Practising Law Institute - Outlook on India 2010:
Delivering on the Promise in Turbulent Times
Real Estate
Mohit Saraf
Senior Partner
Luthra & Luthra Law Offices
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Introduction to the Real Estate Market in India

Since liberalisation in 2002, real estate has been one of the sectors
which has witnessed the most action: it has been in the news
during periods of boom and crisis.

The fluctuating government policy with respect to investment in
this sector is often a useful index of changing attitudes towards the
flow of foreign capital into India.

It has seen many ups and downs over the years, and it was affected
by the recent worldwide economic crisis.

However, the last few months have seen the sector rebound
strongly, with FDI inflows totaling US$ 2.38 billion for the first
nine months of FY 2009-2010.
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Scope of Presentation

This presentation seeks to:
◦ Highlight the emerging trends in real estate.
◦ Discuss the different modes of real estate
financing in India (other than through capital
markets).
◦ Analyse the risk perception regarding real estate
investments in India.
◦ Discuss future trends and the road ahead.
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Effect of the Economic Crisis on the Indian
Real Estate Sector

The recent economic crisis has resulted in a shift in the
way real estate companies in India do business.

During the crisis, the value of real estate assets declined, and
the lack of consumer demand saw fewer upfront
payments, which has been a traditional source of cash
flow to finance construction and development in the
housing sector.

Further, the significant decline in the risk appetite of
investors in the months following the 2008 global financial
crisis, clubbed with the sector’s lack of transparency and
increased risk of oversupply, significantly diminished capital
flows as investors became even more cautious.
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Where is the Primary Demand for Real
Estate?

This has resulted in a shift in emphasis away from the luxury
segment, which saw a steep drop in demand during the
financial crisis.

Now, the emphasis is shifting to the affordable housing
segment, which caters to people in the lower- and midincome category, and consists of homes in the range of
300-1200 sq.ft. Demand is estimated to be as high as 12
million units.

Simultaneously, developers are focusing on Tier-II and TierIII cities, where land is more easily available and cheaper.
There is also demand for affordable housing in these cities,
whose property markets are relatively unexplored.
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Overview of Foreign Direct Investment

FDI in an Indian company is governed by the
Reserve Bank of India under the Foreign Exchange
Management Act, 1999 (“FEMA”) read with the
regulations issued by the Department of Industrial
Policy and Promotion (“DIPP”) from time to time.

As per the extant FDI Policy, FDI is prohibited in
real estate business, construction of farm
houses
and
trading
in
Transferable
Development Rights (“TDRs”).
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Overview of Foreign Direct Investment

‘Real estate business’ means:
◦ Dealing in land and immovable
property with a view to earning profit or
earning income therefrom or trading in
TDRs;
◦ Does not include development of
townships,
construction
of
residential/commercial premises, roads or
bridges, educational institutions, recreational
facilities, city and regional level infrastructure,
townships.
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Overview of Foreign Direct Investment

Under Press Note 2 (2005 Series), FDI in townships, housing,
built-up infrastructure and construction development
projects including, inter alia, commercial premises, resorts and city
and regional level infrastructure, is permitted up to 100% under
the automatic route, subject to the conditions that:
◦ Minimum area to be developed is 10 hectares for serviced housing
plots and 50,000 square metres in case of construction development
projects.
◦ Minimum capitalization of US$10 million/ US$5 million as the case
may be, to be brought in within six months of commencement of
business.
◦ Except with prior approval, original investment cannot be
repatriated within 3 years from minimum capitalization.
◦ Minimum of 50% of the project to be developed within five years of
obtaining clearances.
◦ Sale of undeveloped plots is prohibited.
Challenges Related to FDI in Real
Estate

Press Note 2 is not applicable with regard to
FDI in Hotel, Special Economic Zones
(“SEZs”) and Industrial Parks, subject to
certain conditions.

Investment by NRIs in specific sectors is
permitted without having to conform to the
stipulations of Press Note 2.
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Instances of Regulatory Risk – Lock-in

2009 saw a fair amount of confusion regarding the three-year lock-in
under Press Note 2 on the ‘original investment.’

Earlier understanding was that lock-in applied only to the minimum
capitalization amount of US$10 / 5 million.

Clarified by the DIPP in July of 2009 that the three-year lock-in
applies to the entire investment brought in as FDI.

