partners and focus on asset management
• Growth potential: Finally, the growth prospects of the company and its competitive position within the industry should be evaluated.

REPE funds attempt to provide returns independent of traditional asset classes. As a result of the low correlation to traditional asset classes, investments in REPE increase the diversification of an overall portfolio. A typical REPE fund seeks both income and capital appreciation from its portfolio investments, the overall goal being to achieve a gross IRR in excess of 25%. The fund’s manager will seek to achieve returns through several means, including:

• Capital appreciation on land holdings
• Net operating income on real estate projects
• Capital gains from disposal of real estate projects
• Income and capital gains on equity stakes in real estate development companies
• Projects rental yields, and
• Proceeds from financing activities.

The objective of most of these funds is to invest opportunistically in the Indian property market in order to generate sustainable, scalable returns that fully compensate for the inherent risk in the underlying investments. Currently, the leading players in the domestic REPE industry are Kotak, ICICI, HDFC, Indiareit, ILFS, ASK, Aditya Birla, UIOF, Anand Rathi and Milestone.

Cautionary Notes
The history of REPE funds in India is still limited to the first couple of chapters, since real estate itself emerged as an independent asset class only after the Indian Government opened FDI in the real estate sector in 2005. As such, there is still not a lot of research and data available about the performance of the REPE sector in India.

Unlike mutual funds, which generally invest in publicly traded securities that are relatively liquid, REPE funds generally invest in illiquid securities of private companies. Depending on the strategy used, REPE funds will have illiquid underlying investments that may not be easily sold, and investors may have to wait for extended periods before actual redemption.

The portfolio holdings in REPE funds may be difficult to value, because they are not usually quoted or traded on any financial market or exchange.

Some REPE funds may employ leverage as a means to enhance returns, but leverage also increases risk because it magnifies negative returns if investments are poorly underwritten or executed, or if market conditions deteriorate. Other risks include the sizeable entry costs – and, as in any other equity investment, the possibility of losing significant amounts of money if not invested well.

The author, Ramesh Nair is Managing Director – West, Jones Lang LaSalle India