Grey areas in realty act may affect project financing
L to R: Avikshit Moral, Apurva Kanvinde and Prasham Shah

Real estate has always been a promising sector for various players – be it private equity firms, financial institutions or consumers. But the slew of regulatory changes in recent times has impacted the real estate market in India in several ways, and fundraising, which has never been easy in real estate, is poised to become tougher albeit a more structured and transparent law.

While the sector witnessed a slowdown following the government's decision to demonetise high-value currency notes in November 2016, the introduction of the Real Estate (Regulation and Development) Act, 2016 (RERA) has painted a rather optimistic picture for the sector.

RERA was enacted with the objective of ensuring efficiency and transparency, besides protecting the interest of allottees. Keeping with its objectives, the Act has not only impacted the allotees, but has also significantly impacted all other players in the market.

Mandating promoters to register details of all ongoing and new projects, residential as well as commercial, with the Real Estate Regulatory Authority, was a welcome move. Around 12,500 under-construction projects were registered with the Maharashtra Real Estate Regulatory Authority since the law came into being, enabling all market participants, including end-consumers and financers, to verify the authenticity of the information provided to them.

While the enactment of RERA has strived to address several genuine concerns of allottees and have helped in reinstating their faith in the sector, certain provisions of the Act has raised concerns among a section of market participants, including banks, financial institutions and funds providing construction finance to project companies, and private equity firms investing in project companies.

The definition of a promoter under RERA, for instance, has blurred the lines between a developer and a lender, given that the Act includes the “holder of a power of attorney from the owner of the land on which the building or apartment is constructed or plot is developed for sale” as a promoter.

Typically, in construction finance transactions, lenders take a power of attorney from the project company to enable it to replace the project company and continue construction in case of a default. However, by virtue of the definition in RERA, a lender may fall under the ambit of a ‘promoter’ in such a scenario, and all the obligations of a promoter may be applicable to it.

As a result, it may prevent lenders from exercising their rights under the power of attorney in case of an enforcement. Lenders are now seen obtaining a limited, or specific, power of attorney compared to a blanket power of attorney that they would otherwise seek.

Likewise, the definition of a ‘co-promoter’ in Maharashtra includes an individual or organisation that have been allotted or entitled to a share of the total revenue generated from the sale of apartments, or the total area developed in the real estate project, through an agreement or arrangement with the promoter of the project.

The definition may bring private equity investors, who are entitled to an upside in the real estate project, within its ambit. Therefore, structuring of private equity transactions may have to be rationalised to address this issue.

There’s more. In order to ensure transparency and accountability in the sector, RERA has mandated that 70% of the amount received from allottees should be deposited in a separate RERA account, and should be utilised only towards the cost of construction.

Under existing laws in Maharashtra, cost of construction includes repayment obligations to banks and financial institutions, but repayment obligations to alternative investment funds or returns payable to private equity investors are not permitted out of the RERA account, until certain construction milestones are met. Therefore, these institutions will now have to paid either from other sources, or their repayments would have to be linked to construction milestones.

To add to this, Maha RERA has issued a circular saying that no lien shall be created over the RERA account. Given that charge-over project receivables is a major collateral for lenders providing construction finance, the provisions introduced by RERA will heavily impact such transactions, too.

Earlier lenders would create a charge-on-one account, wherein all project receivables were deposited. In case of an enforcement scenario, lenders would instruct the escrow bank to freeze the account. Now project companies typically are creating separate accounts for distribution of project receivables and a charge is created in a non-RERA account.

This significantly dilutes the collateral in case of a default, because lenders will have a recourse to only the balance 30% of project receivables, and only after amounts withdrawn post construction milestones are met. Alternatively, lenders may require a higher security cover from an alternate collateral.

RERA also says that any majority change in the rights and liabilities in respect of a real estate project requires the approval of two-thirds of allottees and the Real Estate Regulatory Authority. This poses a challenge in case of private equity investments as well as enforcement rights of lenders.

For instance, in in case of a default involving a private equity investment, the investor’s step-in right cannot be exercised freely anymore. Lenders will also not be freely entitled to invoke the pledge over the shares of the project company or enforce the mortgage created over the development rights and the project in case of a default.

Under the RERA, the investors and/or the lenders will now have to work with allottees to ensure the completion of a real estate project.

The amendments brought about by the government of India seems to be a conscious effort to imbibe ethical behaviour and boost the real estate market, but industry insiders hope that the judiciary fills in the gaps to protect the interest of all players in the real estate sector.

Avikshit Moral is a partner at Juris Corp, while his co-authors are senior associate and associate, respectively, at the law firm.

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