Issued after domestic real estate firms sought a clarification, at the
height of the financial crisis when some foreign investors were
seeking to pull out.

This clarification took foreign investors by surprise, and although it is
possible that a crisis was averted, this event can be seen as
demonstrative of regulatory risk.
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Instances of Regulatory Risk – Portfolio
Investment in Real Estate

Another issue is the applicability of FDI Policy norms
to primary investments in listed real estate
companies by Foreign Institutional Investors (“FIIs”)
registered with the Securities and Exchange Board of
India (“SEBI”) under the Portfolio Investment Scheme
(“PIS”) route.

FDI is prohibited for real estate business (Press Note 2
Non Compliant Projects).

Under the PIS route, which is governed by FEMA
regulations, FIIs registered with SEBI are permitted to
purchase listed securities on the secondary market, as
well as on a primary basis through offer/ private
placement.
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Instances of Regulatory Risk – Portfolio
Investment in Real Estate

Underlying philosophy of PIS is that it is a separate route available
to financial investors for making portfolio investment in listed
companies, as distinguished from FDI route. Therefore, it is argued
that even primary investments by FIIs in listed real estate
companies should not be restricted by the requirements of FDI
Policy under Press Note 2 .

In practice, the authorities have taken a view that FII
participation in primary issuance of real estate companies
is regarded as FDI and therefore subject to Press Note 2
requirements, save in the limited cases of IPOs and QIPs.

Union Cabinet in January 2008 stated that a clarification would
soon be issued, exempting FII investments through PIS route from
Press Note 2. However, no such clarification has been issued to
date.
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Other Investment Structures

Due to factors including systemic risks of the sector and
reduced risk appetite of investors, there has been a shift
from pure equity deals to mezzanine deals.

Mezzanine deals attempt to replicate debt
structures in the form of an equity deal. This particular
funding strategy thrived especially because other forms
of capital raising became unobtainable and cost
prohibitive.

They typically involve providing the investor with a
minimum rate of return (within the applicable limit of
300 bps over the SBI PLR), coupled with benefits such as
sharing of excess return, or equity upside through a
buy-back.
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Other Investment Structures

However, there is the risk of such an arrangement being
treated as an ECB.

This risk is highlighted by the policy objective behind the past
decision of the Government and the RBI to only regard such
quasi equity instruments which are fully and mandatorily
convertible in to equity within a specified time as FDI
instruments.

All other forms of preference shares and debentures
are considered as debt and hence governed by the
applicable guidelines on external commercial borrowing.
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REITs and REMFs

Despite experiencing a period of robust growth, the Indian real
estate sector is yet to experience much of an increase in retail
investment. This is mainly because high property prices and the
complexities of acquiring property make it difficult for smaller
investors to directly invest in property. REMFs and REITs would
greatly simplify this process.

The legal framework for REMFs in India has been introduced by
an amendment to the SEBI (Mutual Fund) Regulations, 1996, whereby
REMFs would be just like any other mutual fund, except with real
estate and related securities as underlying assets. They are subject to
the following restrictions:
◦ At least 35% of the net assets must be invested directly in real estate
assets;
◦ Further, at least 75% of the net assets must be invested in:
 (i) real estate assets;
 (ii) mortgage backed securities (but not directly in mortgages);
 (iii) equity shares or debentures of companies engaged in dealing
in real estate assets or in undertaking real estate development projects.
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REMFs

‘Real estate asset’ as defined by the Mutual Fund Regulations
must, inter alia, be property on which construction is
complete and which is usable.

REMFs can invest in real estate development activities, as
they can invest up to 65% of their net assets in the equity
shares or debentures of companies undertaking real estate
development projects.

REMFs could giving a fillip to construction activity by opening
up a new source of funding, and bring more order to the
industry. REMFs could help in closing the gap between the
registration value of property and its actual market value, and
also help in market-based price discovery for
properties and financing property purchases.
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REMFs

The entry of property-buyers with this level of
bargaining power would also ensure that the
quality of projects and construction practices
also improve in the industry.

However, although the legal framework is in
place, REMFs have not been given
permission to start functioning due to
concerns surrounding accurate valuation of
property, tax treatment, and involvement of
foreign investors.
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REITs

SEBI has introduced the Draft SEBI (REIT) Regulations,
2007, which contemplate REITs which will be able to
invest in real estate, which is defined to mean land and
buildings.These regulations are not yet in force.

