 "Real estate NCDs: Good returns but with high risks")
Since March 3, the BSE realty index has gained 14.2 per cent, compared with the Sensex's 3.95 per cent rise. Though real estate developers are reporting a slowdown in sales, in most centres, returns by real estate-linked non-convertible debentures (NCDs) are 18-22 per cent a year.
Therefore, such NCDs continue to be popular among high net worth investors.
Real estate developers can raise funds through housing loans taken by home buyers, construction loans from banks or non-banking financial companies (NBFCs) and NCDs, which they place with the private equity (PE) players of high net worth clients. In some cases, the private equity players or institutional investors subscribe to these NCDs and down-sell these to high net worth clients. A few major entities that have raised funds through NCDs in the past year include DLF, Lodha Developers, Wadhwan Group, Bangalore-based Century Real Estate, Parsvnath Developers and Godrej Properties. These NCDs were a mix of listed and unlisted ones.
What attracts investors to this space is the interest or coupon payment they receive at regular intervals. These could be monthly, quarterly or on a half-yearly basis. It is a secure investment because the value of the underlying security is usually twice the investment, says Anand Moorthy, head (real estate services), RBS Financial Services (India). So, if the developer is launching NCDs worth Rs 100 crore, the underlying assets should be Rs 200 crore.
Sometimes, the high interest NCDs offer is the only option to lure investors, says Rakesh Goyal, senior vice-president, Bonanza Portfolio. "An unfavourable business environment has made the real estate space financially leveraged to a great extent. In the past, a few reputed builders, too, had been unable to meet their interest dues on time. Following that, credit ratings downgrades were recorded, too. In such a situation, these companies rely on instruments such as NCDs to raise funds," he says.
Until interest rates fall, NCDs will continue to offer high returns, Goyal says. Moorthy agrees, saying the outlook is bullish because at the right selling point, there is demand for property. "Today, everyone is waiting, but there's no price correction. New projects, schemes and offers are keeping the sector positive. But going ahead, property prices will be defined by the stage of development," he says. The most important aspect investors have to keep in mind is given the returns are high, the risk associated with these NCDs are high, too. Investors are advised not to have exposure of more than 20 per cent of their total investment in NCDs. Here's a list of a few important checks before investing:
Value of the security
Before investing, check if the security is first-charged registered mortgage. Then, look at the valuation report of the project. This will tell you whether the NCD is over-valued or otherwise. Ensure the cover or security is worth at least twice the amount the issue is raising. At times, security enforcement in dire situations could be a long-drawn and cumbersome process, Goyal says.
History of the builder
Look at the overall history of the builder or the real estate company, particularly on the loan repayment front. Check if the builder has defaulted on previous payments, how much stock he has and how much he has been able to sell. The company should not be very highly leveraged.
Development risk
Most NCDs are raised when the project is in the development stage. If the completion of the project takes long, it might take long for the NCDs to be redeemed, too. "While it is an opportune time to participate in NCDs, given the returns are 17-20 per cent, these depend on sales. If sales are delayed NCDs could be extended. So, be prepared to wait for a year or two more than what is initially promised," says Moorthy. "While a complete default isn't common, sometimes, the developer might delay the payment and your funds could be blocked," said Rajiv Vadhera, chief operating, officer, Bajaj Capital Realty.
End use of funds
Another risk is that related to the end-use of the funds raised through NCDs, as there is no restriction on the utilisation. So, investors must keep a watch on whether the money is being used for construction, making payments for floor space index or transfer of development rights or for repaying existing debt. "If most of the NCD is used to repay existing debt, it isn't a good sign. Investors must ask for quarterly or half-yearly reports of the utilisation of funds. This could be done by asking the issuer company for certificate of payments done. While most NBFCs that place the money on behalf of their clients do this, it isn't an issuer practice," Moorthy says.
Selling prematurely might be difficult
If an investor buys these NCDs with an aim of selling these before maturity through stock exchanges, his/her investment might be susceptible to interest-rate risks. "Any downgrade in the credit rating of these bonds might lead to a substantial fall in the prices of bonds on the bourses. In such situations, one might also see inadequate liquidity on stock exchanges, when they wish to sell their NCDs. And, even if there is a ready buyer, the price quoted might be far below the bond's fair market value," says Goyal.
How do NCDs compare with Reits?
NCDs are bonds issued by real estate companies, while real estate investment trusts (Reits) are like mutual funds or collective investment schemes that invest in real estate projects on behalf of investors, either in properties, mortgages or mortgage backed securities. "While real estate NCDs are fixed-income products for investors, Reits' returns are market-linked. Therefore, they might suit different investor classes. Those personally investing in real estate projects should consider Reits and wait for the same," says Goyal.
Reits are more secure, as an investor gets units corresponding to his/her investment in a visible and operating income generating asset. However, total returns (minus yield) will depend on the rent escalation for the property price to going up, says Moorthy. When you venture into Reits, you know exactly what your cash flow since it is already established with minimum fluctuations. In the case of NCDs, projects' sales and the actual value might be realistic or not, though there is more scope for higher returns.
Therefore, such NCDs continue to be popular among high net worth investors.
