The year was 1993; I was working at CRISIL Ltd. That year, we saw quite a few interesting ‘structured’ obligations that had come to us for rating. One, that was my favourite, was this:
Lokhandwala Construction Industries Ltd (LCIL), a reputed builder, announced a large housing project in Kandivali East, a suburb of Mumbai. It is now known as the Lokhandwala Township.
I do not remember the exact numbers; but approximately 600+ apartments were planned. The project was priced at Rs750/sqft (square foot), at the initial launch. The project had a very interesting funding structure. Since it was an innovative idea, the builder was particular about being compliant with Reserve Bank of India (RBI) regulations—the Securities & Exchange Board of India (SEBI) had just got its statutory teeth and was yet to make its presence felt in this area.
The structure was simple and elegant. LCIL would create ‘units’ for Rs750 each. Each unit represented 1sqft of space in the designated project. Say, there are 600 flats, with an average area of 1,500sqft each. It meant a total saleable area of 1,500X 600 sqft or 900,000sqft. Thus, 900,000 ‘units’ would be created. The units would be sold at par to applicants through a ‘trust’. LCIL would not leverage itself. The money collected would then be given to LCIL to execute the project. There were enough bells & whistles to ensure that the cash-flow was controlled and an audit mechanism was in place. The project completion time was a window of 30 to 36 months from the launch day.
The units were planned to be tradable in the secondary market. One could trade in multiples of 10 units. At any point of time, one could buy enough units and ‘buy’ a flat. Once a flat was bought, the units were extinguished. There was a separate Registrar & Transfer (R&T) mechanism, a financial audit, a designated ‘market-maker’ who would offer a 2-way quote, until the project was completed. Once that project was completed, the units that were not yet converted into flats would be surrendered to the trust, which would get money from LCIL to pay off the unit-holders.
As a unit-holder, one had a direct representation in the market price of the apartment. As the project neared completion, the price of the flat would start rising. The unit prices would rise correspondingly. An investor would ‘participate’ in the movement of the real estate prices. It was a wonderful structure that would have allowed someone with just a few thousand rupees to participate in real estate as an asset. The unit prices would be a proxy for the real estate price of that project. The mechanism was well-honed and we could see that, except market prices, every factor that was subject to execution was well-covered.
The risk assumed by the investor was two-fold. One, timely execution; and, two, price. In the event, the price fell below Rs750/sqft, LCIL would have to find ways to either buy out the units (those not yet converted into flats) or give a discount on the units trading between Rs750 and the prevailing (lower) market price. I recall that the going rate for apartments in nearby localities was around Rs650/sqft. The LCIL project was quite grand in scale and had enough amenities and facilities to justify a premium to market rates (at that time). In other words, the financial risk that we were evaluating was around Rs100/sqft and whether the builder could raise that money, assuming every unit eventually had to be funded. He would also need resources to fund unsold flats.
We were convinced about the feasibility of the project. The discussion centred on real estate market outlook, builder integrity, etc. What if there was zero demand for the project? What if there was a recession and prices crashed to below construction costs? Remember, this was 1993 and most minds were fresh with the fallout of the Harshad Mehta scam and stock market crash.
The instrument was aptly called ‘REAL ESTATE PARTICIPATION SCHEME’ or REPS. As an analyst, I had assessed the capabilities of LCIL to execute the project and the team was convinced about the builder’s capabilities. The team at LCIL was excellent. Legal checks about land titles, building permissions, etc, were all verified and we were satisfied.
From a rating perspective, we had enough financial comfort to provide for a price drop to, say, Rs500/sqft or so.
The only worry was whether it would amount to ‘fixed deposits’ and, if yes, the amount could not be raised. While we were debating about whether or not we should assign the rating, the company wrote to RBI, seeking its approval to launch such a financial instrument. No two guesses about the outcome. The plan had to be abandoned.
Thanks to this project, I got an opportunity to meet Siraj Lokhandwala. I also had the pleasure of interacting with the full-time CEO, Arvind Pahwa. Finding a high-quality professional in the real estate industry was a rarity those days. The structure was put together by the brilliant PS Jayakumar at Citibank (who went on to become the CEO of Bank of Baroda) and Shitin Desai at DSP Financial Consultants. This assignment helped me learn a lot about the construction industry, and gave me an understanding of the Lokhandwala group. I was convinced about their quality and had no doubts that the project would have been a profitable one for investors. Unfortunately, RBI was not willing to look at new possibilities (the scam had burnt all minds).
Finally, 30 years later, our regulators are talking about ‘fractional’ ownership in real estate! Lokhandwala and their team of bankers had come up with this idea in 1993! While our regulators are still ‘talking’, this investment vehicle is already operational for the past few years. There are multiple instruments that offer you fractional ownership in rental properties.
Just like equity shares, real estate is an asset class. Indians have always loved real estate. Given the fancy realty prices in cities like Mumbai, the only way most of us can participate in this asset class is through ‘fractional’ ownership. I am not sure how the laws will evolve. We already have a truncated form of ‘REIT’ (real estate investment trust) with fractional ownership available through buying and selling of units in listed secondary market instruments.
From my experience with the real estate industry, I can say that all investments have an element of risk. However, the risk is not any worse than in stocks. In fact, a stock can go down to zero; but it unlikely that any real estate unit will drop to zero; unless there is a fraud. If the legal structure is immaculate, the only real risks would be execution risk and market price risk. In India, we have rarely seen serious dips in real estate prices. Most builders also seem to have holding powers, thanks to the entry foreign capital, sometimes bank loans or and real estate funds that are willing to step in, at a price.
SEBI is now proposing to ‘regulate’ online ‘platforms’ offering ‘fractional ownership’ realty schemes. No one sought any permission to launch such schemes and SEBI, in essence, accepts that they exist and wants to get in sideways to regulate them.
These fractional ownership schemes open up a new avenue for investors, and a new fund-raising option for the real estate industry. There will be good projects, bad projects and outright frauds. There is no escape. As investors, it is useful to understand the risk before buying into such ‘fractional ownership’. As the name suggests, put in only a fraction of your wealth in these assets. Ultimately, they cannot return more than the average real estate price appreciation. There will be pure fixed-income-oriented products as well as some that promise you a share in real estate price movements. Remember that prices can move in two directions.
Note: Personally, I was very keen to see the launch of REPS. I was tracking the price movements at the project and, if REPS were launched at Rs750, the exit would have been at close to Rs1000. One other important reason I was happy with REPS was that it was taking away the black money out of the equation. It would have been ‘all-cheque’ deals, at a time, when it was quite common for real estate deals to have a large chunk of ‘cash’.