Foreign Investment Norms for Real Estate Liberalized
In a recent press release issued in relation to its meeting dated October 29, 2014 (“Press Release”), the Union Cabinet has cleared the further liberalization of Foreign Direct Investment (“FDI”) in ‘construction-development sector’, in line with the announcements in the Finance Minister’s budget speech for 2014.
The changes sought to be made by the Press Release are set out below.1
Serviced plots and combination projects
Removal of minimum land requirements for serviced plots is a substantial relaxation. It appears that in case of combination projects as well, there shall be no minimum land requirement. Such relaxation could attract creative structuring for foreign investments in smaller areas.
Construction- development projects
In case of construction-development projects, the minimum land requirement has been reduced from 50,000 sq. meters of built-up area to 20,000 sq. meters of floor area. The introduction of floor area concept, as against the earlier benchmark of built-up area may need to be examined. ‘Floor area’ has been stated to be defined ‘as per the local laws/ regulations of the respective state governments / union territories’. Definitions of ‘floor area’ vary from state to state. While floor area is defined for some areas, other areas do not have any definition of the term, such as the regulations for Greater Mumbai. It is to be seen whether floor area in these regions would be equivalent to built-up area or floor space index (FSI), though in some cases, floor area is close to built-up area.
In a market largely driven by debt such as listed non-convertible debentures, a lower minimum capitalization would be helpful considering minimum capitalization can only consist of equity and compulsorily convertible instruments. This will also be helpful in tax structuring and optimization of returns for investors.
Commencement of business of company to commencement of project
‘Commencement of business of the company’ had not been defined in the FDI Policy. It was seen practically that the regulator’s view was that the period of 6 months was to be calculated from the earlier of the date on which the investment agreement was signed by the investor, or the date the funds for the first tranche are credited into the account of the company. However, the criterion has now been changed to 6 months from the commencement of the project of the company, which has been explained to mean the date of the approval of the building plan/ lay out plan by the relevant authority. This is a welcome move since this brings clarity as against dependence on interpretation of ‘commencement of business’.
Period for subsequent tranches
The FDI Policy did not have any restriction on the maximum period till which the investor could infuse funds. However, the Amendment states that subsequent tranches of investment can only by brought in till a period of 10 years from the commencement of the project, which seems to imply that the regulator is reluctant towards real estate projects which have extremely long gestation periods.
Exit on completion
A welcome change is permitting investors to exit on the completion of the project. Hitherto, each tranche of investments were locked-in for a period of 3 years, even if the project was completed. This posed a major challenge for last-mile funding for projects, since the investment was stuck even on the completion of the project.
Lock-in of 3 years from final instalment
The lock-in for ongoing or non-completed projects for 3 years from the final tranche may need to be examined. The earlier regulations required any tranche to be locked in for a period of 3 years from the date of receipt of such tranche only.
50% in 5 years
Another positive move is the removal of the minimum development of 50% in 5 years from the date of obtaining all statutory clearances. Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.
To be eligible to exit at the end of 3 years from the last tranche, trunk infrastructure (explained to include roads, water supply, street lighting and drainage and sewerage) must be developed. This requirement did not exist previously, and has been a recent introduction. This has also removed all ambiguities in relation to the 50% development requirement, since this is no longer linked to the obtaining of statutory clearances.
It is unclear whether existing investment, on the anvil of exit currently would be required to satisfy the trunk infrastructure requirements. This may be a major barrier for investors who have completed the 3 year period from their investment, and are seeking exit, although trunk infrastructure has not been developed. It is also unclear whether existing tranches of investment would be locked in till the end of 3 period from any future tranches, if any.
Grandfathering of the existing investments from the requirements to comply with trunk infrastructure and the lock-in period would be important for existing investments.
Sale of stake from non-resident to non-resident
While the exit of a foreign investor earlier required FIPB approval, transfer of a non-resident investor’s stake to another non-resident investor was not expressly included. The Press Release now confirms this.
A major relaxation which has now been introduced is the removal of the completion certificate requirement. Since these were service plots, a completion certificate was not forthcoming. Addressing this concern, this is no longer required as long as trunk infrastructure is developed.
Earlier, there some ambiguity in relation to when the 50% development requirement would trigger, since it was unclear what all statutory approvals meant. To remove this ambiguity, the requirement for the minimum development of 50% in 5 years has been removed. However, in spirit, the same has been introduced by requiring ‘trunk infrastructure’ to be developed before any exit.
Affordable housing projects have been defined to mean projects which allot at least 60% of the FAR/ FSI for dwelling units of carpet area not being more than 60 sq. meters. Out of the total dwelling units, at least 35% should be of carpet area 21-27 sq. meters for economically weaker section category.
This would encourage creative structuring of investments into affordable housing. While the intent clearly is to encourage investment into affordable housing and housing for the economically weaker section, the equilibrium between luxury housing and affordable housing remains to be seen.
It has been long debated whether FDI should be permitted in commercial completed real estate. By their very nature, commercial real estate assets are stable yield generating assets as against residential real estate assets, which are also seen as an investment product on the back of the robust capital appreciation that Indian real estate offers. To that extent, if a company engages in operating and managing completed real estate assets like a shopping mall, the intent of the investment should be seen to generate revenues from the successful operation and management of the asset (just like a hotel or a warehouse) as against holding it as a mere investment product (as is the case in residential real estate). The apprehension of creation of a real estate bubble on the back of speculative land trading is to that naturally accentuated in context of residential real estate. To that extent, operation and management of a completed yield generating asset is investing in the risk of the business and should be in the same light as investment in hotels, hospitals or any asset heavy asset class which is seen as investment in the business and not in the underlying real estate. Even for REITs, the government was favorable to carve out an exception for units of a REI from the definition of real estate business on the back of such understanding, since REITs would invest in completed yield general real estate assets. The Press Release probably aims to follow the direction and open the door for foreign investment in completed real assets, however the language is not entirely the way it should have been and does seem to indicate that foreign investment is allowed only in entities that are operating an managing completed assets as mere service providers and not necessarily real estate. While it may seem that FDI has now been permitted into completed commercial real estate sector, the Press Release leaves the question unanswered whether these companies operating and managing the assets may own the assets as well.
Analysis: The obligation to obtain all necessary approvals, including the business plans has now been clarified to be that of the investee company in India, doing away with the unnecessary hassles around this for investor.
The changes introduced by way of the Press Release are along expected lines after the Budget Speech earlier this year. The minimum land requirement was an impediment for foreign investment, since it was difficult to find large tracts of land for development to satisfy the minimum land requirements in Tier-I cities. Further, the demand was inadequate for such investment to be made in Tier-II cities, where minimum land requirements could be met. Reducing or removal of minimum land requirements, along with removal of the requirement to obtain a completion certificate for sale of such plots would encourage foreign investment into this space.
While the final press note is still awaited to clarify certain aspects, this seems to be a positive move by the government to attract further investment.
1 The changes brought in by the Amendment are expected to be formalized in the form of a Press Note or by way of inclusion in the FDI Policy, and till such time the changes do not have the binding force of law.