investing in real estate funds

Real Estate Funds - Unlocking Value in Real Estate Assets Krishnan Sitaraman Head – FundServices and Fixed Income CRISIL 4th April, 2008 Agenda No 1 2 3 4 5 Topic Avenues for investing in Real Estate Real Estate Funds – the meaning Real Estate Funds – the Indian scenario Real Estate Funds – are we prepared? Conclusion Slide 2 5 9 18 27 2. 1 Avenues for investing in real estate 3. Avenues for investing in real estate Real Estate Investments Direct Investment Listed Indirect Investment Non – listed Property Stocks REITs Fund of funds Close end funds Property stocks Open end funds Property stocks REITs MBS Partnerships Syndication Pooled Funds Joint Ventures TIC Contracts MBS Mutual funds Close ended funds may also be listed based on local regulations to provide liquidity to investors 4. 2 Real Estate Funds – the meaning 5. Real Estate funds • Real Estate Funds are generally available in two forms, depending on their structure: – Real Estate Mutual Funds (REMFs) – Real Estate Investment Trusts (REITs) • Real Estate funds typically have an investment universe encompassing: – Real estate properties; – Mortgage (housing lease) backed securities; – Equity shares/ bonds/ debentures of listed/ unlisted companies which deal in properties and also undertake property development; and in, – Other securities • In India, Securities and Exchange Board of India (SEBI) has recently come out with its draft norms for launch of Real Estate Investment Trusts (REITs). – SEBI is also expected to shortly announce regulations for the launch of Real Estate Mutual Funds (REMFs) by mutual funds in the country. • CRISIL FundServices (CFS) expects these funds to present investors with an excellent avenue to capitalize on the potential gains from the property markets and at the same time, help in bringing in greater transparency, liquidity and institutionalization in these markets. 6. 3 Key characteristics of Real Estate funds • • Pooling of resources: Individual investments are small and are represented by transferable units Organisational Structure: Varies between companies and trusts depending on local regulations and eligibility criteria – Funds may be both close ended and open ended • • Property and Asset Management: Property management can be outsourced / in – house Operating framework: Minimum percentage of assets that must be in the form of real property or mortgages – Minimum proportion of the income that must be generated from such investments. – Minimum proportion of the income that has to be generated as dividends and distributed to avail the tax benefits that these funds typically have. • • • Leveraging: Normally allowed to raise debt Tax Advantages: Based on local regulations, may be exempt from corporate taxes Governance and disclosure: Local regulations with respect to the number of independent directors and trustees. 7. Benefits of Real Estate funds • Predictable revenue stream with regular incomes – High dividend yields – Good hedge against inflation • Diversification benefits – Low correlation with other asset classes • Higher risk adjusted returns supported by favorable taxes • Affordability and Liquidity • Professional asset management: REIT managers are skilled, experienced real estate professionals • Oversight: Independent directors of the REIT, independent analysts, independent auditors, and the business and financial media monitor a public REIT's financial reporting on a regula basis. • Disclosure obligations 8. 4 Real Estate Funds – the Indian scenario 9. Real Estate funds – the Indian scenario • Presently, in India, only venture funds have been offering real estate funds – Presently available only to high net worth individuals and institutional and global investors – Funds launched in this space include HDFC India Real Estate Fund, India Advantage Fund from ICICI Venture Funds, Kotak India Real Estate Fund, IL&FS Investment Managers, IndiaREIT Fund, Unitech’s CIG Realty Fund, etc • Draft regulations for REITs announced by SEBI in December 2007 – Regulations for REMFs expected soon 10. 5 Real Estate Mutual funds • REMFs refer to schemes of a mutual fund with an investment objective to invest typically in real estate companies – Governed by the provisions and guidelines under SEBI (Mutual Funds) regulations. – Launched by an Asset Management Company – Close ended structure with units listed on stock exchanges – In mid-2006, SEBI first came out with the basic guidelines for REMFs in India. Areas such as valuation, related party transactions and taxation of these funds yet to be addressed Daily NAV disclosure after deducting administrative and management fees Separate custodian responsible for custody of securities • Investment universe: – Mortgage (housing lease) backed securities; – Equity shares/ bonds/ debentures of listed/ unlisted companies which deal in properties and also undertake property development; and in, – Other securities – Directly in real estate properties within India; • It is expected that REMFs would typically invest in debt or equity based securities issued by entities in the real estate space. 11. Real Estate Mutual funds • Indian mutual fund industry growing at a compounded annual growth rate of about 35% over the last five years ended 2007 • Equity fund AUM has risen to about 35% of the industry from 15% levels two years back – This however is still lower than AUM of income-oriented schemes, including debt and money market schemes • REMF offers an investment option that combines both reliable income and strong growth prospects – A favorable alternative for domestic investors – Can potentially enable the mutual fund industry in growing more rapidly. 12. 