Real Estate Mutual Funds (REMF’s)

-- Mayank Jain
Intern, White Forest
The booming Real estate market

The real estate business is estimated to be of over Rs 675 billion and growing at the
rate of 30% a year. In the next 10 years, it is estimated to witness a gigantic rise Rs
4725 billion. The real estate industry has been largely contributing to the GDP also.
Its share has shot up from 5.25% in 2002-03 to 7% in 2004-05. The market is large
and demand driven. It has been making appreciations in value over the years.
Presence of a large number of Fortune 500 and other reputed companies will attract
more companies to initiate their operational bases in India thus creating more demand
for corporate space.

With such strong demand fundamentals it was only a matter of time that the
Government allowed mutual funds to pump in the real estate market. (SEBI) has set
the ball rolling for real estate funds. As recent as 16th April, 2008 SEBI has issued the
Securities And Exchange Board Of India (Mutual Funds) (Amendment) Regulations,
2008 through which one can invest directly and indirectly in Real Estate. All one may
now need to shell out is a sum as low as Rs 5,000 to Rs 10,000 to invest in real estate.
HDFC Property Fund, DHFL Venture Capital Fund, Kotak Mahindra Realty Fund,
Kshitij Venture Capital Fund (A group venture of Pantaloon Retail India Ltd.) and
India Advantage Fund (ICICI) are some of the prominent institutions that have started
their REMF’s.

Why REMF?

Today, the Indian economy is growing at a scorching pace and the real estate sector is
growing even faster. Eventually, more and more money is chasing a limited quantity
of high-quality property. This makes real estate potentially one of the best investment
opportunities out there. Statistics say that
a similar investment in developed countries
would fetch a return of 3% to 4% whereas it would fetch 12% to 15% in India.

How an REMF (Real Estate Mutual Fund) will work

An REMF is a scheme much like any other closed-end MF scheme (that invests in
shares and bonds) except for the fact that the new entity will invest in real estate.
There are two conditions of investment set by SEBI.

1.) First, it is mandatory for an REMF to invest at least 35 per cent of its corpus in
completed real estate assets (read flats, row houses, bungalows, and shops). These
could be either residential or commercial properties, but must be finished and
ready-to-use and not under construction.

The REMF will get title deeds and the custodians (registered with the board) will be
the owners of these premises - it's like buying a second home or a small office.
Simply stated, instead of reading a moniker like 'Mr. Govindan' on the name - plate
against, say, a first floor flat number at a building's entrance, one could now have a
neighbor called 'HDFC Real Estate Fund'.

The REMF will then rent out these properties and earn rental income that it will pass
on to the unit holder. When the REMF's tenure ends, it will sell these properties and
generate capital appreciation and eventually pass on these earnings to the unit holder.
With as low as Rs 5,000, an individual can now own a part of a property through an
REMF.

2.) The second investment condition of SEBI mandates that at least 75 per cent of the
corpus should be invested in real estate or related securities. These can be
debentures of real estate companies and mortgage-backed securities and equity shares
of real estate companies listed on the stock exchange. Under this, an REMF can also
invest in 'under-development' properties. But it can neither buy barren land, nor can
it undertake construction activities. This works in the following way:
It will partner with a real estate developer and then take a stake in a special purpose
vehicle that the developer will have set up for constructing a particular project. Note
that the REMF will take a stake in that project and not in the developer company or
its other projects across the country.

The REMF will buy unlisted shares in that SPV, not more than 15 per cent of its own
corpus (as per the guidelines). Once the project is completed, the gains arising out of
it are passed on to the unit holders to the extent of the REMF's stake in the SPV. An
REMF will be closed-end MF and units will be listed on the stock exchanges. One
can trade units on the exchanges very much like shares, unless, the said scheme
provides for a mechanism of redemption of units on a periodic basis.

What’s there in it for you?

An REMF offers a whole lot of advantages over direct investment in real estate. For a
small investor, investing in property will now become affordable, owing to a
substantial reduction in minimum investment size. Buying a REMF unit will be far
cheaper than buying a small office or residential property in a tier-II city. Thus, there
are now minimal entry barriers and no leasing or maintenance hassles. Additionally,
there will be more liquidity, as REMF’s will be listed on exchanges.

Furthermore, an asset class like property can preserve the value of an investor’s
portfolio from the eroding effect of inflation. Also, a real estate fund adds to one’s
portfolio is that of stability. Unlike other asset classes, real estate rarely earns negative
returns, and does not suffer high volatility. Over years, the value of real estate usually
increases manifold. This also makes it a good hedge against inflation. Real estate is a
good long-term investment.

However, it’s not all roses for an investor. One major problem with REMF’s is its
gestation period. Real estate investments investors need to be patient. Buying
property, developing it and then renting it out or selling it, is a high gestation activity.
It could take some time before the REMF actually starts making money.
Also, the profile of the MF must be looked into before investing. Beyond the
mandated 35 per cent in finished real estate projects and within 75 per cent of the
scheme's corpus, an REMF can invest in different types of securities.

Here's where one REMF can significantly look and behave differently from another.
An REMF may choose to hold 35 per cent in completed real estate assets and deploy
40 per cent in equity shares of real estate companies and then invest the balance 25
per cent in another set of equity shares.

Asset allocation will be riskier in cases like above as against those that have a healthy
dose of mortgage-backed securities and debentures of real estate companies and
money market securities that earn a fixed interest income. Thus, it is wise to look up
an REMF’s asset allocation before investing in it.

The picture is not all that comfy

REMF however, should not be taken as a secure investment. Especially in light of the
present economic scenario. Real estate usually goes hand-in-hand with the secondary
market. It has been a trend in history that stock market crashes always precede a real
estate bust. History is replete with such examples:

• Japan’s real estate market crashed in 1990 following the stock market crash. It
is almost 18 years since, but the real estate market is still stagnant in Japan.
• In 1991, post the Harshad Mehta led market crash in India, the real estate
markets also crashed and prices remained stagnant for next 6-7 years. They
bottomed out in 2002.
• In 2001, the tech-led Nasdaq crash caused the real estate market to fall
around 20-30 percent.

Whenever the stock markets have passed through boom times, demand for – and
consequently prices – of property have gone high. Likewise, in depressed stock
markets, property prices tend to soften. The reason for this relation between the two
markets is that, in rising markets, investors find real estate as the ideal place to park
the huge gains made in the stock markets, leading to escalation in prices; conversely,
in a falling market disposal of property is the quickest way to cover losses, leading to
a fall in property prices.

The same conditions exist right now. In India, residential properties prices have fallen
down by 15% in Ahmedabad, Mumbai etc. after the fall in stock market prices. Thus,
some critics believe that we are in for a hard knock in the real estate sector.

Conclusion

An arrival of REMF’s is an exciting opportunity for Indian retail investors and for the
real estate sector. It will allow far more investors to put their money in real estate and
diversify their portfolios. In turn this will generate tens of thousands of Crores, which
will help develop the real estate sector. The proposed real estate funds are poised to
have an exponential growth in India. Overall, it seems to be a positive development
for the real estate industry as well as the retail investors.