Real estate-focused private equity funds are putting a good chunk of their fresh investments in India in pre-leased commercial development projects, including IT Parks and special economic zones (SEZs), as they look for guaranteed returns from these investments. Although these projects churn out returns which are a tad lower than the conventional residential developments, they essentially provide annuity incomes for investors. Consequently, most of the funds now want to balance their portfolios with pre-leased commercial assets as these could act as a much-needed cushion in case investments in residential projects fail to yield the average expected return of 25 per cent.

Based on industry sources, VCCircle estimates peg private equity deals worth as much as $380 million were sealed in pre-leased properties in the past six months -- a little less than half of the total private equity investments in the realty sector during the period.

Ambar Maheshwari, managing director (corporate finance) at the property consultancy Jones Lang LaSalle India, says, “A lot of investors have burnt their fingers by investing in underdeveloped commercial properties as there is oversupply in this space and no one knows which project will end up as commercially viable. Therefore, investing in pre-leased commercial developments are low-risk investments with guaranteed returns.”

Taking this opportunity, international private equity funds like Blackstone, Baring Private Equity Fund and Xander Inc have bet on IT Parks through their real estate funds (most of these assets are pre-leased) and the list of funds acquiring such assets is on the rise. In the first quarter of CY2012, transactions worth Rs 1,268 crore have been signed according to property consultants and according to sources in the know, another Rs 1,200 crore will be infused through similar transactions across the northern belt alone in the next six months.

In one of the biggest transactions last year, PE bigwig Blackstone had acquired an IT park project in Pune for Rs 810 crore, jointly developed by India’s largest realtor (according to market cap) DLF and Mumbai-based Hubtown.

Although the Indian government does not allow foreign direct investment (FDI) into ready commercial office space projects, foreign investors are allowed to invest in IT Parks and SEZs under industrial park guidelines. Spur in transactions in pre-leased commercial assets have also brought on board a series of rental yield funds which invest in ready commercial assets, generate annual returns and plough back to investors. Thus, investors have assured visibility of returns from these investments.

The trend seems to be catching up as IndiaReit, the realty fund floated by billionaire Ajay Piramal, is looking to raise a rental yield fund to provide annuity income to its investors. Bangalore-based Azure Capital is also eyeing $60 million for its rental yield fund.

According to Sharik Currimbhoy, CEO of Element Capital Advisors, a real estate investment advisory, “There has been a substantial shift in the way funds are being deployed in real estate assets as money is now flowing towards pre-leased commercial buildings. The ticket size for these projects is much higher than investments in residential or early-stage development assets. Most of the funds are targeting returns of 11.5-12 per cent, which would include forex risks and these funds plan to stay invested for 5-7 years.”

In such a transaction, a fund buys out a developer’s entire or majority stake and if there is a debt tied with the asset, the fund pays it off and acquires the asset. On the other hand, most of the developers with ready commercial assets on their books use lease rental discounting as a favoured method to raise money from banks.

Private equity funds are expecting returns of 10-12 per cent through these transactions with a capitalisation rate of 8-9 per cent in the next 3-5 years. They expect the capital value of properties to increase and thus provide better secondary exits. The rationale is clear as in India, lease terms are negotiated every three years and there is 15 per cent incremental rise in rental values. PE funds are, therefore, expecting that these assets will eventually provide total returns of 15-18 per cent.

“These assured returns are a better proposition than the promised 25-30 per cent return that PEs expect from other conventional deals as in most such cases, funds are not able to generate the 25 per cent plus promised returns,” adds Maheshwari of Jones Lang LaSalle India.

Traditionally, Indian realty has witnessed more money allocation in residential real estate rather than in commercial assets, which is more commonly found in US and European economies. Across the world, investments in commercial real estate assets are the most favoured option by funds and they are listed and traded. But the Indian government does not permit real estate investment trust (REIT) listing or real estate mutual funds (REMFs) to function in the country. This loads the dice against such investments. Of the Indian realtors, Mumbai-based Indiabulls Real Estate has two commercial properties and trades in Singapore as a REIT.

Funds are now ready to look at low-risk low returns as most of the investments marked three or four years ago have either failed to take off or have not seen completion according to drawing board plans. Fund managers are, therefore, looking for assets like IT parks which are ready and already have tenants on board as that can be the most profitable proposition to attract investors in a cash-strapped market.

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