Equity versus debt: Which one a realty investor prefers?

Rubi AryaMilestone Capital AdvisorsImportance of real estate as an alternative investment class has grown significantly over the last decade. Traditionally, real estate finance used to be in an unstructured manner through a set of high net worth individuals (HNIs) that each developer closely worked with to fund acquisition or construction of a project. These could be either in form of debt or equity. Over the past decade, new channels of sophisticated real estate financing from institutional sources have emerged in India that co-exist with the unstructured ones, reducing dependence on any particular source of financing. The era of continuous growth in this sector necessitated a more organized and reliable source of capital. These include bank financing, financing from NBFCs, fund raising from equity capital markets (though not many real estate companies were listed or ready to be listed) and fund raising from private equity funds.With RBI restricting use of bank debt for land acquisition, equity and mezzanine capital became the favoured options for such end use. This also coincided with the opening up of the real estate sector to foreign direct investment (FDI) in 2005 resulting in transformation of sentiment in the country. In this pre global financial crisis (GFC) era, equity was also available freely and key sources of financing were equity from the listing on the public markets and from private equity funds. Equity was the preferred mode of financing in the pre GFC era on account of the following reasons:•One of the few sectors to provide high returns in the range of 25%-30%•Substantial demand for financing•Diversification on account of investing in different geographies and asset classes viz. residential and commercial•Easier exit with no reliance on IPOsHowever, these investments by way of equity did not generate enough returns on account of the following:•Over aggressive project execution timelines•Overestimating developers project execution capability•Aggressive Valuation•Excessive cash out and no or little developer’s skin in the game•Reliance on IPOs / Capital marketsThe lessons learnt from the experience in the pre crisis era led to private equity funds altering their fund infusion strategies to structured debt financing from equity or preferred equity financing. PE players have adopted structured debt/ mezzanine route of investment as the primary mode of investment in real estate transactions. Some of the key characteristics of such structured deals include:•Secured transaction with mortgage of project land and control of cash flows of the project•Returns structured through a mix of regular coupons and back ended returns (at time of redemption)•PE players provide moratorium for principal repayment as per the needs of the project and requirements of the developer•Ability to structure as part assured and part equity linked return based on project performance•Can provide investment against identified inventory instead of the entire projectAlso taking into account investment by offshore funds through the structured debt route, the portfolio allocations by way of structured debt have been increasing on account of:•No regulatory cap on returns unlike those of external corporate borrowings (ECB)•Offers downside protection with potential equity upside: Non convertible debentures (NCDs) have a different risk return profile than pure private equity and suits limited partners which want downside protection while participating in equity linked upside. NCD products can be structured where the returns are linked to the underlying performance of the issuer or are linked to market returns on other underlying securities/indices. For example, the returns may be linked to the price of stock of a listed subsidiary of the issuer or the trading price of an index•Self liquidating in nature : Being debt instruments they are self liquidating in nature since redemptions are pre defined•Limited end-use restrictions: Unlike other instruments, there are limited restrictions on which companies can issue NCDs and into which sectors can a PE invest using NCDs. There are sectoral caps under the FDI Policy which do not apply to issuance of non-convertible debt. Furthermore, the market has seen proceeds of NCDs being used as mezzanine finance, for promoter finance and for acquisition finance; thereby opening these avenues for PE.•Equity like features: NCDs can be issued with investors having the benefit of corporate governance rights similar to equity such as limited veto rights and board seats. For eg: for investments made by Milestone from our offshore fund in various real estate projects we have been prudent to take benefit of such rights and have fund representatives as directors/board members in the investee companies.Hence structured debt offers an attractive investment strategy for some investors since it has lower risk compared with a typical equity investment, combined with self-liquidating structures in certain instances that take away the uncertainty of returning capital. Such strategies also offer a fair degree of portfolio diversification and influence asset allocations. Though going forward (2-3 years from now), equity deals may find some traction given that commercial real estate funding will become more active maybe due to REITs etc.., from a safety point of view, structured debt will continue to remain the preferred route for investments in the residential space.