FOREIGN DIRECT INVESTMENT IN INDIAN REAL ESTATE SECTOR – SOME INSIGHT[1]

by Durai on October 15, 2010

 The Indian real estate sector which was open to foreign direct investment through automatic route by virtue of Press note 4 of 2001 was restricted by Press note 3 of 2002 series which provided that foreign investors could, after obtaining prior government approval, develop integrated townships of a minimum 100 acres in size or containing a minimum of 2000 dwelling units and Press note 3 of 2002 restricted the flow of foreign direct investment in this sector and this led the government to open up the sector upto 100% under automatic route by issuing Press note 2 of 2005 subject to certain conditions thereunder.

Foreign investors by virtue of Press note 2 of 2005 are now allowed to invest 100 percent into an Indian entity involved in real estate development in India, without seeking prior permission from the Government of India, or the Reserve Bank of India, or the Foreign Investors Promotion Board, or the Ministry of Finance, subject to the conditions prescribed under Press note 2 of 2005. However, FDI is not allowed in real estate business i.e. dealing in land and immovable property with a view to earning profit or earning income there from.

 FDI in the Construction and Development Sector:

 Under Press Note 2 of 2005, Foreign Direct Investment  is allowed upto 100 percent in townships, housing, built-up infrastructure and construction-development projects which would include but not be restricted to, housing, commercial premises, hotels, resorts, hospitals, educational institutions, recreational facilities, city and regional level infrastructure, without  prior permission from the Government of India,  the Reserve Bank of India (RBI), the Foreign Investors Promotion Board (FIPB), or the Ministry of Finance (MoF), subject to the conditions prescribed under this Press Note 2 of 2005. The conditions include:-

                                 i.            With respect to the conditions relating to ‘Minimum Capitalization’, a minimum capitalisation of US$ 10 million for wholly owned subsidiaries and US$ 5 million for joint ventures with Indian partners and the funds would have to be brought in within six months of commencement of the business of the Company.

                ii.            The ‘original investment’ cannot be repatriated before a period of three years from completion of minimum capitalisation, however, the investor may be permitted to exit earlier with prior Government approval through the FIPB.

 DIPP has, on July 15, 2009 clarified in their Bulletin Board service that for the purpose of Press Note 2 of 2005, it is clarified that “original investment” means the entire investment brought in as FDI for the purpose of taking up Press Note 2 of 2005 compliant construction development projects which would then remain locked-in for three years.

 Prior approval may be required if the foreign investor has a prior investment in the same or allied field and Press Note 1 and 3 of 2005 are consequently attracted.

Recent modifications following Press Note 2 of 2005:

Press Note 7 of 2008  clarifies that the conditions and requisites detailed in Press Note 2 of 2005 are not applicable to non-resident Indians (NRIs) investing in real estate or in the real estate development sector. NRIs may invest in housing and real estate development projects across the country, for upto an extent of 100 percent.Further, the Master Circular on foreign direct investment dated July 01, 2009 prohibits foreign direct investment in construction of farm houses in India.

Investments in Industrial parks, exempted from Press Note 2 of 2005:

Press Note 3 of 2008 clarifies that investment which are made in Industrial parks are exempted from the application of Press Note 2 of 2005 and 100 percent FDI is allowed through automatic route both investing in the establishment of industrial parks and setting up an industrial park provided that the industrial parks meet the following conditions:

                          i.            The units should comprise a minimum of 10 units and no single unit shall occupy more than 50 % of the allocable area;

                        ii.            The minimum percentage of the area to be allocated for industrial activity shall not be less than 66 % of the total allocable area.

Investment in Hotel and tourism sector – exempted from Press Note 2 of 2005:

Press Note 2 of 2006 has clarified that investment in hotel and tourism sector and special economic zones shall be exempted from the applicability of Press Note 2 of 2005, in these sectors 100 percent FDI are allowed  vide Press Note 4 (2001 Series).

Real estate mutual funds- (REMF’s): The Securities and Exchange Board of India (SEBI), vide a press release number PR- 166/2006 dated June 26, 2006 has given investors the option to invest in REMF’s.

The mutual fund schemes are allowed to invest, (a) directly in real estate properties within India; (b) mortgage (housing lease) backed securities; (c) equity shares/ bonds/ debentures of listed/ unlisted companies which deal in properties and also undertake property development and in, (d) other securities.

REMF’s are governed by SEBI (Mutual Fund) Regulations, 1996 and the schemes are to be close – ended only and the units shall be listed on stock exchanges. Foreign Institutional Investors are allowed to invest in REMF’s.

