Solid high ground

A shrewd grasp of the Indian real estate market has given domestic PE funds the upper hand

Soumik Kar

American statesman Benjamin Franklin, in the best tradition of timeless aphorists, surely didn’t have private equity (PE) funds or the Indian real estate market in mind when he sagely uttered, “An investment in knowledge pays the best interest”. But he could well have been talking about them as I found out while working on this story: domestic real estate PE funds that invested with knowledge of the local property market made money; the rest are still trying to figure out what went wrong.

Look at the line-up: only domestic funds such as Kotak Realty Fund, Indiareit Fund Advisors, ASK Property Investment Advisors and HDFC Property Fund have made good money. Foreign PE funds such as Tishman Speyer, JP Morgan Chase and Lehman Brothers have made very little or no money. Why did some funds then, perform better than the others? 

We have to go back to the heydays of 2005 to understand this, for that’s when the government first allowed 100% foreign direct investment (FDI) in the real estate sector via the automatic route. International and domestic PE funds couldn’t get into real estate fast enough back then. It was a mad rush characterised by investments in just about everything from townships to special economic zones (SEZs).

FDI in India’s superheated real estate market jumped 80 times from ₹171 crore in 2005 to ₹13,586 crore in 2010. Investments of foreign funds peaked in 2007, when they pumped in around $5.73 billion compared to $4.05 billion put in by domestic funds. The slowdown of 2008-09 was unexpected and ugly. Buyers backed off and projects that looked promising suddenly had no takers. The end result: many foreign funds got mired in delayed or unapproved projects, or into neck-deep arbitration with developers. For instance, the Indian arm of New York-based AIG Global Real Estate has sent a legal notice to Bengaluru-based real estate company RMZ Corp over an equal joint venture project in Hyderabad.

The bone of contention is AIG wants RMZ to exit the project because it has failed in developing it. AIG had invested ₹350 crore in the project, which got delayed because the joint venture partners could not agree over whether the project should be residential or mixed use. In the National Capital Region, Citi Property Investors (now owned by Apollo Global Management) and JP Morgan Chase & Co have filed separate arbitration proceedings against BPTP, claiming that the developer has failed to provide an exit for their investments. JP Morgan has invested ₹241 crore in the company in two tranches. Citi had invested ₹322.5 crore in the company and ₹399 crore in the company’s projects.

Analysts say foreign funds made huge mistakes because they underestimated the byzantine Indian real estate market. Very few foreign funds, such as Morgan Stanley Real Estate or Xander Group, which have local fund managers as heads, understood the risk of land aggregation, approvals and execution. They bought into any growth story that was sold to them by real estate developers. New York-based Vornado Realty Trust for instance, invested ₹315 crore in Delhi-based real estate developer, Uppal Group’s 269-acre SEZ in Gurgaon. The fund is yet to exit its investment. It is the same problem with Citi Property Investors, the real estate unit of Citigroup, which bought a 40% stake in five SEZ companies of real estate firm BPTP for ₹399 crore. There has been no exit so far. They learnt the hard way that they had to invest in people on the ground to succeed. 

As things played out, foreign funds lost their nerve and took a backseat by the time the real estate market started recovering from the slowdown in 2009. Domestic funds were made of sterner and smarter stuff — that same year, they invested $665 million, for the first time far exceeding the $183 million sunk by American and other overseas funds.  Sanjay Dutt, managing director of real estate consultancy Cushman & Wakefield, has an explanation for this. He says that most funds that came to India were new. “Many people who committed to India at that time were opportunistic funds with a short-term view, looking to make a quick return on their investments. As one looks back now, the winners have all been local fund managers,” he adds. 

Staying grounded 

Kotak Realty Fund (KRF), in particular, has been a trailblazer. The fund is one of few that have consistently managed to return money to investors. KRF, which was established in May 2005, is headed by S Sriniwasan, an ex-investment banker. Dutt says that experience has clearly helped. “Srini does not have a real estate background but his more than a decade’s experience in investment banking must have helped him identify the right opportunities.”

Aiding Srini along this very profitable journey has been V Hari Krishna, director, KRF, who has 15 years of experience in real estate, having worked at consultancy firms Jones Lang La Salle and CB Richard Ellis. Krishna says, “Our definition of a worthy investment is something that we can exit easily,” And exit it has. In the last three years, KRF has exited 15 of its 33 investments, with an average return of 27%. The fund has returned a handsome $325 million to its investors. Krishna says prudent investing has saved the fund from losing money, and goes on to add, “We never went by any fads like SEZs or townships, which ruled the market during its peak.” The fund also stayed away from secondary cities, sticking instead to the top metros. 

Deals at KRF are mostly structured as secured transactions with elements of debt and equity, and no deal is done if the internal rate of return (IRR) is below 22%. CEO Sriniwasan says this has helped the fund have a significant say in project execution. “We structure our investments as part equity and part non-convertible debentures,” he says of the process he has followed for four years now. “Cash flows from residential sales repay interest on debentures and other things. We pioneered such deals in the market and a number of peers are now following a similar strategy. It gives me and my team tremendous pride and satisfaction that we have led others.”

KRF has $765 million funds under management and is now looking to raise another $200-300 million from domestic investors in what would be its fifth round of fund raising. It plans on parking the bulk of these moneys in residential projects, following a narrow investment strategy that offers easy exits. “Exits in residential projects self-liquidate when sales happen,” points out Krishna. “Commercial property is more difficult to exit. It has to be first leased and then sold to either third-party investors or buyers. Moreover, there is no REIT market in India to list the property.” A REIT (Real Estate Investment Trust) is an entity that raises money from investors to own and manage property.

