Fund managers see plenty of potential in Indian real estate. But they also see a lot of challenges, writes Maha Khan Phillips

In May, Dutch asset manager APG acquired a minority stake in Lemon Tree Hotels, the Delhi-based group, to develop a portfolio of mid-market hotels in India. APG also signed an agreement to set up a hotel development joint venture called Fleur Hotels Private, which will invest more than €284.3m to develop and own 4,500 rooms by the end of 2016.

APG felt it was the right time to invest in the country, for a variety of reasons. "First of all, we entered the market due to the strong growth and return perspectives of India," says Daan van Aert, head of non-listed real estate in Asia for APG, which manages €299bn of assets on behalf of Dutch pension funds. "Second, attractive demographics of the population with a significant majority younger than 35 years-old, and a growing workforce, makes India even more appealing to invest in. Third, from an Asian portfolio perspective, adding investment in India leads to diversification benefits, partly due to the domestic consumer and services-led economy, which is different from most of the other large Asian economies. Last, but not least, comparable to China, there is a strong urbanisation trend going on in India as well. This strengthens the need for quality real estate in the cities."

APG does see challenges too however. "Like any other emerging market, corporate governance and partner risk remain the most challenging aspects of investing in Indian real estate," says Sachin Doshi, senior portfolio manager for real estate at APG. "However, if you filter through the landscape, there are strong institutional parties that one can partner. Also being a capital-intensive business, the current lack of financing in India creates hurdles for local developers who are looking to grow and meet the rapidly increasing need of real estate in most Indian cities. However, we see this capital constrained environment as an excellent investment opportunity."

APG is one of a handful of institutions that has looked at India because of these opportunities. Morgan Stanley Real Estate Investing, which appointed Shirish Godbole as head of India at the end of last year, is also an active investor. Since 2006, it has invested in property companies and several projects, including: Oberoi Realty, based in Mumbai, which successfully listed in 2010; Panchshil Reality, based in Pune, and Mantri Developers, based in Bangalore.

In May, private equity funds Blackstone and Kohlberg Kravis Roberts (KKR) were in talks with India's UB Holdings about buying some of its commercial real estate for $123m (€99m), according to news reports, while in February Russell Investments said it would be making commitments in the next six to 12 months.

Martin Lamb, an Asian private real estate expert at Russell, says institutional property investment in India is problematic for a number of reasons, including poor market transparency, information asymmetry, a modest pool of experienced local professionals, lack of infrastructure, as well as distinctive regional differences across the nation which inhibit country-wide investment coverage. "However, institutional investment from both domestic and international sources can help address some of these challenges, while at the same time benefiting from the very inefficiencies, dislocations, and evolving regulations these conditions may engender," he says.

Lamb also believes that India is often overlooked, because it seems like a difficult market for outsiders to access. "India is quite distinctive, geographically and culturally, from both Eastern Asia and Europe and America, and it is my opinion that opportunities in India are often overlooked because it is outside the comfort zone of investors both in the west and the east," he explains.

Regulatory restrictions, transparency
But investing in real estate is also complicated for foreign fund managers. In 2005, for the first time, the government opened the market to foreign direct investment, but allowed investments in greenfield development projects only. In 2009, the regulation was opened up further to include investment in specific sectors of real estate where investments could be made on a non-development basis, including hospitality, IT, and industrial parks.

"Eventually, the government will have to open all of this up," says Anuj Nangpal, director, investment advisory at DTZ International Property Advisors. "Sooner or later, there will be a situation where office buildings and retail blocks will be allowed to be sold by everyone. The developers are crunched for liquidity."

The liquidity crunch has helped foreign fund managers find opportunities. Partners Group, which has $300m invested in direct and secondary investments in India, says commercial asset acquisition below replacement cost is a good play today, as there is a scarcity of capital and existing investors want to exit.

For example, the firm recently invested in the development of villas in Gurgaon, a satellite city within commuting distance of Delhi. Gurgaon has the country's third-highest per capita income, so demand for upscale residential space is high. Yet developers face high barriers to entry, since local authorities stipulate that upscale townships must only be built on plots of 100 acres or more of continuous land.

Partners Group had a local development partner, which had secured rights to purchase adjoining land parcels and merge them into a new large parcel of 108 acres that could be developed into an upscale township. However, because of tightened lending standards, the developer needed third-party capital.

"Partners Group provided the preferred equity to fund the land acquisition," says Pam Alsterlind, a partner and co-head of the private real estate business at Partners Group. "The investment is currently expected to generate a 27% IRR and 2.1 times the money invested based on a preferential return as well as equity participation features, and is secured by the sale proceeds from all villas developed on the land parcel."

Any project delays or cost overruns on the project are paid for by the developer. "We view this as an innovative structure to capitalise on strong demand growth for upscale residential units in a particularly supply constrained part of the Indian residential market," Alsterlind adds.

According to research from CBRE, the residential sector has traditionally been a leading driver of real estate demand. Because of the rapid pace of urbanisation of Indian cities, there is a shortage of more than 26 million housing units in the country. While the majority of this shortage is limited to the low-end segment of the population, speculation and investment interests have meant that the mid-market population is also in need of homes. By early 2011, the housing market had risen 40-50% in Mumbai and Delhi, according to CBRE.

In the office sector, the firm says that demand has slowed down significantly in Q1 2012, with around 4.1m sqft of office space getting absorbed across the leading cities in the country, compared to 6.5m sqft in the previous quarter. The firm predicts a gap in demand versus supply, but says prime corporate office space in the central business districts is not expected to be impacted as adversely, with values remaining stable.

"The best risk-adjusted ideas that are available in the market are in the residential property sectors," says Henry Ching, principal in Mercer's real estate boutique business. "That's not to say that there aren't interesting ideas for retail and office. We have data showing that there will be strong demand for this, but finding the right partners is difficult, and operational and execution risk is high. We haven't seen many managers committed to doing these kinds of strategy."

Anshuman Magazine, chairman and managing director for CBRE South Asia, agrees: "Most people invest in residential." He explains that India is still a new market. "Institutional investment in real estate is still limited. To begin with, 15 years ago, even a bank would not lend money for real estate development, because the market was perceived as being high risk and the players in the market were not organised. Institutions and banks didn't want to take a chance, and transactions would often happen in cash, which means unaccounted money," he says. Now, Magazine believes, the market will continue to grow. "It may be at a slower or a higher pace, but I feel like we are at the bottom still, and can only go up. That's why we will continue to see investments coming in."

Not everyone is convinced about investing in India, however. One real estate manager said it was too concerned about corruption, particularly in the real estate sector, to invest there.

According to the Indian government, economic growth will be at around 7.6% in 2012-2013, which makes the country compelling.

"India is trying to get better, but a lot of the time it's difficult to know who you are dealing with," Ching says. "It's important to have some transparent governance structures to get a sense of whether your money will be protected in case something goes wrong."