They would be prohibited from investing in vacant land
or engaging or participating in property development
activities.

REITs must distribute an amount not less than 90% of
their annual net income after tax to unit holders as
dividends each year, which is similar to the regulations in
other jurisdictions.
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REITs and REMFs Compared

Some similarities between REITs and REMFs as
contemplated in India; both are closed-ended
schemes listed on stock exchanges.

Comparison:
◦ REMFs in their present form are a potential source of
financing for real estate projects.
◦ A REIT can invest only in finished projects and not those that
are under construction; consequently, major chunk of income
from rental income.
◦ While REITs help investors earn a regular income, REMFs allow
them to also enjoy capital appreciation.

Both have the potential to provide a smooth exit option
to foreign investors at favourable valuations.
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REITs and REMFs

However, neither REMFs nor REITs have actually
gotten off the ground yet in India, and their exact
form (in the case of REMFs) and legal framework
(in the case of REITs) remain to be seen.

Some real estate groups such as Ascendas and
Indiabulls have, in the last few years, chosen to
list trusts holding property in India on the
Singapore exchange, a route which has met with
some success.
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Modes of Real Estate Financing - ECBs

Borrowings in foreign exchange by a person resident in India
from non-residents is regulated under the provisions of FEMA
along with the ECB guidelines issued by the RBI. They can be
availed under the RBI Approval Route or the RBI Automatic Route.

This mode of financing is typically preferred as the cost of the
domestic borrowing is presently significantly higher than that of
international borrowing.

Presently, the cost of overseas borrowing (inclusive of all costs such
as hedging and other transaction costs) is estimated to be 7-8% for
companies with good balance sheets, which is significantly lower than
the domestic credit cost of 9-11%.

As per the ECB Guidelines, utilization of ECB proceeds for the
real estate sector is prohibited. However, for this purpose, the
term ‘real estate’, excludes the development of integrated townships.
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Modes of Real Estate Financing - ECBs

Earlier, utilization of ECB proceeds for
development of integrated townships was
prohibited.

Purpose was to stem inflow of foreign debt and
capital, which was causing larger macroeconomic effects including the appreciation of
the Indian rupee.

However with the changing economic times,
this restriction has been removed with effect
from January 2, 2009.
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Modes of Real Estate Financing - ECBs

ECBs can be raised by corporates engaged in
the development of integrated townships
only under the RBI Approval Route.

Earlier, ECBs for SEZ development were not
permitted. With effect from June 2009, RBI has
permitted SEZ developers to avail of ECB
under the Approval route for providing
infrastructure facilities within the SEZ.
Modes of Real Estate Financing – Domestic
Borrowing

The RBI has devised exposure norms for banks, which take into
account the risk factors associated with exposure to Commercial Real
Estate (“CRE”).

CRE is defined as real estate where the prospects for repayment would
depend primarily on the cash flows generated by the asset. Eg. office
buildings to let, retail space, hotels).

Over the last few years, RBI has loosened norms regarding CRE
exposure, reducing the risk weight from 150% to 100% in November
2008, and reducing the provisioning requirement for advances from 2% to
1%.

However, cost of borrowing is still very high.

Further, banks are not permitted to extend fund based or non-fund
based facilities to private builders for acquisition of land, even as part of
a housing project
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Modes of Real Estate Financing –
Domestic Lending to SEZ Developers

Earlier, wary of SEZs being used for real estate
development purposes, the RBI classified loans to
SEZ developers as real estate lending.

More recently, to promote the development of SEZs,
the RBI in September 2009 reclassified lending to
SEZ developers for the purposes of developing,
operating, or maintaining an SEZ, and lending to codevelopers
engaged
in
construction
of
supporting infrastructure such as sewerage and
electrical lines, as infrastructure lending, thereby
reducing the cost of borrowing for SEZ developers.
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Risk Perception

Most new real estate projects in India involve the
acquisition of agricultural land and its conversion
to commercial or residential use, which is capital
intensive, and for which real estate developers often
turn to foreign investors.

Regulatory view uncertain – FDI for acquisition of
agricultural land for the development of integrated
townships.

