Residential Real Estate – Preferred Investment focus of Private Equity

In an emerging market like India, where the risks of execution of a project and government policy run high, the expectation of return on capital employed has always been high. Since the time private equity funds (domestic and FDI) started evaluating investments in India their return expectations were in the range of IRR 25% which in some cases went as high as IRR 30%. 

The growing middle class in India is becoming more and more affluent on the back of growing IT sector and manufacturing sector and demanded better quality housing.  As India has the youngest demography globally and one the largest workforce which is growing year-on-year - the housing demand has always been high. The Union Government of India has also created various schemes supporting developers of affordable housing and offered interest subsidies to buyers of affordable housing under the Pradhan Mantri Awaz Yojna to achieve the 2022 mission for realizing the goal of housing for all.

Residential real estate business in India (unlike other markets globally) is a business where the developer starts realising cash flow before delivery of the product. The initial investment is restricted to land cost and approval cost. Post land is completely paid up and project approvals are received typically a developer doesn’t need to infuse any further equity. In the days of high sale volume the construction was completely funded from sale of units and in the current scenario where sales volumes have been volatile, the cash flow gap is funded via bank/NBFC debt at an approx. cost of IRR 15%. The blend of the cost of bank debt with institutional equity brings down the cost of capital substantially of the project.

Commercial projects are usually developed with heavy investment and have a high gestation period. A commercial project usually needs equity for purchase of land, payment of premiums related to approvals and construction of the building. Normally lenders such as banks and NBFC’s shy away from funding development of a commercial project as cash flows from sales / lease rentals get realised only towards the completion of the project or post completion in case of a lease. Post completion, the occupancy/sale of the project is dependent on the demand and absorption velocity. It may take 6 months to 2 years for a complete exit from a commercial project after its development.

The self-liquidating model of residential projects with the visibility of interim cash flows from sales attracts private equity investors towards the residential projects. The visibility of exit from the projects is also stronger. The demand from strong demographics of India and housing being a priority sector within the Union Government’s policy also plays an important factor in making an investment in the residential sector. Lastly, the low blended cost of capital for a residential project makes it an attractive bet. 

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