The current standoff in real estate markets due to global uncertainty, high interest scenario and flagging demand has put the investor in a fix. Apart from the macroeconomic issues there are number of risks associated with the developer where the investor cannot exercise control and mitigate them.
Developer risk emerges due to overleveraged positions and undertaking several projects beyond the developer’s execution capabilities. This further impacts the ability to complete projects in the given time period with promised quality standards.
In addition, direct investments bring a higher percentage of transaction cost through stamp duty/registration thus the product price has to appreciate to cover for these costs before any return is earned.
For instance, an investment of Rs 5,000 per sq ft should appreciate to Rs10,500 per sq ft to absorb stamp duty/registration cost of Ra 500 per sq ft while the remaining R5,000 per sq ft will offer 26 per cent internal rate of return (IRR) over a three year period provided the entire payment has been made upfront.
Direct investment in case of leveraged returns has to take into account carrying cost (interest cost) and in the case of non leveraged returns should consider opportunity cost.
Opportunity cost is the cost of opportunity lost in case the investment is not yielding desired results i.e. in both cases interest and opportunity become a double edged sword.
Ideally an investor is likely to invest in a city where one resides. This concentration of all investments in one market also gives rise to a risk. For instance this risk is being more appreciated by investors in Hyderabad due to current socio-political crisis prevailing in the state.
The investor also has additional limitation of identifying a growth corridor, which has an ability to offer superior risk adjusted returns.
The risks we have seen earlier can be mitigated, if these investments are routed through Domestic Real Estate Private Equity Fund. Such funds are pooled vehicles registered with the market regulator Securities and Exchange Board of India.
The duration of these funds is typically 5-7 years. The commitment period of these funds denote the time duration during which the money is invested in phases. Since the commitment period of these funds are 2-3 years, it offers staggered investment opportunity thereby also reducing the risk of investing the entire money during peak of the cycle.
In addition, these funds provide compounding opportunity due to the size and scale of investment. The fund size also enables the investor to invest across cities and thereby mitigate concentration risk provided prudent limits are set for investment in multiple cities.
The asset management professionals manning the REPE funds are in a better position to select the right development partner based on objective selection criteria as they have the necessary experience in construction to monitor day to day progress of projects invested, ensuring that projects are completed on time and meet the requisite standards.
Returns in real estate can be optimised if an investment is made at project development stage. REPE being equity partners share the profit margins of the developer unlike the direct investor who is solely dependent on the end product price appreciation.
To illustrate: R 5,000 per sq ft can be end product pricing for retail customer but developer and private equity fund may have invested at approximately 1/3rd of the price as land cost. The other 1/3rd which is construction cost is financed by retail customer and the balance 1/3rd is the profit margin of the developer and REPE fund.
Hence appreciation is not the target by REPE. Direct investment necessitates appreciation as the only means of making decent returns at the cost of not managing any risk.
For investors looking to make good returns in realty, REPE is the better alternative. However, before you park your money with a fund, do carry out due diligence of the track record and the strategy adopted by the fund manager.