Proposed Foreign Investments (National Security Concerns) Act:

There is also a proposal to enact an Act called the Foreign Investments (National Security Concerns) Act, to bestow powers upon the central government to ensure national security is not compromised by FDI.

Government to tighten rules for FDI approvals:

FIPB now intends to scrutinize proposals in which funds are routed through tax havens like Mauritius, and those that fall under a proposed ‘sensitive list’, even if they are under the current automatic approval route.  FIPB would make it mandatory if the investment is in the ‘sensitive list’ and real estate has been included in the proposed ‘sensitive list’.

Proposed Real Estate Investment Trust (REIT):

        i.            SEBI had proposed in 2008, to recognize and constitute a new category of investors which would have the option of investing in real estate sector vide the Draft Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations, 2008.

      ii.            Under the draft REIT regulations, an REIT has been defined thus: ‘a trust registered under the Indian Trusts Act, 1882 and registered with the Board under these regulations, whose object is to organise, operate and manage real estate collective investment’.

    iii.            REIT would operate like a mutual fund, however, as one where investments of individual investors are invested in real estate, rather than stocks of companies.

     iv.            Despite the fact that the Draft REIT Regulations for India have been formulated by SEBI, they continue to remain in the draft stage and are hosted on SEBI’s website for public comments.

 RBI MASTER CIRCULARS / NOTIFICATIONS WITH RESPECT TO REAL ESTATE:

(1)   RBI Master Circular on Housing Finance dated 12/01/2009:

  • The Reserve Bank of India by a Master Circular RBI/ 2009-10/75 DBOD. No.DIR. (HSG). BC.08 /08.12.01/2009-10 has sought to consolidate the framework of rules/regulations and clarification on Housing Finance issued by Reserve Bank of India from time to time. The object of the regulation has been stated to be to ensure the orderly growth of housing loan portfolios of banks.
  • It states that in view of the need to increase the availability of land and house sites for increasing the housing stock in the country, banks may extend finance to public agencies and not private builders for acquisition and development of land, provided it is a part of the complete project, including development of infrastructure such as water systems, drainage, roads, provision of electricity, etc. and that such credit may be extended by way of term loans.
  • The project should be completed as early as possible and, in any case, within three years, so as to ensure quick re-cycling of bank funds for optimum results. If the project covers construction of houses, credit extended therefore in respect of individual beneficiaries should be on the same terms and conditions as stipulated for direct finance.
  • It has been advised that banks should have a Board approved policy in place for valuation of properties including collaterals accepted for their exposures and that valuation should be done by professionally qualified independent valuers.
  • As regards the valuation of land for the purpose of financing of land acquisition as also land secured as collateral, banks are guided to: Extend finance to public agencies and not to private builders for acquisition and development of land, provided it is a part of the complete project, including development of infrastructure such as water systems, drainage, roads, provision of electricity, etc.
  • In such limited cases where land acquisition can be financed, the finance is to be limited to the acquisition price (current price) plus development cost. The valuation of such land as prime security should be limited to the current market price. Wherever land is accepted as collateral, valuation of such land should be at the current market price only.
  • The RBI has noted that while the development of real estate is welcome, there is a need for the banks to curb the excessively risky lending by exercising selectivity and strengthening the loan approval process.
  • Banks have been directed to ensure that the borrowers have obtained prior permission from government/local governments/other statutory authorities for the project, wherever required and that while the proposals could be sanctioned in normal course, the disbursements should be made only after the borrower has obtained requisite clearances from the government authorities.

(2)   RBI’s Second Quarter Review of Monetary Policy for the Year 2009-10 dated 05.11.2009:

  • The RBI has decided to increase the provisioning requirement for advances to the CRE (commercial real estate) sector classified as ‘standard assets’ from the present level of 0.40 per cent to 1.00 per cent.

(3)   RBI Notification on Guidelines on Classification of Exposures as Commercial Real Estate (CRE) Exposures dated 09.09.2009:

  • Bank finance to developers of infrastructure facilities in SEZs would be taken as infrastructure lending, as against the 2006 ruling that classified these as commercial real estate (CRE) exposures.
  • Final guidelines on the definition of CRE exposures, necessitated due to risks involved in the real estate and Basel-II Framework are also laid out in this notification, which states inter alia that banks can finance cost of land development, which will be classified as CRE for the reason that the source of repayment would be the lease rentals, however, loans for acquiring land to private developers for setting up of SEZ are not permitted. It also states that banks should keep in mind the substance of the transaction rather than the form.
  • The guidelines are based on principles and come with illustrative examples based on which banks should be able to determine. For example, it is possible that an SEZ may be developed by a single company entirely or mainly for its own use. In such cases the repayment will depend on the cash flows generated by the economic activities of the units in the SEZ and the general cash flow of the company rather than the level of real estate prices. It should not then be classified as CRE. In cases where lease rentals are insulated from volatility in the real estate prices by way of lease agreements for periods not less than that of the loan, such cases need not be treated as CRE from the time such conditions get fulfilled.
  • These guidelines have further clarified that exposure towards acquisition of units in SEZs or purchase and working capital requirements etc. would not be treated as CRE exposure and consequently would be treated as infrastructure lending.

