Practising Law Institute - Outlook on India 2010: Delivering on the Promise in Turbulent Times

1. Practising Law Institute - Outlook on India 2010:Delivering on the Promise in Turbulent Times Real Estate Mohit Saraf Senior Partner Luthra & Luthra Law Offices

2. 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. Introduction to the Real Estate Market in India

3. 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. Scope of Presentation

4. 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. Effect of the Economic Crisis on the Indian Real Estate Sector

5. 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 mid-income 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 Tier-III 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. Where is the Primary Demand for Real Estate?

6. 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”). Overview of Foreign Direct Investment

7. ‘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 includedevelopment of townships, construction of residential/commercial premises, roads or bridges, educational institutions, recreational facilities, city and regional level infrastructure, townships. Overview of Foreign Direct Investment

8. 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. Overview of Foreign Direct Investment

9. 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. Challenges Related to FDI in Real Estate

10. 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. Instances of Regulatory Risk –Lock-in

11. 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. Instances of Regulatory Risk – Portfolio Investment in Real Estate

12. 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. Instances of Regulatory Risk – Portfolio Investment in Real Estate

13. 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. Other Investment Structures

14. 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. Other Investment Structures

15. 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. REITs and REMFs

16. ‘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. REMFs

17. 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. REMFs

18. 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. REITs

19. 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. REITs and REMFs Compared

20. 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. REITs and REMFs

21. 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. Modes of Real Estate Financing - ECBs

22. 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 macro-economic 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. Modes of Real Estate Financing - ECBs

23. ECBs can be raised by corporates engaged in the development of integratedtownships 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 - ECBs

24. 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 Modes of Real Estate Financing – Domestic Borrowing

25. 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 co-developers engaged in construction of supporting infrastructure such as sewerage and electrical lines, as infrastructure lending, thereby reducing the cost of borrowing for SEZ developers. Modes of Real Estate Financing – Domestic Lending to SEZ Developers

26. 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. Risk Perception

27. 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. Risk Perception

28. 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. Risk Perception

29. 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. Risk Perception

30. 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. Risk Perception - Other Issues

31. 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. Proposed Legislative Changes

32. 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. Proposed Legislative Changes

33. 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. Proposed Legislative Changes

34. 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. Road Ahead – Real Estate Financing

35. 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. Road Ahead – Land Title Reforms

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