Investing in India's real estate sector

August 27, 2008
Investing in India's real estate sector
Foreign investors need to address some key issues and regulatory
requirements before jumping in
By ROHAN SOLAPURKAR

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.

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.

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.

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