A big-bang appreciation like in equity won’t happen in REITs: Rahul Guptan

If you compare REITs to investment trusts, the market has still not formed a view as to how to treat this product in its asset break-up, says Rahul Guptan.

The opportunity for real estate investment trusts (REITs) in India is huge, and if this market were to mature in the right way, it could attract a significant number of people who are currently putting their money into savings bank accounts or fixed deposits to get stable returns, Rahul Guptan, partner with international law firm Clifford Chance Pte Ltd, said.

“If you compare the place we are in with REITs to where we are in with investment trusts, it’s very similar. From the time dust settled on all regulatory issues and clarifications, the first investment trust got done in 18-20 months, and we’re in that 18-20 months with REITs as well,” he pointed out.

For foreign investors looking at India’s real estate space, the changes in rules and regulatory clarity over the last 2-3 years have played a huge role in lowering risks, leading to increased participation, he said.

“You’re (foreign investors) probably taking a risk call based on macroeconomic factors, rather than an interpretation of an XYZ rule in the foreign investment regulations,” Guptan added.

Edited excerpts from an interview:

How big an opportunity are REITs in India?

REITs had to happen. In India, from developers to investors to land-owning companies, they have all looked for years to monetize their assets, and REIT has proven itself as a product and structure across many markets. Given the quality of real estate available, commercial real estate specifically, the opportunity is huge. The reason we have not seen a transaction so far is because when the rules came out, it needed some clarifications; and tax and stamp duty issues weren’t clear. They have all been ironed out now, and we are now in a situation where we have enough regulatory clarity for the first REIT transaction to take place.

If you compare the place we are in with REITs to where we are in with investment trusts, it’s very similar. From the time dust settled on all the regulatory issues and clarifications, the first investment trust got done in 18-20 months, and we’re in that 18-20 months with REITs as well. Historically, from a capital markets product perspective, it never happens that an unknown promoter or an unknown company is the first to take advantage of a major regulatory change. So, it will be an established player who has the gravitas to understand the product and the structure and who will navigate the product through the Indian regulatory sphere.

Even from an investor perspective, they are going to be hesitant as it’s high-risk. Which is why you should have the right promoter or the right investor base to take the transaction to the public.

If you compare REITs to investment trusts, the market has still not, in my personal view, formed a view as to how to treat this product in its asset break-up. A big-bang appreciation like in equity is not going to take place in an investment trust or REIT. The appreciation happens over time.

You buy it for the stability of the return when the asset class is mature—it is only when the investment trust churns the portfolio, or the REIT starts to buy or sell assets that you’ll see the trading pops and the upturn in the unit price value. So, that mindset also has to come to the investors in India.

There is also a lot of hesitation about launching the next investment trust or REIT, when the price of the two existing investment trusts are hanging around IPO levels—slightly lower or higher. People will wait and watch to see how these guys perform against the yield that they promised. If they are able to maintain that yield and there is no serious backlash or failure by any of the existing players, the market will stabilize.

But in a lot of countries where REITs have been successful, the capital markets haven’t been as robust or yielding attractive returns. Capital markets in India are a different story altogether—so will REITs ever be attractive to investors here?

You have to view investors in a REIT or an investment trust slightly differently from an average equity investor. People who are investing in equity are looking for returns daily, monthly, a fixed IRR (internal rate of return), based on the money and leverage that they are employing.

REITs and investment trusts are viewed as more stable resources in which to park your money, as opposed to parking it in your bank or FD (fixed deposit). Today, with the falling interest rate environment in India, where banks are not giving double-digit FD interest rates, there is a definite need for an alternative asset class for retail investors.

A lot of people put their money in FDs and savings bank accounts. Those are the people who are going to get attracted to this product. People who put their money in mutual funds are today putting it in non-convertible debentures to get the returns that they want. Those mutual funds that are looking to get fixed, stable returns will look at REITs and investment trusts. This isn’t going to happen overnight. We are in August 2017, and there have just been two investment trust deals. I think that the market has to develop.

And once the market develops, you will really see the value for not just real estate developers and infrastructure developers. Today, we are looking at these products only for the likes of IRB, Sterlite, and Reliance, who have eight road projects, five power plants and large commercial offices. But there is nothing to stop a corporate, which owns a building, from putting that in an asset class and unlocking the value of that real estate. If you look at the Singapore example, you’ve put ships, office complexes, and land into business trusts. If the market matures the right way, you have a population of a billion people and with the push for people to have bank accounts, they will all be looking at these instruments.