6 Real Estate Investment Trusts • Investment vehicles that invest in real estate directly, either through properties or mortgages – Operate primarily with the objective of earning regular income and improving riskadjusted returns. – Globally enjoy a favorable tax treatment in many countries May have significant restrictions on investment universe and distribution of income. • According to NAREIT (National Association of REITs), “a REIT is a company dedicated to owning and, in most cases, operating incomeproducing real estate, such as apartments, shopping centers, offices and warehouses. Some REITs also are engaged in financing real estate.” • REITs are generally of three types as given below: – Equity REITs – Mortgage REITs – Hybrid REITs 13. Typical REIT structure Unitholders Lenders of Debt Principal and interest Investment in REIT units Distributions Debt REIT Manager Sub contract REIT Ownership of assets Act on behalf of unitholders Trustee Net Property income Property Manager 14. Property Property management services The global scenario 7 Real Estate Investment Trusts • Draft norms on REITs from SEBI in 2007 – Mandate an architecture comprising the Trustee and Real Estate Investment Management Company model – Banks, public financial institutions, insurance companies and corporate houses can be trustees of REITs At least fifty per cent of the trustees and directors of the real estate investment management company have to be independent directors – Close ended scheme structure with units listed on stock exchanges – Allowed to invest only up to 20% of total assets in incomplete and nonincome generating properties Investment in vacant land is not allowed. Investment in securities or own schemes not allowed unless specified Concentration limits of upto 15% in any single real estate project upto 25% of all the real estate projects developed, marketed, owned or financed by a single group of companies. 15. Real Estate Investment Trusts • Mandatory valuations from a property valuer at least once a year – Disclosure of NAVs as and when annual valuation is done • Mandatory rating of schemes by rating agencies • Leverage limits of upto over one-fifth of the assets • At least 90% of the post tax income to be distributed as dividends every year • SEBI’s draft norms however do not mention anything on taxation of REITs. – Globally, favourable tax treatments have enhanced the attractiveness of these schemes to investors. 16. 8 Key differences between REMFs and REITs 17. Real Estate Funds – are we prepared? 18. 9 Real Estate Funds and India’s real estate sector • Key areas in which Real Estate Funds can positively impact India’s real estate sector: – Enhancing liquidity of the sector Lack of liquidity impairs secondary market transactions Real Estate Funds can provide liquidity through a more broad-based, and wider participation of domestic retail investors – Institutionalization Enhanced competition with institutional investors competing in a bigger way with the unorganised sector for market dominance Higher professionalisation – Greater acceptability for real estate as an investment asset class Opportunities to retail investors to participate in the real estate sector Asset diversification to corporate investors – Help build a vibrant, secondary real estate market – Improve sector transparency 19. How big is the Indian Real Estate Funds opportunity? • Real estate stocks expected to grow around three fold to above USD 1400 billion by 2010. • Real Estate Funds expected to have the potential to hold at least a 5 per cent share (more than USD 70 billion) of the total real estate market by 2010 – India offers a greater opportunity for Real Estate Funds than any other country in the world. The yields on commercial real estate across metros in India are higher than those prevalent in the global real estate markets. Apart from the information technology (IT) and IT-enabled services (ITES) sectors, retail, insurance, banking, healthcare, hospitality and consulting businesses have also been growth segments in recent times driving the demand for real estate. A higher demand can be seen in the retail segment with an expected influx of clothing and lifestyle stores, restaurants and beverage chains, entertainment and leisure complexes. 20. 10 Key issues that need to be addressed however… • Limited availability of world-class realty: • Quality of the asset a key factor that determines its ability to successfully survive economic downturns and maintain stable rental rates and occupancy levels – Presently, there is a shortage of good assets in the real estate sector in India in terms of scale and quality Regulations such as the Urban Land Ceiling Regulation Act have played a part in constraining the development of these assets. As a result, a few good projects are being chased by all the large funds, resulting, in turn, in fears of over valuation affecting investor confidence. 21. Key issues that need to be addressed however… • The reasons for limited availability of quality developments are: – Unorganised, largely fragmented sector, characterised by small players with a local presence – Limited number of professionally managed world-class companies with a pan-India presence – Significant scope for improvements in terms of location, layout and design, construction techniques, material quality, amenities offered to create long term value and face industry downturns – Absence of an enabling role by ensuring the supply of quality real estate as in Hong Kong and Singapore – Limited number of property management companies, providing quality services such as construction, development, repair and maintenance on properties. 22. 