Investment

The Middle Path in Real Estate

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The Middle Path in Real Estate 

Real estate is a cyclical business and cyclical downturns may provide good investment opportunities 
The middle path in real estate

Investing in real estate is about remaining invested for the long run as volatility gets minimized. Over time, this characteristic has drawn many investors to real estate. However, there are limitations to directly investing in this asset class—lower liquidity, largely unorganized deals and prone to legal complications, are a few of them. But you can approach real estate investing in more ways than one depending on your need for liquidity and your investment horizon.
Types of Investment

An investor typically allocates her overall investment pool broadly into three buckets—equity, debt and mezzanine (which is a combination of debt and equity)—depending on the risk appetite, age, income profile, return expectation and liquidity requirement. These investments, in turn, get invested across sectors either directly or through financial products such as bank fixed deposits, mutual funds, debentures, among others.

In real estate, investments have traditionally happened through direct purchase of land, plots or apartments. Such investments are equity in nature. Returns have mostly been good over a longer time horizon. But there may be challenges related to title, regulations, approvals and development, especially in an under-construction property. It gets even more difficult when an investor tries to diversify and move to new geographies. High transaction costs, lack of transparency and low bargaining power make the exercise tougher.
Structured Debt
 
For real estate, structured debt is a secured investment option that provides tangible underlying collateral in the form of land, development rights, flats, or other formats, along with an income stream over the tenor of the debt along with the repayment of debt. It is basically a medium-term fixed income product that has the potential to provide a high yield to investors without them actually having to go through the entire process of buying, managing and selling the underlying real estate.
Mezzanine Investments

These have the best of both equity and debt. These provide regular income through a fixed coupon (similar to bank debt) and subsequent project-linked equity upside either in the form of earmarked inventory or share in revenue. They also provide protection rights like mortgage on land, project escrow, pledge of shares and guarantees. These structures result in a win-win situation for both investors and developers. Investors get regular income, capital protection and participation in the project upside while the developer gets repayment flexibility and lower initial payouts, which eases the liquidity pressure.

Traditionally, real estate funding has been through the developer, who puts in the initial equity to tie in land and approvals using her own resources and funds from pre-sales to buyers. This was supported by construction finance from banks and accruals from further sales. Around 2005, with the opening up of foreign direct investments (FDI) in real estate, FDI money through private equity funds became an important source of finance, which fuelled real estate from 2005-08. After the global financial crisis in 2008, FDI funding took a back seat and was replaced by banks and non-banking finance companies. Over the past few quarters, even bank funding has dried up and replaced by high yield debt from domestic funds and financial institutions.

Current Scenario

 The economic environment is uncertain, but we believe that the fundamentals remain strong and we are at the fag end of the economic down cycle. The stress may continue for another 12-18 months; but there will be good opportunities to cherry pick and make secured investments with good developers. There is potential to also share the upside as the economy stabilizes and the next upcycle begins over the next 2-4 years.

Given the sluggish economic environment, slow pace of sales and tight liquidity, a product that offers funding to undertake and complete projects and yet does not put undue pressure on the cash flows in the initial stages or drains cash flow affecting project completion is ideally suited to the developers. From retail or high net worth investors’ point of view, mezzanine investments offer a good medium-term opportunity to make attractive risk-adjusted returns which provide a regular income in the form of coupon, a floor on the returns and downside protection through a debt like structure. To invest in real estate through the structures defined, approach an adviser or a private equity fund manager.

Real estate is a cyclical business and cyclical downturns may provide good investment opportunities. But it is also a high-risk proposition. The next 12-18 months provide a good investment window to capture this opportunity.

by Sharad Mittal, director and head, real estate investments, Motilal Oswal Private Equity Advisors. 

Source:- LiveMint 

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