Contact Us

PE players tweak investment strategy for real estate

Business Standard, Neha Pandey Deoras & Yogini Joglekar, New Delhi

October 25, 2012


Jones Lang Lasalle's latest release, Finding Real Value in a Course Correction, highlights how Private Equity players have made a sustained change to their investment strategy and developers have modified their development mechanics to ensure value creation for their investors and partners during uncertain times. The report also looks at the changing roles that banks and the government could play leading to better asset creation.

The report says private equity (PE) funds are re-aligning the five Ps of real estate investments (portfolio, protection, philosophy, profiling and partnership) and aim at optimal value creation in accordance with the changing market conditions. The capital flows into the residential sector have recorded an upsurge, with the share increasing to over 50 per cent in 2009, 2010 from 15 per cent in 2008. With an eye on structured transactions aimed at risk mitigation, PE firms are increasingly focusing on investments in fundamentally strong markets. There is need for a proactive role of banks to ensure that only creditworthy participants and quality projects have access to finance.

The real estate industry is treading into a new cycle post its learning over the past four to five years. After their exposure to both a pre-GFC (global financial crisis) and post-GFC scenario, industry stakeholders have made changes to adapt to the evolving trends.

With changing times and market conditions, PE funds need to tweak their investment philosophy to ensure optimal value creation for their Limited Partners (LPs) and General Partners (GPs). Given that the residential property segment is self-liquidating, that is, where returns flow is faster on the back of high demand, PE players have spurred their investments in this asset class. PE funds stay away from construction financing of commercial or residential real estate.

Earlier, PE players used to look at high returns due to lack of means and precedences to detail risk factor in India. This underestimation of risk and the subsequent overheating of the realty sector saw them return to their former practice of stringent risk profiling tests. Having been saddled with delayed project executions and low demand levels in major cities, funds are now undertaking a much more detailed analysis of risks.

Partnering with developers with weak financial positions led to jeopardising project execution and resulted in contractual arguments besides creating illiquid assets. Development partner's trackrecord, market reputation, delivery capability, financial health, business flexibility, and control sharing are today being considered as imperative parameters at the time of examining development partners.

Fund portfolios focused on convertible or preferred instruments to plain equity. PE players were also looking at reducing risk in their portfolios by investing across different locations, and diversifying their assets and partners.

PE funds are now increasingly looking at preferred returns structures that enable them to take out their capital prior to the developer. With capital raising becoming complex due to cautious global financial conditions and volatile currency markets, investors along with fund managers have to ensure their investment and exit strategies are correct.

The report also says there is need for a proactive role of banks to ensure that only creditworthy participants and quality projects get finance. Banks are the biggest source of project financing and banks have huge exposure to real estate.

Thus, a reduction in loan-to-value (LTV) ratio will allow banks to lend less while the developer maintains a healthy equity of his own in the project. The central bank should therefore, allow reduced risk-weightings on construction loans for residences that have been presold, while putting the required LTV ratio higher compared to commercial real estate loans.

Once Basel III comes into effect and capital adequacy norms become stricter, increased capital costs will make loans expensive. The idea should be to keep lending rates in a reducing environment, while ensuring that capital adequacy norms will help banks protect themselves against increase in NPAs.