The author is Bipasha Kundu, a fourth year B.A. LL.B. (Hons.) student at WBNUJS, Kolkata.
The real estate sector holds special importance in the Indian economy, owing not only to its role as one of the major employers but also due to the multiplier effect it has on other industries. As of 2022, around 5,00,000 housing projects were stalled in India and were worth around Rs. 4.48 lakh crores. The same is a manifestation of the liquidity crisis, which this sector seems to be perpetually marred with. Traditional routes of financing are proving to be inadequate to keep this sector afloat all by themselves. Meanwhile, Alternative Investment Funds (“AIFs”) are increasingly gaining prominence in India. As per data published by SEBI, as of 30th June, 2023, commitments worth Rs. 8.45 lakh crores were raised, funds worth Rs. 3.74 lakh crores were raised, and Rs. 3.50 lakh crore worth of investments were made by registered AIFs cumulatively. Several Category II AIFs have their investment strategy focussed on real estate projects. These AIFs have become important for financing numerous real estate project. In this article, I attempt to unpack the nuances of the liquidity crisis in real estate sector and analyse how AIFs are mitigating the same.
Understanding the Liquidity Crisis in Real Estate Sector
Liquidity in the real estate market determines how difficult it becomes for project developers to arrange construction finance, that’s not only necessary for project developers to start the construction but also contributes heavily to the working capital. As per some estimates, working capital can amount to around half of the cost of the project.
A major reason for the liquidity crisis in real estate sector is the NBFC crisis, triggered by the IL&FS blow-up of 2018. IL&FS defaulted on its repayment for the first time in June 2018, worth Rs. 450 crores. Three months later, IL&FS defaulted again, and this time worth Rs. 1,000 crores. Consequently, IL&FS’ credit rating decreased significantly. IL&FS was under a massive debt of Rs. 91,091 crores. The fact that IL&FS chose to fund long-term projects through short-term loans probably contributed to the crisis. Taking more short-term loans became increasingly difficult due to increased costs, which led to a delay in projects. Ultimately, IL&FS couldn’t make timely repayments. Moreover, mutual funds became extremely cautious in lending to NBFCs.
The share of real estate has consistently risen in NBFC lending. Funding in this sector has become more dependent on NBFCs due to contracted lending from banks. RBI released a circular on 19th April, 2022, to regulate lending activities of middle and upper layer NBFCs. The circular categorically mentions that loans to the real estate sector are to be disbursed only when the borrower has obtained all the required permits and clearances. In light of the NBFC crisis, these regulations seem to be a prudent step to ensure that NBFCs don’t undertake disproportionately high risks. However, NBFC funding has been most crucial in the initial stages of real estate projects, and that could be adversely affected by these regulations.
The onset of COVID-19 pandemic further widened the liquidity gap in the market. The focus of banks also shifted from commercial real estate to retail loans in the housing sector to minimize risk. The cost of common raw materials like cement and steel also witnessed a significant increase due to the pandemic.
What are Real Estate-based AIFs?
In India, AIFs are regulated by Alternative Investment Funds Regulations, 2012. AIFs are “privately pooled investment vehicles.” The fund can be structured as a trust, company, limited liability partnership, or body corporate. It has to invest the collected funds according to the defined investment policy. Even though the fund needs to be incorporated in India, it can collect investments from both Indian and Foreign investors. However, funds that come under the ambit of SEBI’s other regulations (like the Mutual Funds Regulations and Collective Investment Schemes Regulations) do not qualify as AIFs. There are three categories of AIFs. Category I AIFs are supposed to be “socially and economically desirable.” Category II is the residuary category. Category III AIFs are those that employ very “diverse and sophisticated” trading strategies.
An AIF is generally structured as a trust to avail easier compliance requirements. In a typical AIF, the sponsor is the entity that sets up the fund. The sponsor has to have a continuing interest of either 2.5% of the entire corpus of fund, or Rs. 5 crores, whichever is lower to maintain a “skin in the game.” If the fund is structured as a trust, then the settlor settles a trust by means of a Trust Deed. The responsibility and power to manage the fund is transferred to the Investment Manager through an Investment Management Agreement. The fund issues a Private Placement Memorandum detailing the terms and conditions, investment strategy, expected rate of return, risks involved, track record of the fund management team, etc. Finally, the investors execute a Contribution Agreement, through which they agree to invest in the fund as per the agreed terms.
Real estate-based AIFs fall under Category II. However, it is important to note that these AIFs cannot directly invest in any real estate projects. They can only invest in securities of the real estate project developer companies. Any such real estate-based AIF cannot invest more than 25% of its investible funds in a single company. Real estate-based AIFs are considered comparatively less risky than several other kinds of AIFs because of its somewhat long lock-in period which makes them less volatile.
The Role of AIFs in Bridging the Liquidity Gap
Several project developers find it difficult to execute a project to its completion because of a gap in funding and routing funds through the traditional sources have increasingly become difficult for the project developers. AIFs provide a non-traditional route for financing the same. There are several benefits associated with the AIF route of financing. Firstly, each AIF can be tailored to address the highly specific requirements of an investor. Such customization is possible mainly because of “side letters” granted to investors by the fund manager. By means of side letters, terms of agreement provided by the fund documents can be altered in favour of the investor. As of now, the fund managers have full flexibility to lay down the parameters for granting side letters to investors, whether based on quantum of commitment or strategic relevance. However, the same has to be disclosed in the Private Placement Memorandum so that all investors are aware of the same. Secondly, AIFs are often preferred by investors who are High Net-worth Individuals because of the prospective long-term growth, which often outweighs the great degree of risk involved and gives them an opportunity to diversify their portfolios. Thirdly, the regulatory framework relating to AIFs has been actively improved upon by SEBI, and by virtue of the same, Real Estate-based AIFs contribute towards increasing transparency in the real estate sector.
One of the best examples of AIFs contributing actively to bridging the funding gap is the SWAMIH Fund launched by the government of India. The objective of the fund is to bail out over 1,600 projects consisting of 4.6 lakh individual housing units. The corpus was initially set at Rs. 25,000 crores. Out of the Rs. 25,000 crores, Rs. 10,000 crores would be paid by the government, and Rs. 15,000 crores would be provided by SBI and LIC. Subsequently, the government invested an additional Rs. 5 crores in the fund. However, the funding cannot be used to repay existing debts. To be eligible to get the benefit of this scheme, the projects should be at least 30% completed and should be registered under RERA. The projects need to come under the “affordable” or “mid-income” category, which has been defined taking into account the city in which the project is situated. This fund provides funding in the form of non-convertible debentures. As of March 2023, Rs 2,646.57 crore had been released and the fund had been successful in getting over 22,500 housing units completed.
As traditional routes of funding for project developers become arduous, the role of AIFs in financing real estate projects and leading them to completion has only become more important. Data published by SEBI clearly indicates that AIFs continue to become more prevalent in India. Real estate-focussed AIFs are playing an important role in infusing much-needed capital in the sector. The SWAMIH fund is one of the best examples of the same and has proved to be successful in bailing out thousands of housing units in just three years. SEBI has been quite active in improving the regulatory framework surrounding AIFs and it is expected that it would make them more investor friendly. Real estate-based AIFs, provide an avenue to investors to participate in real estate markets without having to directly own underlying assets. In contemporary times, the majority of the funds in AIFs are sourced through domestic investors themselves, and it can be expected that in the coming years, benefits of Real Estate-based AIFs will possibly go beyond tier-I cities in India.