(4)   RBI Notification on Assessment of Group Risk – Exposure to Real Estate Sector dated 24.09.2009:

  • Notification No. RBI/2009-10/167 states that, as a matter of prudence, banks may meticulously assess the inherent group risk of their borrowal accounts falling under the purview of the real estate sector.
  • It states further that they may, while assessing the loan requirements of large builders / land developers, carefully analyse the financial credentials / viability of the borrowers on a consolidated basis supported by the consolidated accounts / position of the group as well as the financial credentials / viability of the relevant unconsolidated related entities such as Special Purpose Vehicles (SPV’s).

(5)   RBI Notification on Finance for Housing Projects dated 26.10.2009:

  • Notification No.  RBI/2009-10/191 states that, while extending finance to housing schemes, Urban Cooperative Banks are advised to stipulate as part of terms and conditions that:
  • The builder / developer / company, disclosed / would disclose in the pamphlets / brochures etc., the name(s) of the bank(s) to which the property is mortgaged.
  • The builder / developer / company would append the information relating to     mortgage while publishing advertisement of a particular scheme in newspapers / magazines etc.
  • The builder / developer / company would indicate in their pamphlets/ brochures that they would provide No Objection Certificate (NOC) / permission of the mortgagee bank for sale of flats / property if required. Banks are also advised to ensure compliance of the above terms and conditions and funds should not be released unless the builder / developer / company fulfill the above requirements.

 EXPECTED CHANGES IN INDIAN LEGISLATION WITH RESPECT TO THE REAL ESTATE SECTOR:

Draft Model Act for Real Estate (Regulation of Development) Act:

  1.         i.            The Ministry of Housing & Urban Poverty Alleviation (Housing Section), on 3rd September, 2009 came out with a Draft Legislation on the Model Real Estate (Regulation of Development) Act.
  2.       ii.            The proposed Act is concerned inter alia, with, the “establishment of a Regulatory Authority and an Appellate Tribunal to regulate, control and promote planned and healthy development and construction, sale, transfer and management of colonies, residential buildings, apartments and other similar properties, and to host and maintain a website containing all project details, with a view to protecting, on the one hand the public interest in relation to the conduct and integrity of promoters and other persons engaged in the development of such colonies and to facilitating on the other, the smooth and speedy construction and maintenance of such colonies, residential buildings, apartments and properties and for matters connected therewith or incidental thereto.”

The key highlights of the proposed legislation would be:

  1. A project would not be allowed to be advertised before registration with the Regulatory Authority. This registration would ensure that the project has obtained all sanctions. The advertisements should be specific and clear without any misleading images or highlights about the project.
  2. Builders should use proper terminologies and would be required to give a detailed specification of carpet area, super built up and floor area. In addition to that, they would also need to give information about all the extra charges levied for common spaces such as corridors, parking and lifts, etc.
  3. Any individual who plans to buy a property can inspect all the documents pertaining to approvals, sanctions, any other relevant document related with the property. The draft has made this mandatory for developers.
  4. Developers would be required to make the buyers aware of the fact if they have taken any loan against that property. The regulatory body would have to ensure that the end products delivered to the buyers is what they had in mind at the time of investment.
  5. All property transactions, sale or purchases, would be logged with the Regulatory Authority thereby making Income Tax an obligation. This step would also ensure the elimination of illegitimate property and black money.

The Bill is, however, still in the draft stage and if approved by the legislatures of various State Governments, it would herald an era of increased regulation in the real estate sector.

Insurance cover likely for real estate deals:

Recent reports seem to suggest that some Insurance companies are ready to cover the risks that are involved in real estate deals through various Insurance policies and their Insurance products are awaiting the approval of the Insurance Regulatory Development Authority (IRDA). In India, none of the property transactions, whether they are large acquisitions or a simple sale of a land or a flat, are covered through an insurance policy by an Indian insurer. Thus, title insurance is likely to cover the potential owner of a property against loss from defects in title.

 


[1] Durai Murugan P.V.K., BA BL(Hons) LL.M (Business Laws), NLSIU.

Leave a Comment

Previous post:

Next post: