London's Alternative Investment Market saw a spate of listings of India-focused real estate funds in the later part of the 2006/2007 financial year. This included, interalia, Unitech's Ltd's Unitech Corporate Parks Plc, and Hiranandani Group-supported Ishaan Real Estate. These listings not only underscore the international interest in real estate, but also highlight the fact that Indian real estate has matured, using innovative structures to access international finance. The Indian market for real estate finance has come a long way in recent years. Real estate financing has moved away from excessive dependence on pre-launch sales to accessing institutionalized funding avenues, both domestic and international.

Foreign direct investment

A big part of international investment into Indian real estate has been received as foreign direct investment (FDI). FDI in Indian real estate has been liberalized in stages. The FDI regime is governed by the Foreign Direct Investment Scheme under the FEMA (Transfer or Issue of Security to a Person Resident Outside India) Regulations 2000 (the FEMA Regulations) as modified by Press Note 2 of 2005. The press note permits 100% FDI into townships, housing, built-up infrastructure and construction development projects (including commercial premises). The policy permits FDI only in projects where development is required. FDI in existing properties that have already been developed and have a rental income is not permitted under this policy. The press note permits foreign equity into Indian companies undertaking real estate projects, subject to the following requirements:

• The minimum area to be developed for serviced housing plots is 10 hectares and for construction development projects is 50,000 square metres. In a project with a combination of both, compliance with either specification is enough.
• The minimum capitalization for a wholly owned subsidiary is $10 million, or $5 million for joint ventures with Indian partners. These funds have to be brought in within six months of commencing business.
• The original investment cannot be repatriated until three years have passed from the date of infusion of minimum capitalization, though an earlier exit might be permitted with prior approval of the Foreign Investment Promotion Board.
• At least 50% development of the integrated project must be completed within five years from the date of obtaining all statutory clearances. The sale of undeveloped plots is not permitted.

These conditions no doubt create certain ambiguities. For example, if a foreign investor makes the investment in stages, with a minimum investment of $5 million made in the first instance and a substantial investment made within a short period later, would the restriction on repatriation apply only to the first tranche of $5 million, even if the investment was clearly not enough for the size of the project to be undertaken? Similarly, the timeframe specified for development of the project does not provide the flexibility required for development of large projects, which are typically undertaken in tranches.

However, the fact that these conditions are not being viewed as a deterrent to investment in Indian real estate is evident from the fact that FDI in real estate in India has increased. The real estate and construction sector in India witnessed an influx of $1.45 billion, which accounted for 12% of the total FDI inflows received in 2006, up from 3.4% in 2005.

It is also not surprising that joint ventures with local players are preferred by most investors over wholly owned subsidiaries. The local partner's knowledge of Indian environment and practices enables the venture to navigate through the issues, such as lack of clear titles and non-transparent financial dealings, that mark real estate in India.

Pre-IPO placements

The sector has seen investments by international real estate developers such as Lee Kim Tah Holdings, CESMA International, Evan Lim, and Keppel Land from Singapore, Salim Group from Indonesia, Edaw from the US, Emaar Group from Dubai, and IJM and Ho Hup Construction from Malaysia. Leading institutional investors such as JP Morgan, Morgan Stanley, Fallaron Capital have also invested in the sector.

As several prominent Indian real estate companies, such as DLF Universal and Parsvanath Developers approached Indian capital markets in 2006, debate emerged on whether private placements by financial institutional investors at pre-IPO stages would be treated as portfolio investment or as FDI. The Portfolio Investment Scheme under the FEMA Regulations permits foreign institutional investors registered with SEBI to purchase shares and convertible debentures of Indian companies through a registered broker on stock exchanges. The Portfolio Investment Scheme permits investments by FIIs during the IPO. Portfolio investments are not subject to the restrictions (including those on capitalization, minimum area of development and the three-year lock in) that apply to FDI under Press Note 2. So real estate companies and the FIIs investing in them were keen on classification of these investments as portfolio investments because many of their existing projects were not FDI compliant.

The debate found the Reserve Bank of India locking horns with the Department of Industrial Policy and Promotion (DIPP) and Securities and Exchange Board of India (SEBI). SEBI and DIPP argued that the FEMA Regulations do not distinguish between FIIs participating in an IPO or a pre IPO. However, RBI took a view that a pre-IPO offer was in the nature of a private placement or preferential allotment and so must be FDI compliant.

The government has now decided that all pre-IPO investment or private placement to foreign institutional investors (FII) in real estate companies is FDI and so is subject to the requirements of Press Note 2. However, necessary notification for this is yet to be issued by SEBI or RBI.

Debt funding

The government's restrictive view on FII investments into real estate also reflects RBI's concern about the creation of an asset bubble in real estate and the inflationary impact of foreign funds flowing into real estate. While economists and stakeholders in the real estate sector in India continue to debate whether there is a real estate bubble or not, the RBI has been taking steps to streamline the flow of funds into this sector.

While end use of external commercial borrowings for real estate purposes has been prohibited from the beginning, in 2005 RBI created a small window for raising ECB to fund integrated townships. However, RBI has now, by its notification issued on May 21 2007, barred real estate companies from raising funds through ECB to develop integrated townships.

The Ministry of Finance has declared that fully convertible preference shares would be treated as part of share capital and would be included in calculating foreign equity for purposes of sectoral caps on foreign equity. It has also stated that foreign investments coming as any other type of preference shares (non-convertible, optionally convertible or partly convertible) would be considered debt and so would be governed by the ECB Guidelines. This would apply with prospective effect.