Real estate developers can raise funds through housing loans taken by home buyers, construction loans from banks or non-banking financial companies (NBFCs) and NCDs, which they place with the private equity (PE) players of high net worth clients. In some cases, the private equity players or institutional investors subscribe to these NCDs and down-sell these to high net worth clients. A few major entities that have raised funds through NCDs in the past year include DLF, Lodha Developers, Wadhwan Group, Bangalore-based Century Real Estate, Parsvnath Developers and Godrej Properties. These NCDs were a mix of listed and unlisted ones.
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Investors can subscribe to NCDs through wealth management companies or NBFCs. Real estate PE funds are also increasingly investing through NCD route. After collecting the funds from clients, wealth managers invest these in debentures that have the land and under-construction projects of real estate companies as underlying securities. A Special Purpose Vehicle is set up for the investment and the money is invested through a trust the NBFC sets up on behalf on the debenture holders. Typically, the investment is for one-three years.
What attracts investors to this space is the interest or coupon payment they receive at regular intervals. These could be monthly, quarterly or on a half-yearly basis. It is a secure investment because the value of the underlying security is usually twice the investment, says Anand Moorthy, head (real estate services), RBS Financial Services (India). So, if the developer is launching NCDs worth Rs 100 crore, the underlying assets should be Rs 200 crore.
Sometimes, the high interest NCDs offer is the only option to lure investors, says Rakesh Goyal, senior vice-president, Bonanza Portfolio. "An unfavourable business environment has made the real estate space financially leveraged to a great extent. In the past, a few reputed builders, too, had been unable to meet their interest dues on time. Following that, credit ratings downgrades were recorded, too. In such a situation, these companies rely on instruments such as NCDs to raise funds," he says.
Until interest rates fall, NCDs will continue to offer high returns, Goyal says. Moorthy agrees, saying the outlook is bullish because at the right selling point, there is demand for property. "Today, everyone is waiting, but there's no price correction. New projects, schemes and offers are keeping the sector positive. But going ahead, property prices will be defined by the stage of development," he says. The most important aspect investors have to keep in mind is given the returns are high, the risk associated with these NCDs are high, too. Investors are advised not to have exposure of more than 20 per cent of their total investment in NCDs. Here's a list of a few important checks before investing:
Value of the security
Before investing, check if the security is first-charged registered mortgage. Then, look at the valuation report of the project. This will tell you whether the NCD is over-valued or otherwise. Ensure the cover or security is worth at least twice the amount the issue is raising. At times, security enforcement in dire situations could be a long-drawn and cumbersome process, Goyal says.
History of the builder
Look at the overall history of the builder or the real estate company, particularly on the loan repayment front. Check if the builder has defaulted on previous payments, how much stock he has and how much he has been able to sell. The company should not be very highly leveraged.
Development risk
Most NCDs are raised when the project is in the development stage. If the completion of the project takes long, it might take long for the NCDs to be redeemed, too. "While it is an opportune time to participate in NCDs, given the returns are 17-20 per cent, these depend on sales. If sales are delayed NCDs could be extended. So, be prepared to wait for a year or two more than what is initially promised," says Moorthy. "While a complete default isn't common, sometimes, the developer might delay the payment and your funds could be blocked," said Rajiv Vadhera, chief operating, officer, Bajaj Capital Realty.
End use of funds
Another risk is that related to the end-use of the funds raised through NCDs, as there is no restriction on the utilisation. So, investors must keep a watch on whether the money is being used for construction, making payments for floor space index or transfer of development rights or for repaying existing debt. "If most of the NCD is used to repay existing debt, it isn't a good sign. Investors must ask for quarterly or half-yearly reports of the utilisation of funds. This could be done by asking the issuer company for certificate of payments done. While most NBFCs that place the money on behalf of their clients do this, it isn't an issuer practice," Moorthy says.
Selling prematurely might be difficult
If an investor buys these NCDs with an aim of selling these before maturity through stock exchanges, his/her investment might be susceptible to interest-rate risks. "Any downgrade in the credit rating of these bonds might lead to a substantial fall in the prices of bonds on the bourses. In such situations, one might also see inadequate liquidity on stock exchanges, when they wish to sell their NCDs. And, even if there is a ready buyer, the price quoted might be far below the bond's fair market value," says Goyal.
How do NCDs compare with Reits?
NCDs are bonds issued by real estate companies, while real estate investment trusts (Reits) are like mutual funds or collective investment schemes that invest in real estate projects on behalf of investors, either in properties, mortgages or mortgage backed securities. "While real estate NCDs are fixed-income products for investors, Reits' returns are market-linked. Therefore, they might suit different investor classes. Those personally investing in real estate projects should consider Reits and wait for the same," says Goyal.
Reits are more secure, as an investor gets units corresponding to his/her investment in a visible and operating income generating asset. However, total returns (minus yield) will depend on the rent escalation for the property price to going up, says Moorthy. When you venture into Reits, you know exactly what your cash flow since it is already established with minimum fluctuations. In the case of NCDs, projects' sales and the actual value might be realistic or not, though there is more scope for higher returns.