In the first piece of our ‘Real Estate Funding’ series, we had dealt with some of the key structures and funding models for real estate investments into India. In this piece, we have dealt with some key considerations for real estate investors.

• ASSET CLASS: The asset class within ‘real estate’ into which investments are made determines the gamut of rights that investors generally seek. Residential real estate is self-monetising, and hence the rights sought by investors are geared towards ensuring proper construction and development, and end use utilization of funds. On the other hand, commercial real estate is more of a yield play and in addition to the above, the terms on which properties are leased out are critical to investors, in addition to the terms on which developers may undertake lease rental discounting. Even within commercial real estate, asset classes are critical since the customer base and demand may vary from time to time. For instance, some developers prefer strata sale, or sale of a certain portion of office buildings for liquidity purposes.
• REVENUE STREAMS: Different asset classes have differential revenue streams. While residential real estate revenues are directly linked to the sale of units in the project, commercial real estate is a long-term yield play. Accordingly, the rights of the investors in relation to seeking control over the revenue streams also vary.
  • CONTROL OVER CASH FLOWS: In both commercial and residential real estate, investors prefer to have watertight escrow / trust and retention accounts at the project company level to ensure all cash flows are routed through these accounts, and they have adequate control over the same. RERA (see below) also dictates the manner in which the project receivables are appropriated and this is critical to be factored into the cash flow control mechanisms.
  • MINIMUM PRICES: To ensure no indirect diversion of funds, in addition to base terms, investors set minimum sale/lease price for the developers to sell or lease units in projects. These are referred to as the ‘minimum sale price’ or ‘minimum lease price’. The developer is provided some leeway on these prices only in case of bulk sale / bulk leasing above an objective threshold.
  • TERMS OF SALE / LEASE: Investors prefer to retain some control over the terms of the sale or leasing of units. Investors tend to set base / floor terms (generally commercial in nature), and developers are required to undertake any sale lease on terms equal or more favorable to the terms laid down by the investor.
  • COST OVERRUNS: One of the major concerns in real estate projects is cost overrun and investors prefer the developer / promoter to back-stop or undertake to cover for such overruns from other sources. Having said, that, in commercial real estate, after the development of the project, cost overruns are generally due to unforeseen circumstances (such as force majeure) and investors are more amenable in permitting project revenues being used to cover for such overruns.
• RERA: Under the Indian real estate regulatory regime, every project (with some exceptions) is required to be registered with the Real Estate Regulatory Authority. Investors should ensure that the projects are duly registered before funding, since marketing and sale / leasing of units can commence only post registration. Further, security invocation rights of investors may also be adversely impacted by the Real Estate (Regulation and Development) Act, 2016 (“RERA”) and the manner in which the project is registered. Additionally, RERA has provisions with respect to the manner in which the receivables from the project can be used, providing that 70% of the receivables are locked-in, and released only in accordance with the actual expenses incurred towards the construction of the project. The developer also has significant obligations under RERA, which may have severe consequences from a monetary and reputational perspective. It would be prudent of an investor to look into these and consider the potential hurdles RERA may create upfront.
• GOVERNANCE: In addition to cash flow controls, investors generally require robust governance rights in the project. These are provided for by way of representation on the board and committees of the project company, extensive information rights and reporting requirements as well as ‘project monitoring’ or ‘project management’ committees, which have now become commonplace in Indian real estate. While ‘PMCs’ are sometimes completely independent bodies, it’s not uncommon for investors to have substantial representation on / control of such ‘PMCs’. A PMC is formed with the twin objective of overseeing the operational aspects of the project, and ensuring that the investors’ rights are adequately safeguarded. The suggestions of the PMC may be structured to be binding on the board, providing the investor decision making ability through the PMC. The PMC also obliviates the requirement of the investor to have majority control of the board to control governance (thereby mitigating consolidation risks for the investor and reducing potential fiduciary liability on individuals as directors.
• SECURITY CREATION AND ENFORCEMENT: In case of debt investment, the biggest hurdle faced by real estate lenders is the existence of bank lenders, with exclusive first charge on all assets of the investee. While amenable to subservient charges being created, banks are generally inflexible when it comes to ceding control over cash flows and investors get control over the funds only post servicing of the bank loans and maintaining any other amounts required under the banking arrangements (such as debt service reserve amounts). Further, while investors may take extensive step-in rights, methods to actually implement the same at a practical and granular level (including re-branding nuances and addressing specific challenges under the regulatory framework (such as under RERA) should be addressed carefully.
• PREPAYMENT: Real estate debt investors should be wary that once projects have commenced construction, bank financing may be available to lenders, incentivising them to consider refinancing the relatively more expensive investor debt with cheaper bank lending. While it may not always be plausible to restrict such refinancing, reasonable lock-in or increased IRR pay-outs in case of refinancing from external sources are quite common in Indian deals.
• BANKRUPTCY: As an industry standard, developers establish separate SPVs for each project, all held under a common holding company. The investors in the projects generally prefer to be at the SPV level, i.e. ‘closer to the asset’, and remote from issues or concerns of other projects. While this is cleaner for the investor, it exposes them to risks of insolvency of the developer at a group level, thereby limiting the efficacy of the security availed. A group-level solvency risk of the developer should be assessed and if required adequate safeguards at the group level (including aggregate limits on borrowings and contingent liabilities) must be imposed. Ensuring that the lender is considered as a ‘financial creditor’ is also critical.
• INSURANCE: A relatively nascent phenomena in India, investors should consider requiring developers to obtain title insurance for projects in India. With the lack of a centralised database with respect to title in India, properties being mired with title concerns are not uncommon in India. In such cases, obtaining a title insurance may be helpful to prevent loss of value emanating from any such claims. Additionally, insurers are also open to insure portfolio of assets for developers or investors, permitting expansion of the portfolio as well.

These considerations are critical for any investor to bear in mind when investing into Indian real estate.
Dipanshu Singhal and Karan Kalra