ASSETS VERSUS BUBBLES IN REAL ESTATE

The finance ministry has reportedly turned down a proposal by the Department of Policy and Promotion (DIPP) that had suggested doing away with the mandatory three-year lock-in period for FDI in the real estate sector. The ministry's point of view is that a lock-in acts as a deterrent, checking speculation and protecting the sector from the sudden flight of capital. This could be particularly true at times of an unprecedented crisis, such as the global meltdown in 2008, when foreign institutional investors pulled out nearly $5 billion worth of equity investments between September and October 2008. For sure, there is a big difference between portfolio investments or hedge fund money coming into the stock market and money that is being channelled into the development of projects that by nature are of a much longer gestation. However, the ministry's contention is that despite the correction after the meltdown, real estate prices were not eroded to the extent that values of some other asset classes were, largely because the lock-in prevented investors from sending their money back home.

 

The ministry may have a point. After all there's no running away from the fact that there could have been some volatility in real estate prices had investors been allowed to repatriate their investments. However, given the fact that there is tremendous interest in the Indian real estate market and that most of the investments are of a long-term nature, how much money would have flowed out, is debatable. According to one estimate, nearly $20 billion worth of foreign investment has come into the Indian market since FDI was first allowed. So, in any case, imposing a lock-in on the original investment, which is between $5 million for a joint venture and $10 million for a 100% subsidiary, depending on the structure of the entity, should not bother long-term investors. As of now, it appears that the lock-in will be imposed on a rolling basis—in other words, the investment amount will be locked in for three years. That may seem harsh but again, shouldn't hurt too much. All that investors would need to do at their global investment committee meetings is to point out that the Indian government has shifted the goal post. But that shouldn't really make anyone too uncomfortable about putting in money to work in India given its reputation as one of the world's top business destinations.

 

Some investors have been suggesting that the minimum space requirement of 50,000 sq feet, for a project to be eligible for foreign investment, should be reduced because smaller projects tend to lose out. There could be some merit in that though it's hard to know where to draw the line. Actually, it's not such a bad idea given that there is a shortage of good projects in any case. The other area where foreign investors have been looking for easier regulations is when it comes to selling fully developed property to foreign buyers. There are some assets, such as malls, which when fully constructed, can't be bought by a foreign investor. There is a clear rationale for this, namely that there is a fair chance that such purchases would fuel asset inflation and moreover, the government believes it would be tantamount to trading in land. However, foreign investors argue that if foreign money has been used to develop an asset, the investor should be allowed to sell that property to another foreign investor locally. They argue that the original purpose, namely that foreign money should have been used to create the asset, would have been served. It's a tricky situation and for the time being perhaps, it's best to leave the rules as they are. One way in which a foreign company can sell out to another foreign entity is through an overseas transaction but that's not really desirable.

 

Not surprisingly, foreign investors also want to send more money home. Typically, foreign investments, in real

estate space, are made either in the form of pure equity shares, preference shares or compulsorily convertible debentures (CCDs). Dividends are payable on equity shares as also preference capital while interest can accrue on the debentures till the time that they are converted. Repatriating dividends, investors say, is tax inefficient because it would attract dividend distribution tax at the rate of 17%. They want a way out of this and want to send home money in a more tax-efficient manner, of course, only once the project is completed. How that can be resolved isn't clear right now. It's true that investors need to make returns and also to prove to their overseas shareholders that their money was wisely invested. That will encourage further investment and all said and done India is a capital-starved country, so it won't hurt to encourage project finance. At the same time, when foreigners enter a market, they do so with some idea of what they're going to make. So dividend distribution tax should be pencilled into those returns.