Realty MF rules: Some issues

CIO of Kotak Realty Fund V Hari Krishna says that Sebi's Real Estate Mutual Fund guidelines is a positive one, but some structural issues need to be addressed.

He futher adds that the first real estate investment could hit markets in the next six months. However, daily NAV calculations will be difficult for under development projects, he says.

Excerpts from CNBC-TV18's exclusive interview with V Hari Krishn

How have you read the news about real estate mutual funds and what sort of appetite do you see?

The recent measures of Sebi on Real Estate mutual funds is clearly a positive for the mutual fund industry and also for the recipients of capital from the real estate industry, which traditionally has been under capitalised.

I believe that the capital challenges available within the real estate industry have already been solved to a great extent by the entry of venture capital funds, private equity funds and also international investors into the domestic markets. This whole measure is positive at a macro level but there are certain structural challenges in the architecture of the scheme.

For example, when one compares the structure of the scheme proposed in India to other international markets, be it Asian markets or the US markets or the Australian markets, one of the key differences is that internationally real estate investment trust or real estate mutual funds typically invest in existing operational income producing property portfolios, whether they are shopping centers, business parks, offices, hotels or service departments.

They generally do not invest in developing properties or vacant land or under construction properties, which have yet to start generating cash flows.

In the Indian context, apart from the provisions to invest in mortgage backed securities and list of real estate companies and debt of real estate companies (listed or unlisted), they are also allowed to invest essentially in development projects and also companies, which are undertaking development projects, which I believe provides certain structural challenges to overall operationalisation.

Are you saying that our mutual funds are then probably seeking to model themselves more on an absolute capital appreciation over a period of time delivery rather than an income yield perspective?

That is right. That is a very key difference. The reason why some of the challenges which are being discussed in the Indian markets, I have heard mutual fund industry players mentioning valuations as one of the key challenges in the Indian industry and some of the other issues.

Typically most these issues would have not been of the magnitude there in India at this point of time because of the fact that internationally most of these investments trusts invest income-producing properties that are generating a certain kind of cash flow.

Then it is for the individual retail subscribers or the pensions funds who are subscribers to these investments trust, to purchase these securities at a given dividend yield because there is certain cash flow available. Typically the dividend yields, these investments trust get traded and dividend yields which are about anywhere between 125-250 basis points over 10 year government security rate in those particular markets.

By the same corollary in India these cash flows schemes would have probably been valued at perhaps 9-10% range given where the G-sec is today at this point of time. But if the architecture provides for development projects where one is a purchasing a land in the suburbs of Chennai and developing a residential project, it does not have cash flow characteristics for the first 3-4 years. Then the valuation becomes

How do you sell it to retail investors then? Does it carry more intrinsic capital appreciation or depreciation risk because of the fundamental model?

Clearly the model, which has been proposed at this point of time given that it has the flexibility to invest in development projects and companies, which are taking developmental projects is at the other end of the risk returns spectrum. Whereas internationally the real estate investment trust model provides excess to retail investors in pension fund subscribers at the risk return spectrum which is more towards the low to medium end.

Whereas the risk return spectrum here is much higher here. I would think the format would be that the retail investors I presumed need to be convinced about the capital appreciation story to invest in the current architecture.

For a mutual fund then in the listed universe what sort of opportunities does it present? Is it indeed the development projects or do you think they can stretch to argument to pick up something that might straddle a huge land bank?

They could invest in listed companies as well as companies which are undertaking projects as well as land bank companies. But most of them do not generate any cash flows for the first 4 (although he sounds like 40 years) years of operations. In a 7 year clause ended fund one will stand assuming that most of the return to investors is coming back in the form of capital redemption at a premium hopefully towards the last few years.

I think there are certain other challenges, which mutual funds, the current architecture would faced. For instance it does not define any leverage norms at this point of time. Internationally most of the real estate investment trusts has caps on the maximum leverage, such funds can sort of take on typically between 35-60% odd.

The leverage norms have not been defined. I think there needs to be a huge evolution in the whole accounting code for reporting the operations of some of these sort of funds. For instance internationally there is concept called free funds flow from operations FFO.

There is an accounting code which clearly defines how is the FFO calculated, which I think still needs to be evolved in India at this point of time. There are certain critical operations which needs to be address simultaneously in order for the current scheme to be fully successful and fully understood by retail investors.

If you had to rate the three as investment alternatives between buying real estate, buying real estate stocks or buying into realty mutual fund, how would you rate them?

I think they are two different animals, clearly real estate stocks are well understood in terms of what they are offering and it is play on projects and operational parameters of one particular operating company whereas the real estate mutual fund would hopefully offer one access to many more such companies. That is the critical difference.

How do you go about declaring daily NAVs if one were to invest heavily into projects under construction or properties or land banks on which properties will come up?

I think it is extremely difficult to generate daily NAVs for under development projects on a day-to-day basis because in most parts of India there is not too much of transactional evidence in terms of regular real estate transactions and which is were the difficulty lies in estimating net asset value on a regular basis especially on a daily basis.

When do you expect the retail real estate mutual fund to hit the stands?

I presume within next six months.

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