11 Key issues that need to be addressed however… • High transaction costs: • Current regulations in India involve high transaction costs, and present problems in ensuring clear land titles, and prolonged delays in obtaining clearances. • The sector also faces the following problems: – Lack of proper land records – Inadequate town and infrastructure planning for a sustained, planned growth – Bankruptcy laws which have a lot of scope for improvement – Multiplicity of development laws and non-standardisation of laws across states leading to delays and increasing costs 23. Key issues that need to be addressed however… • Lack of transparency and information: • Lack of adequate disclosures on land/property transactions, underreporting of taxable income and absence of uniform accounting norms for revenue recognition. – As land/property transactions need to overcome regulatory constraints, avoid stamp-charges on multiple transactions, and lack of clarity on titles, disclosures are usually low. – Taxable income is under-reported in cash transactions. – The accounting norms allow both percentage completion and project completion methods to be adopted, which results in non-uniform revenue recognition in the industry. • There is also a near complete absence of a credible database on real estate markets, in terms of property demand and supply, absorption rates, geographic price data, occupancy rates, rentals, and capitalisation rates for commercial, retail, and residential property segments. 24. 12 Key issues that need to be addressed however… • Illiquid secondary markets: • An efficient secondary real estate market facilitates a price discovery process by enabling market demand-supply forces to arrive at the efficient price. – In such a market, whenever the prices fall below their intrinsic value, the demand would rise to the extent the price equilibrium is restored. Similarly, whenever the prices rise above their intrinsic value, sellers would increase in the market to ensure rationality in the market. • Currently, the lack of information and transparency and the high stamp duty/registration charges constrain the development of the secondary market. 25. Key issues that need to be addressed however… • Valuation of properties is not standardised: • There are no standardised, accepted practices for property valuations at present. – No meaningful benchmarks available among properties. – In the absence of standardised valuation techniques, it is difficult to identify intrinsic valuations from the premium assigned by speculators. • The impact of extraneous variables such as interest rates and inflation are also not factored in adequately into the valuations of properties. 26. 13 Conclusion 27. Conclusion • Multiple benefits through the launch of Real Estate Funds in India – Ease of access to realty markets for retail investors Affordable to investors who in turn can own the good quality properties and have access to expert management. Provides investors with an efficient medium for diversification and asset allocation. Mortgage realty funds can provide a fillip to mortgage finance by creating a secondary market. – Medium to infuse large doses of capital into the realty sector. – Aids in making the sector more organized and transparent. – Offers developers and other companies, avenues to release property assets from corporate balance sheets into professionally managed firms. Realty sector can have access to funds at a cheaper cost, and thereby access to better margins. 28. 14 Conclusion • Real Estate Funds help meet two crucial ends – Stable, income – oriented investment options for long term investors – Liquidity and depth for the secondary market • CRISIL believes that Real Estate Funds can be a potent tool in institutionalising the real estate sector in India – There is however, a need for strict disclosures and other regulatory norms as well as an enabling framework, before Real Estate Funds can be formally introduced in the country. 29. Annexure 15 Correlation of real estate stocks to other asset classes Correlations of Real Estate stocks to other asset classes (1990 - 2006) Finland Luxembourg International US Large Cap US Small cap International Korea UK Cash US Bonds Bonds stocks stocks Stocks Global Real Estate 0.05 0.18 0.25 0.51 0.51 0.71 Canada Netherlands Germany USA Belgium France Mexico Singapore Israel Japan Taiwan Hong Kong Malaysia Bulgaria Turkey Australia New Zealand Source: Charles Schwab Investment Management Perspectives 31. Category wise market capitalisation of US REITs US REITs - Category wise market capitalisation Equity 93% Hybrid 1% Mortgage 6% 32. Source: NAREIT 16 Increasing participation of countries across the globe in REITs Canada UK Finland Luxembourg Korea Netherlands Germany USA Belgium France Mexico Italy Bulgaria Pakistan India Singapore Israel Japan Taiwan Philippines Hong Kong Malaysia Turkey Australia New Zealand Blue lines indicate countries that are close to finalizing REIT structures 33. Global REIT market by region Canada Finland Breakdown of Global REIT market by Luxembourg region UK North America , 56.40% Korea Netherlands Germany Belgium France Europe, 12.60% Japan Taiwan Hong Kong Malaysia USA Mexico Africa, 0.30% Far East , 9.50% Bulgaria UK, 8% Singapore Israel Oceania, 13.20% Turkey Australia New Zealand 34. Source: NAREIT 17 Global REIT market by number (February 2007) Canada UK Finland Luxembourg Korea Netherlands Germany USA Belgium France Mexico Singapore Israel Japan Taiwan Hong Kong Malaysia Bulgaria Turkey Australia New Zealand 35. Source: AME Capital – Global REIT Report - 2007 Global REIT market by capitalisation (February 2007) Canada UK Finland Luxembourg Korea Netherlands Germany USA Belgium France Mexico Singapore Israel Japan Taiwan Hong Kong Malaysia Bulgaria Turkey Australia New Zealand Source: AME Capital – Global REIT Report - 2007 36. 18 Global REIT market by returns Global REITS - Total rate of return - Three year to 30 June 2007 (%) Canada South Africa Turkey Singapore France UK Japan USA South Korea Canada New Zealand UK Finland Luxembourg Korea 41.56 40.12 33.56 Netherlands Germany Belgium France 20.87 20.48 18.13 16.09 Bulgaria 14.49 10.66 8.51 0 5 10 24.46 24.26 23.85 29.55 27.82 Japan Taiwan Hong Kong Malaysia Mexico Netherlands Australia US Belgium Hong Kong Malaysia Singapore Israel 20 25 30 Turkey 15 Australia New Zealand 35 40 45 Source: Ernst & Young Global REIT Report - 2007 37. CRISIL Limited 38. www.crisil.com 19