In recent years, several large global private equity (PE) funds, sovereigns and pension vehicles have entered the real estate market. How has that changed the market in terms of valuations? Also, does the entry of these big names mean investors now view India differently? 

My impression is that valuations have gone up, and that’s natural when there is capital coming in. What has happened in these rounds of investments—and that was missing earlier—is that the latest ones are a lot about partnerships. People are coming in and just taking a 5-10% stake, but doing so through co-invest structures. Multiple investors are taking that combined risk, and not exposing themselves to the whole thing. Second, when investors are committing large pools of capital, they are doing so with control.

Today, as a foreign investor, you can come into real estate with a fair degree of control and ownership over the asset. That has only happened in the past three years. Regulatory clarity has been a very important factor. In the past, there have been cases where investors have lost money, and not been able to exit. Compared to that, the risk is much lower. You’re probably taking a risk call based on macroeconomic factors, rather than an interpretation of an XYZ rule in the foreign investment regulations.

Agreed, regulations have eased, but have not investors, especially PEs, become wiser from past lessons? It is no longer about grabbing a 5-10% and having a bit of India in their portfolio.

There is an interesting report by McKinsey from 2015 on Indian PE. They have done an analysis based on a poll of LPs and GPs (limited partners and general partners), and they’ve compared two investment periods—prior to 2011 and post that. All international investors touched upon themes they now want to go with an established promoter—it’s no longer about backing an idea.

Today, it is about, ‘You’ve got three power plants and you want funding from us, then we will look at your business. We will come in if we have control and access day-to-day management and operational features of the project that we are funding’. A lot of these themes have changed because laws have changed. The route to foreign investment and the ability to take control have been made easier, Companies Act has been amended, Competition Act has come in, and the bankruptcy code is in place. In the life cycle of a country where laws have been changed and brought up to speed, all this has happened in a very short period of time.

You’re seeing definite benefits but the real story will only be revealed over a longer period of time. One of the key findings of that McKinsey report is that the ones who come in before 2011 came in with the intention of getting in and out of India fairly quickly. But every LP and GP now understands that it is a long-term play. And in that long term, there will be ups and downs, where you will or won’t meet your IRR. 

Many of the pre-2011 investments are still stuck.

Yes, but if you look at 2008-11, the post-financial crisis period, the deals were few and far in between. We had a blip of transactional work in 2009-10, because of the elections and the quantitative easing in America. There was a lot of funding for people, and you had local Asian and emerging markets doing really well. But then, we went into a lull after that, with years without a single IPO (initial public offer), QIP (qualified institutional placement), or fund-raising exercise, and that trend has only changed in 2015-16.

It’s that same exact story if you came in around 2009 and expected to exit by 2011, it was not going to take place. Any emerging market is subject to macroeconomic factors, political factors and global conditions that you don’t have control over. Right now, sitting in August, we have seen a definite slowdown in the past few weeks of India deal volume, purely on the back of geopolitical issues that are coming out of the region. It’s not just India, but it has affected everybody in the region as well.

Is it related to the tensions with China or Pakistan, or is it overall unrest?

It’s a combination of factors—North Korea, America, regional uncertainty. These factors have real impact on transactions. It’s tough enough to do business with all these factors, and India has its own unique factors. For example, when the Supreme Court passes an order in the Vodafone tax case and the government goes and changes the law retrospectively. That’s a factor which is nothing else but self-inflicted. You have local factors as well that come into play and impact business. Navigating through all of that is what makes it challenging as well as exciting doing business in India.

As far as investor concerns go, how has that changed over time? What are the common questions and concerns of investors relating to India?

I put clients into two buckets—one is the sophisticated client with eyes and ears on the ground and understanding of what is happening there even if they don’t have an office in India.

Their questions are very specific to what they want to do in India. There is, surprisingly, still a category that does not know India that well. They are aware it’s a market that they should be in, and they are trying to understand how to structure investments, but a lot of times, they buy into misconceptions. For those clients, it’s a big educational process.

But the questions more or less come down to the same things—the big concern is corporate and public corruption. There are a lot of questions around how endemic corruption really is, and how do they deal with it. These clients also want to know how to structure their investments, exit options, tax policies, regulatory approvals, and whether their agreements will be enforceable, and where they should go for dispute resolution, among others.

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