Home Truths. An indirect way to invest in property

Property is an asset class that many investors own in different degree. Besides owning physical assets, investors who do not have any end-use for a property can consider investing in funds that provide funding to real-estate developers. These are private equity (PE) funds registered with SEBI as Category-II Alternate Investment Funds (AIFs). They provide different risk-return and tenure choices. AIFs require a minimum investment of ₹1 crore for you to participate.

The funds may invest in residential properties, office or retail spaces such as malls. They may also pick different locations for these investments. For example, some may focus on top cities while others may consider tier-II/III cities.

Within these themes, funds may provide debt to developers through non-convertible debentures (NCDs) or take equity stake in the project. In general, debt funds offer relatively more predictable returns. Investments may also be in the form of structured debt — a mix of debt and equity — wherein there is regular interest payment along with provisions for upside. Unlike regular debt, there is more flexibility in structuring the repayment tenure and other terms, based on the nature of the project.

Some funds also invest with the goal of earning rental income. These are typically invested in commercial assets.

Realty PE funds typically have a tenure of 5-8 years. Often, funds have an option to extend the tenure, as exits from investments take time. The funds charge an annual management fee which is usually 2 per cent of the assets. Investors might also have to pay one-time set-up fees. These funds have a hurdle rate, the minimum return beyond which they take a share of the profits, which is fixed or based on a benchmark. They may typically take 20 per cent of returns in excess of the hurdle rate.

An investment in a PE fund is a private contract between the fund and the investor, and unlike MFs, the investment value and returns are not publicly available. There is information on partial exits published from time to time. For example, Motilal Oswal’s IREF II fund (which has made 14 investments since 2015), had an internal rate of return (IRR) of 22.1 per cent in its seven exits. Kotak Realty Fund’s investment in Palava City project (Mumbai) gave an IRR of 18.75 per cent in 2.5 years when it exited for ₹838 crore in March 2018 (average fund return has been 20 per cent since 2013-14).

You must understand that these are some data points and may not be representative. The fact is that the performance of funds has not been great. Many have failed to return money even after the end of the tenure, because projects were delayed and exits did not happen. Those who had invested in commercial property also had issues in selling the asset and providing return.

The key reasons are the same as those for choosing to invest in the equity or debt market through MFs. One, it reduces the effort in identifying, monitoring and getting returns. Two, the selection is left to subject-matter experts who can derive higher returns. Three, you can build a portfolio that is diversified, rather than take more risky concentrated bets. Four, there is also slightly better liquidity compared with buying a property, as the fund may potentially provide partial exits from individual investments.

Realty PE funds are specialised, long-tenure, illiquid financial instruments and are not suitable for many investors. For one, the ticket size of an investment is large. You also need to understand the theme, the fund manager’s skills and the market conditions before investing. You must also account for the management fees which lower returns. The funds are closed-ended, and illiquidity for long periods of time is something that you need to plan for. Exit timings are also not predictable due to market-cycle and local-market uncertainties.

Fund launches were very active prior to 2010, but with the downturn, launches have been slow. However, since last year, there has been some interest, and schemes are being launched.

The continued stress in the property market provides opportunity for the funds. Developers are facing cashflow crunch as purchase of under-construction properties has dropped. And with the recent liquidity crisis in the market, loans from banks and NBFCs have been drying up. So, they are being forced to explore higher-interest-rate debt or equity funding from PEs.

With the potential to launch real estate investment trust (REITs), there is hope that PE funds that invest in commercial property can hope to get an exit by selling the asset to REITs. Also, since 2005, when many real-estate PE funds started, the property market has seen a full cycle, and there is performance data on various themes and funds. This gives more confidence to investors when selecting. High net worth investors can hence consider selective schemes that have an established track record and risk-management process.

The writer is an independent financial consultant

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