The measure has a big impact on access to fixed interest funds by Indian real estate companies. The FEMA Regulations permit maximum dividend of 300 basis points over the SBI prime-lending rate on preference shares. This usually works out to be about 15% to 16%, while the ECB Guidelines had an all-in-cost (including interest) ceiling of 350 basis points over Libor, which works out to about 7% to 8%. The higher dividend permitted on preference shares coupled with the prohibition on ECB in real estate, led to an increasing number of companies accessing foreign funds through the preference share route. This funding was often debt financing masquerading as preference share capital because international investors often raised low-cost debts from international markets (6% to 8%) and deployed it for higher dividend income as preference capital in real estate companies in India, earning a neat differential.

However, because preference capital (unless it is fully convertible) will now be treated as ECB, it will be subject to the all-in-cost ceilings applicable to ECB, creating a disincentive for investment through this route. Also, RBI's notification in May 2007 reduced the all-in-cost ceiling for ECB to 150 basis points (from 200 basis points) over Libor for ECBs of maturity between three and five years and to 250 basis points (from 350 basis point) over Libor for ECBs having maturity of over five years.

Taxation of foreign venture capital funds

Foreign investment in real estate has also been hit by amendments made to the Income Tax Act 1961 by the Finance Act 2007, which has de-recognized real estate venture capital funds (REVCF) registered with SEBI as venture capital funds (VCF) eligible for pass-through treatment for tax purposes. Earlier pass-through status was available to REVCF under Section 10(23FB) of the Income Tax Act 1961 and the income of the VCF was not included as taxable income. Further, under Section 115U any income received by a person out of investments made in a VCF was chargeable to income tax in the same manner, as if it were the investor's income gained by making investments directly in the venture capital undertaking. So the income was not taxable in the hands of the VCF but was taxable in the hands of the investor. A large number of beneficiaries in VCFs were foreign investors who would route their investment through a pooled vehicle set up in Mauritius, to take advantage of its beneficial capital gains tax regime and the favourable double-tax treaty with India.

The Finance Act 2007 has restricted the definition of venture capital undertakings to specified sectors, meaning the scope of venture capital fund has also been limited. The modified list does not include real estate, so real estate venture capital funds no longer enjoy their tax-neutral status.

Innovative structuring

Despite the tightening of the regulatory framework, investors have lined up an impressive arsenal of funds for investing in Indian real estate. Private equity investments in India are estimated to have touched $7.46 billion in 2006 and are expected to grow to $10 billion in 2007. According to the "Study on the Future of Real Estate Investment in India" issued by the Associated Chambers of Commerce and Industry of India, the real estate market is growing at 30% a year and offers the highest returns to investors.

Given the growth being witnessed in this sector and the funds at stake, real estate players are already looking at developing structures to access foreign funding, particularly since access to domestic bank finance has been restricted by the various onerous provisions and capital adequacy requirements imposed by RBI in its attempt to control banks' increasing financial exposure to the real estate sector.

For example, because the preference capital route has been blocked, local real estate players are considering setting up wholly owned subsidiary companies with capital of just a few dollars in tax havens such as Cyprus, Malaysia and Mauritius. These subsidiaries in turn receive funds from overseas investors as preference and convertible shares and invest the same as FDI into parent companies. This enables the Indian real estate company to access funds at a fixed cost, without flouting regulatory restrictions. On the other hand, long-term players are also realizing that FDI could be the main route for investment and are restructuring their corporate structures to take benefit of that. Indian real estate companies are increasingly looking at hiving off existing FDI-compliant real estate projects or acquiring new FDI-compliant projects using special purpose vehicles (SPV), which can then receive foreign investment. Undoubtedly, some of these structures are carefully sidestepping regulatory prohibitions, though others are being developed to ensure compliance with regulatory requirements.

However, one fact remains clear. As Merrill Lynch forecasts that Indian realty will grow from $12 billion in 2005 to $90 billion by 2015, stakeholders in real estate are bound to find ways and means to ensure that they are in a position to take advantage of this bounty. The government will also, having taken steps towards permitting and liberalizing FDI in real estate, at some point have to evaluate and balance the need for sound regulation with the investment and growth imperatives, to ensure that it helps rather than impedes the growth of a healthy real estate sector in India.

Author biographies

Shivi Agarwal Dhir & Dhir Associates Shivi Agarwal is a partner in the corporate advisory group at Dhir & Dhir. She advises clients on a range of commercial and corporate transactions, and has extensive experience on merger and acquisition transactions, and on corporate restructurings. She holds a BA (Hons) and an LLB from the University of Delhi. Deepak Dahiya Dhir & Dhir Associates An associate at Dhir & Dhir, Deepak Dahiya practises company and foreign investment law with a special focus on joint ventures and foreign direct investments. He holds a BA (Hons) and LLB from the University of Delhi and an LLM from the University of Leeds. Dhir & Dhir Associates provides advisory and litigation services for commercial and corporate transactions, through its offices at Delhi and Mumbai. Alok Dhir, the managing partner of the firm, is a leading professional in the area of financial and corporate restructuring in India. The firm has established a leading position in corporate restructuring, and mergers and acquisitions and has recently made successful forays into private equity and debt funding transactions. It has also been advising clients on joint ventures, technology transfer and collaborations, and foreign direct investments in India. The firm has a strong corporate and civil litigation team handling litigation and dispute resolution proceedings at various courts across India. The business facilitation, advisory and litigation practice of the firm provides end-to-end solutions based on a commercial perspective.