Tuesday, April 29, 2008

REMFs: The New Indian Real Estate Investment Opportunity

It was back in 2006 that SEBI had cleared the deck for the launch of real estate mutual funds (REMFs) as means to enable retail investors to take advantage of the enhancement in Indian property prices. For almost two years, there were no concrete steps taken to promulgate regulations for the establishment of REMFs. However, on April 25, 2008, SEBI announced amendments to the SEBI (Mutual Funds) Regulations, 1996 that permit the launch of REMFs. The notification amending the Regulations is available here.

The REMF scheme is one which invests directly or indirectly in real estate assets or other permissible assets. Some of the key features of REMFs as allowed by SEBI are as follows:

- Existing mutual funds are eligible to launch REMFs if they have adequate number of experienced key personnel / directors.

- Sponsors seeking to set up new mutual funds, for launching only REMF schemes, shall be carrying on business in real estate for a period not less than five years. They shall also fulfill all other eligibility criteria applicable for sponsoring a mutual fund.
- Every REMF scheme shall be close-ended and its units shall be listed on a recognized stock exchange.

- Net asset value (NAV) of the scheme shall be declared daily.

- At least 35% of the net assets of the scheme shall be invested directly in real estate assets. The balance may be invested in mortgage backed securities, securities of companies engaged in dealing in real estate assets or in undertaking real estate development projects and other securities. Taken together, investments in real estate assets, real estate related securities (including mortgage backed securities) shall not be less than 75% of the net assets of the scheme.

- Each asset shall be valued by two valuers, who are accredited by a credit rating agency, every 90 days from date of purchase. The lower of the two values shall be taken for the computation of NAV

- Caps have been imposed on investments in a single city, single project, securities issued by sponsor/associate companies etc.

- The amended regulations have also specified accounting and valuation norms pertaining to REMF schemes.
The delay in the launch of REMFs is perhaps understandable. There are several complexities involved in the operation of real estate funds that require careful consideration. I had written an op-ed column in businesslawyer.in a few months ago highlighting these complexities:

“The delay in establishment of a legal regime for real estate mutual funds can be ascribed to complexities associated with the Indian real estate sector. To mention a few, the real estate sector is bogged down by problems with title to land owing to the absence of proper maintenance of title records. India does not offer title certification and properties are often the subject-matter of litigation for protracted periods of time. The real estate sector is also burdened with a high incidence of stamp duties – achieving uniformity and reduction in stamp duties is an almost impossible task as stamp duty on conveyance of immovable property is a matter for states to legislate, and not the Centre. Apart from legal problems, there are also commercial issues to grapple with – to name just one, valuation of real estate is highly contentious. Due to the existence of these fundamental issues relating to the real estate sector, investments in this sector tend to be risky.

Regulation of REMFs need to take into account these risks specific to the real estate sector so that while REMFs provide an attractive investment avenue to retail investors, regulation also protects their interests against industry-specific risks. This can be achieved through stringent disclosure norms that are prescribed by the regulators.”
The amended regulations issued by SEBI on REMFs do address some of these concerns, while they are lacking on others. First, on the question of specific disclosure norms governing REMFs, the regulations do not specify the disclosures to be made by REMFs while launching a scheme, and it is left to SEBI to prescribe those. While it may have been prudent for the disclosure norms to have been set out in the regulations themselves, there is still opportunity for SEBI to prescribe the disclosure norms. It would be imperative for SEBI to announce a detailed set of disclosures for REMFs that take into account the risks involved in real estate investments. This ought to be effected promptly, and in any case before REMF schemes are in fact launched by mutual funds. A uniform set of disclosures would also enable investors to compare various REMF investment options.

Second, on the question of valuation, SEBI’s efforts are laudable as it appears to have placed significant emphasis on this aspect, as the amended regulations contain a great level of detail not only in respect of the norms of valuation, but also on the manner in which the valuation process itself is carried out. For example, there are requirements for valuation by two valuers who do not possess any conflict of interest. Further, there is a cooling off period whereby no valuer can continue with valuation of a particular real estate for more than two years and that no such valuer can value that same asset for a period of three years thereafter.

In all, with the returns from the real estate sector looking quite promising, this step of allowing REMFs provides an additional opportunity to retail investors to benefit from property value appreciation, and the Indian markets will certainly witness the launch of several REMF schemes in the near future, now that SEBI has paved the way for them.

What is still unclear though is whether REMFs would be the only avenue available to retail investors, or whether real estate investment trusts (REITs) would also be an option. As we had discussed in an earlier post on this blog, SEBI had announced draft regulations for REITs in December last year. While some of the features of REMFs are similar to those of REITs, their treatment in the respective regulations by SEBI is not quite the same. There have been no further steps taken on the REITs front, and it remains to be seen whether the REMFs presently announced eclipse developments on the REITs front or whether we could possibly witness the emergence of REITs in addition to REMFs.
(Update – May 7, 2008: Here is a column in The Economic Times analysing the new regulations on real estate mutual funds)

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