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Debt Financing for Real Estate


Rohit Bhase, JBIMS MFM,

Company Secretary, LL.b., PGDSL

Real estate in India has seen phenomenal growth and if you agree with the experts, the boom in urban markets is to stay unaffected by falling GDP. Residential properties (capital or rental) will continue to fetch premium, thanks to high demand from HNI / NRI customers and restrained supply due to municipal issues and slow execution. Commercial properties though look weak today due to limited demand, a flood of residential projects as a ‘unanimous choice’ by developers will cut the supply by FY 14-15 and may spike the prices due to sheer unavailability of space. Filling this demand – supply gap will take at least a couple of years which will keep the commercial property rates sky-high.


Being capital intensive and long gestation business, real estate development demands huge financing at regular intervals while the realisation takes its own time depending upon the execution capabilities of the developer. This calls for a cost effective finance mix right from the stage of acquiring land / development rights.


Till late 90, real estate was a game of many scattered players with no single dominant leader, most of which were haphazard / amateur / single project developers. Even today such players do constitute a large chunk of the market but for due to their limited need for finance, herein we will not refer to them. The focus of the article inter-alia is on large developers and their financing needs. These large developers with several on-going projects look for funding from various sources. Let’s look at the traditional once first.


Bank finance: Traditionally, this has been a major source for developers as well as investors. Here, Bank would create mortgage on the property and / or structure, hypothecate the stock of material and / or cash flows from the sales would be collateralised in favour of the Bank. However, this mode over a period of time has led to many issues, some of which are as follows,

·         RBI has put in place stringent rules for banks’ credit exposure to real estate, requiring Banks to frame and adhere prudential norms relating to the ceiling on the total amount of real estate loans, single/group exposure limits for such loans, margins, security, repayment schedule and availability of supplementary finance.

·         RBI does not allow Banks to finance acquisition of property. Only construction loans are permitted.

·         Banks are required to ensure that property titles are clean and requisite governmental / municipal approvals are in place. (This is where lot of developers get disqualified !)

·         Slow recovery process of bad loans (However, now SARFAESI Act has made it easy for banks)


Bank finance is cumbersome for developers too as the security creation ratio goes as high as 2.5 to 4 times of the facility amount (which means that for land valued Rs. 400 Crore, developer gets only Rs. 100 Crore of finance). Clauses like first and exclusive charge on property, cross-collateral, call-back of facility at the discretion of the Bank in facility agreements take away the financing flexibility from the developers.   


FIs / NBFC Financing : While the Banks got restrained from real estate financing, FIs and NBFCs went for it and aggressively expanded their book size. With RBI not so tough with Development Finance Institutions (DFIs), Housing Finance Companies (HFCs), Non-Banking Financial Companies (NBFCs), developers preferred them over Banks. These institutions also offered structured finance to developers with returns linked to IRR, customised re-payment period, conversion to equity option etc. Though these institutions are not as stringent as the Banks, they charge high interest rates, demand veto rights and additional securities (such as pledge of shares, corporate guarantees of holding companies, personal guarantees of promoters etc.) NBFCs not covered under SARFAESI Act also face substantial credit recovery risk.


Off late RBI realised that these institutions esp. NBFCs were borrowing from Banks and lending / investing in real estate. It may be also noted that NBFCs borrow short and lend long. This way Banks get indirectly exposed to real estate and asset-liability mismatch and this flow of fund could lead to systemic crisis. RBI is now trying to discourage this route by limiting the activities for which NBFC can get Bank finance.


Money Lenders and Investors : While many developers avail finance from Money Lenders and Investors particularly for land acquisition, they have limited funding capacity and do not serve large developers. It’s an unregulated area and its own pros and cons.


Foreign Funding : It can fall in two categories ECB or FDI. Let’s look at each of them


External Commercial Borrowing (ECB) : ECB is a pure debt facility. Under the extant exchange control regulations, ECB is prohibited for the real estate sector and ECB proceeds cannot be used for real estate. ECBs is however, permitted for ‘integrated townships’ for a limited window if the minimum area to be developed was 100 acres or more, making it impossible for projects in Metros where land bank of 100 acre is either not gettable or not affordable. 


Foreign Direct Investment (FDI) : FDI includes equity instruments or instruments compulsorily convertible in equity. Realty Funds, FIIs fall are leading investors of this category. Per se FDI is also not allowed for real estate business. But it is permitted for construction of townships subject to conditions such as minimum built-up area of 50,000 sq. mtrs., lock-in period of 3 years, at least 50% project completion within 5 years etc. From investor perspective, the prominent risk is that the security cannot be created in favour of the Investors as FEMA does not allow the same. FDI is also exposed to regulatory issues and at several instances regulators have invalidated options vested in investors (such as put / call / tag along / drag along etc.). Developers are also exposed to exchange risk (e.g. a developer who received FDI of US $ 100 mn. for 51% equity stake in 2007 when exchange rate was Rs. 45 per US $, actually received Rs. 450 Crore. Today where exchange rate is Rs. 55 per US $, to buy-out this equity stake from the foreign investor, he will have to shell out Rs. 550 Crore i.e. US $ 100 mn. at just face value, ignoring other committed return on investment).


To overcome these exposures and bottlenecks, some finance and legal wizards have found out new avenues where realty funds and FIIs who are flushed with money and are keen to invest in Indian real estate market, get easy access.


Recent developments in market shows that FIIs esp. realty funds are acquiring NBFCs. Once, they acquire NBFCs, investor route their investments through NBFCs. These NBFCs in turn lend to developers. This offer following major benefits vis-à-vis normal NBFC finance or FDI route:

·         Security can be created in favour of NBFC

·         FDI rules are not applicable so no lock-in of investment and funding can be given to smaller projects as well.

·         Exchange risk eliminated for developer.


However, this also comes with following concerns :

·         Such NBFC cannot carry out investing activity i.e. it cannot invest in equity / quasi equity instruments. Thus, returns linked to equity are not allowed. 

·         Any NBFC has to adhere to concentration norms as per RBI’s prudential norms and funding a group is capped at 25% and a company at 15% of its owned funds.

·         NBFCs as such do not enjoy protection under SARFAESI.

·         Transfer of returns from NBFC to Fund and exit of Fund from NBFC is complicated and tax-inefficient.


Another mode for FIIs to invest in Indian Real Estate Market is via corporate debt market. Under this route, a developer issues Debentures to domestic investors pursuant to SEBI Regulations (either on private placement basis or under public issue) and lists the same on the wholesale debt market segment of any recognized stock exchange pursuant to Debt Listing Agreement. A FII or Realty Fund can then acquire these Debentures from market. For exit also, it can sell these debentures in the market or hold till maturity. While private placement is an easy process, public issue has stringent and lengthy compliances.


This route offers following advantages:

·         Security is created in favour of a SEBI Regd. Debenture Trustee,

·         Credit rating of debentures is mandatory.

·         FII acquire it under automatic route without any approval.(easy entry and exit and no condition precedents as applicable to FDI route).

·         No TDS on interest paid on listed debentures, No long term capital gain tax is sold in market.

·         No lock-in of investment. 

·         Developer need not dilute equity and no exchange risk for developer.

·         Limited compliances for developers.


The developers need for finance is ever growing and ability of domestic financiers to meet them is limited. It thus calls for more and more foreign funding in the sector. The sector has already recorded inflows in excess of US$ 10.89 bn. between April 2000 and November 2011.


While the regulators’ concerns with this sector are justified due to its opaque   structure, evidence of unaccounted money, asset bubbles etc., transparent, affordable and hassle free mode of financing for developers is also justified and expected.