Hitting home run after home run

Local funds have made big money in residential

as well as commercial projects 

Its shares are traded and the bulk of its revenue comes from property rent. It helps that a good chunk of Kotak’s 28-member team has a real estate or construction sector background. “We have had the same team of experienced people for the last five or six years,” says Sriniwasan. “In a business where you have to stay married to an investment for a couple of years, continuity of management matters.”

Not that there haven’t been mistakes but, “We course corrected in a couple of investments when things went wrong,” admits Sriniwasan. For instance, when a project was not meeting its deadline, Kotak restructured the deal and invited another realtor to develop the land. In another instance, the team expected to rent out a property in the Delhi-NCR region, completed just before the Lehman crisis hit the market, at ₹37 per sq ft per month. Then, the market hit rock bottom. “We sat down with the developer and decided that, instead of keeping the property idle, we would lease it out at ₹30 per sq ft per month,” Sriniwasan explains. “By doing so, we were able to meet our interest and debt obligations.”

KRF’s secret sauce, clearly, is its ability to rein in developers. “The real estate sector is an undisciplined industry,” Krishna says. “It needs people like us to bring in discipline.” Kotak has local people on the ground breathing down the necks of developers to make sure its projects are on schedule. “We keep a close eye as the focus is on getting the developer to deliver.”   

Same to same

Being in sync with market realities has also helped Indiareit Fund Advisors and ASK Property Investment Advisors. Quiz the funds on the reasons for their success and their answers sound uncannily similar to KRF’s, which maintains that “it is all about finding the right partner in the right location at the right time.”

Amit Bhagat, managing director and CEO of ASK Property Investment Advisors, says finding a quality partner is half the job done. “We always look for a quality partner because it is his intent and his capability that will decide the return on the investment.” Bhagat says the quest is to find an impeccable partner who respects every stakeholder, be it his buyer, investor or lender. “We look for qualities such as whether he has rewarded any private equity investor in the past,” he adds. “It was not possible to verify this five years back because there was no investment history, but now we can do that”

ASK is a rare fund — in March 2012, the IRR on its investment in ATS Infrastructure’s Noida project stood at an impressive 56%, and it gave a fantastic return of 2.45 times (₹121 crore on an investment of ₹50 crore) in less than two-and-a-half years. This was one of the seven projects in which ASK invested from its initial fund of ₹326 crore. It raised a second fund of ₹1,000 crore, most of it domestically (and many of them repeat investors) in June 2012. 

 “You need local knowledge,” agrees Indiareit CEO Khushru Jijina, who lays the blame for the failure of other funds to the lack of it. Indiareit has regional offices in Delhi, Bengaluru and Hyderabad to have local people on the ground. “In India you have land issues, title issues…it is not easy getting money out of this country unless you understand the system well,” he adds. 

More local gospel 

Shobit Agarwal, managing director, Jones Lang La Salle, agrees that a deeper understanding of the local market sets apart the winners from the losers. “Domestic fund managers operating in India understand the challenges of doing business in India; they understand that chief ministers change, approvals take longer than expected and that, therefore, they need to budget for it,” says Agarwal. “Domestic funds have very robust underwriting models and the right acumen. Sriniwasan, for instance, is a very old hand. Jijina has been in business for 20 years. You can’t sell a pipe-dream to these people.”

Indiareit certainly didn’t buy into any dream. The fund has exited eight projects since 2008 in addition to exiting three funds, with an average return of 27-28% on its investments. It has returned around ₹1,340 crore to its investors and now manages ₹3,700 crore of funds. Indiareit also did not touch long gestation projects such as hotels, office space or malls. The fund invested purely in residential projects with little or no debt. While there is no one favourite transaction, a formula that worked well for the fund is its investments in Mumbai.

A large part of the fund’s portfolio was in the city, despite it being considered an overpriced real estate market. The thinking was that in such a land-scarce city, there will always be scope for prices to move up. The strategy did work, considering that many of Indiareit’s successful exits such as from two projects of Ariisto Group, a residential project at Santacruz and a mixed-use project at Goregaon, have been in Mumbai. 

Indiareit, too, keeps a tight leash on its partner, to make sure the invested money is used well. Not only does the fund never give cash out to its partner, it makes sure its partners have invested some amount of ‘hurt money’ in the project, so that the developer hurts, too, if something goes wrong. “If I like a project, I would still like to have some ring fencing so that money doesn’t get transferred to another project,” says Jijina. “We may even demand escrowing of cash flows from a project. We have clauses that say that if a developer doesn’t perform in a particular manner, we can take over the project.” While Indiareit has not taken over any project as of now, Jijina says the fund will not stop short of doing so if the need arises. “You will see some action happening soon,” he said. “We could take over some project.”

Arun Natarajan, founder, Venture Intelligence, a firm that tracks private equity investment in India, says the real estate private equity landscape in India is now completely dominated by domestic funds. “This has more to do with the FY09 global recession, when foreign funds went away and never came back. A few funds were asked to withdraw from private equity investment by the US regulatory authorities,” says Natarajan. “In their absence, domestic funds consolidated their position.”

Domestic funds have a clear edge now because of their rapport with developers and lessons learnt from earlier investments. But Natarajan says this could change. “Foreign funds such as Blackstone have become more aggressive, so we could see more foreign funds returning to the Indian market.” And when this does happen, it will be interesting to see whether domestic funds hold their fort. Kotak’s Sriniwasan believes his fund will continue its good run. “At various points in time there will be new opportunities and challenges. Given our skill sets, we will always be able to provide customised financing solutions. The way we run our business and our speed of decision making will give us the edge.”


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