Investing In India's Real Estate Sector

Source : The Business Times, August 27, 2008

Foreign investors need to address some key issues and regulatory requirements before jumping in

INVESTMENT in the Indian real estate sector continues to grow, albeit the pace may be slowing just a little. Foreign developers as well as private equity funds remain bullish, long-term, on India's property market.

From a foreign investor's perspective, the recent correction in real estate prices in some parts of India is good news in that it could result in land being available at attractive values.

Unclear picture: As for partially completed projects, the foreign direct investment (FDI) guidelines do not clarify whether FDI would be permitted into such projects Not only is investment flowing into the 'first-tier' cities, but attractive real-estate deals are also being negotiated and signed in 'second-tier' cities such as Indore, Jaipur and Cochin.

But although Indian property may make an attractive investment for foreign investors, it is important that they address some of the regulatory issues prior to making an investment.

According to India's current foreign direct investment (FDI) policy, 100 per cent FDI is allowed under the automatic route - that is, without requiring government approval - for the construction and development projects that include housing, commercial premises, resorts, educational institutions, recreational facilities, city and regional-level infrastructure and townships.

But this is subject to certain conditions:

# Minimum area for development under each project should be:

i) 10ha in the case of services housing plots; or

ii) 50,000 sq m in the case of construction development projects.

iii) In case the project is a combination of the two, any one of the two conditions would have to be met.

# Minimum capitalisation of US$10 million for wholly owned subsidiaries and US$5 million for joint ventures with Indian parties.

# The funds have to be brought in within six months of commencement of business of the company.

# The original investment is subject to a lock-in period of three years from the completion of minimum capitalisation.

# At least 50 per cent of the project must be developed within a period of five years from the date of obtaining all statutory clearances.

# Investors would not be permitted to sell undeveloped plots.

Though the investment policy seems straightforward, investors still need to address some key issues and comply with other regulatory requirements.

For example, when it comes to funding, India's exchange control regulations permit external commercial borrowings (ECBs) - that is, commercial loans in the form of bank loans, buyers' credits, suppliers' credits, and loans from shareholders.

There are several restrictions on the end use of ECB funds. One of these is that the proceeds of ECBs cannot be used for the purpose of acquiring real estate in India. Accordingly, ECBs cannot be used for real estate development in India.

Preference shares are also considered as ECBs and, likewise, cannot be used to invest in a real estate project in India.

The only exception is the use of compulsory convertible preference shares or fully and mandatorily convertible debentures, which would be treated as part of equity and would be considered as FDI.

Therefore, apart from pure equity funding, only compulsory convertible preference shares and fully and mandatorily convertible debentures can be used. This would tend to minimise the options available for funding a project in India because all funds would have to be in the form of equity or instruments which can be converted into equity.

As per the FDI regulations, a foreign investor's original investment 'cannot be repatriated before a period of three years from completion of minimum capitalisation'.

Original investment

The question therefore arises as to the meaning of the term 'original investment'. Should the term be interpreted as 'minimum capitalisation' or should it be interpreted to mean the funds brought into the company in the first six months?

Since the term is not defined, it becomes important to have a correct interpretation, as the 'original investment' is subject to a three-year lock-in period. The view that seems to be emerging is that funds brought into the company in the initial six months - that is, the minimum capitalisation of the commencement of business - is the original investment and subject to the lock-in period.

However, the risk is that if an amount in excess of the minimum capitalisation is invested during the first six months, the entire amount would be treated as 'original investment' and would be subject to lock-in. To minimise this risk, only funds to the extent of minimum capitalisation should be invested during the first six months.

Investors in real estate have to bring the funds into India within six months of 'commencement of business'. Again, the term 'commencement of business' has not been defined. It can be interpreted in various ways; for instance, in the construction business it could mean the point at which construction actually commences.

The view emerging from Indian regulators is that the term 'commencement of business' means when the shareholders agreement or joint venture agreement is signed. Accordingly, the funds have to be invested within six months upon signing the agreement.

Finally, there are questions surrounding partially completed projects. The FDI guidelines do not clarify whether FDI would be permitted into these.

The question would arise as to the meaning of 'partially developed'. In this connection the view appears to be that if the project is less than 25 per cent complete, FDI would be permitted. However, in this case it may be prudent to seek prior approval of the Foreign Investment Promotion Board before making an investment.

Given the fact that India desperately needs good-quality housing and commercial space, the current slowdown in deals in India is likely to be temporary.

In due course, growth in the Indian real estate sector will resume with more acquisitions and consolidation. But foreign investors planning to enter India's real estate sector need to address a number of regulatory issues before they go in.

The writer is the head of tax of BDO Raffles in Singapore. The views expressed in this article are his own