Situation exacerbated by the fact that domestic bank
financing for acquisition purposes for private
developers is not permitted.
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Risk Perception

Assets of Indian real estate companies are often held by a
network of SPVs, which are not subsidiaries of the company,
but in which the promoters have significant cross-holdings.

This structure typically exists in light of restrictions under the
land-ceiling laws.

As a standard business practice, the real estate developer
enters in to joint development agreements with the SPVs
in relation to the property.

Accordingly, the actual builder/ developer does not hold the
title of the property, which poses significant risks, particularly in
the event of a bankruptcy.
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Risk Perception

Land acquisition in India can pose several
problems:
◦ No system of issuance of title certificates, which
necessitates title verification for the preceding 30
years.
◦ Land records have not been computerized, and
are still manually maintained and scattered.
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Risk Perception

As a result a buyer must undertake to verify the ‘chain of
title’ for the preceding thirty years to ensure that he can
obtain clear title to the property from the seller, which is
expensive and time-consuming.

This thirty year period exists because under the law of
evidence a document which is thirty years old or more is
presumed to be valid, and further, under the law of limitation
the right of a mortgagor to redeem property possession
of the property subsists for thirty years after the right
accrues.

Problems related to title verification can be solved by
computerising and centralising all land records, and also
through the introduction of products such as title insurance.
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Risk Perception - Other Issues

Conflicts between Central (or Federal) law and State law
complicate matters. For example, the minimum area to be
developed for serviced housing plots under Press Note 2 is
10 hectares, while the Haryana and Punjab land ceiling laws
prescribe a maximum holding of 7.25 and 7 hectares
respectively.

Further, land is a State subject, and levies such as stamp
duty and registration charges vary widely from state to
state.
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Proposed Legislative Changes

To deal with some of the problems faced by consumers while
dealing with property developers, the Government has
proposed the Model Real Estate (Regulation of
Development) Act.

It is meant to serve as a template along the lines of which
State Governments will enact legislation.

The Act aims to regulate builders and developers, and
bring in greater accountability by casting obligations upon
them and also creating a regulator for the residential space in
the real estate sector.

Envisages the setting up of a Real Estate Regulatory
Authority in the State, as well as an Appellate Tribunal.
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Proposed Legislative Changes

Important provisions:
◦ Property developers must register their projects with
the Regulatory Authority, and furnish a bank
guarantee amounting to 5% of the estimated cost
of the project.
◦ Failure to register can result in imprisonment of up to
three years; if an offence is committed under the Act, it
is possible to proceed against those in charge of the
business of the company.
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Proposed Legislative Changes

Important provisions (contd.):
◦ Developer cannot advertise project without registration,
prior filing of materials.
◦ Developers must enter into a registered agreement to
sell, before they can accept any deposit or advance from a
buyer. This protects the interests of the buyer, as the
prevailing market practice is that buyers make payments in
instalments as and when the builders demand, and the
registered deed of conveyance is executed only when
payment is complete. It also ensures that all relevant stamp
duties and other levies are paid.
Road Ahead –
Real Estate Financing

While the trend of FDI inflows into the real estate sector
seems set to continue, it is likely that the sector will look
increasingly towards the capital markets to raise funds.

REMFs and REITs are likely to emerge as important methods
of financing, although issues connected to taxation and
valuation will need to be resolved before this becomes
possible.

Market capitalization of real estate firms in India is about
2.2% of the aggregate equity market capitalization – this is
well below the 10-15% level found in most advanced
economies. This indicates that there is considerable potential
in the sector.
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Road Ahead –
Land Title Reforms

Computerisation and centralisation of all land records is a sine qua
non. The National Land Records Modernisation Programme should be given
priority.

Land-title reforms, which have been attempted in states such as Rajasthan,
are absolutely necessary. There is going to be a shift with respect to the law
of land title in India, from the ‘presumptive’ system of land titles to the
Torrens system, so as to confer conclusive titles such that:
◦ There is a single agency to handle property records.
◦ The record of a title should depict the conclusive ownership status, and
probing into past transactions and titles of the property should become
unnecessary.

Title insurance, which is not yet available in India, should be introduced.
The market is being explored - the National Insurance Corporation
attempted to introduce a title insurance product in 2008, which was,
however, not approved by the insurance regulator.
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