New SEBI Rules Should Increase Funding Options for Small Real Estate Developers in India

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Recently enacted Indian regulations should create increased real estate sector liquidity at a time when it is sorely needed. According to the Economic Times, the Securities and Exchange Board of India (SEBI) has now given approval for seven Alternative Investment Funds, a new investment vehicle, to establish operations in India.

Under the SEBI regulations, an Alternative Investment Fund is defined as "a privately pooled investment vehicle which collect funds from investors, whether Indian or foreign for investment in accordance with a defined investment policy for the benefit of investors".   Alternative Investment Funds include real estate funds.

The creation of a new investment structure is good news for India's many small real estate developers who have struggled to obtain capital in the current fiscal environment.  International investors have been rattled by the Indian Government's increasing focus on offshore structures and threat to apply tax rules retroactively to purchases and sales of India domestic entities through offshore entities.  Medium and smaller developers also can have challenges meeting the capitalization and project size thresholds to qualify for real estate FDI.

Smaller developers also face domestic financing hurdles, as banks prefer to lend to large real estate groups who are better capitalized, have better track records and larger land banks.  This is increasingly the case given India's generally weakening real estate environment.   According to the Jones Lang LaSalle Blog "India Real Estate Compass" absorption rates in India's top seven cities dropped 35% in the first half of 2012 compared with the first half of 2011.

India's macroeconomic outlook is also far from bright. It was reported that Morgan Stanley has revised downwards India's expected GDP growth rate for 2012 to 7.4% and, despite current low inflation rates, interest rates remain very high, pushing down real estate affordability.  Due to worries that an interest rate cut will increase inflationary pressure and create limited growth, it is not expected that the Reserve Bank of India will cut rates at its next meeting.

Apart from creating new funding options, the new Alternative Investment Fund rules should also strengthen investor perceptions of the sector.   Funds are required to clearly set forth their investment strategy and that strategy can only be changed with the consent of at least two-thirds of the unit holders in the fund.

In a regulatory step that should create increased investor confidence, the SEBI rules require the Sponsor and the Manager of the Alternative Investment Fund to establish policies and procedures to identify conflicts of interest, disclose conflicts of interest and "abide by high level principles on avoidance of conflicts of interest with associated persons."

Alternative Investment Funds also have express transparency obligations, including the requirement to disclose information to investors regarding "financial, risk management, operational, portfolio, and transactional information regarding fund investments.

Despite the difficult current market conditions, unmet demand in India remains very high.  For India to meet that demand, it is vital to make real estate development capital available to a broad range of real estate developers and give investors confidence.  The new regulations, which create a new fund structure with express conflict of interest provisions and transparency requirements, should be a step in that direction.