FEMA Provisions for FDI in Real Estate Sector

With 100% Foreign Direct Investments (FDI) in real estate now being allowed and as the equities falter, the action is hotting up in the real estate market. Private equity players are considering big investments, banks are giving loans to builders, and financial institutions are floating real estate funds. The total outstanding loans by the banking sector to real estate rose by 84.4% to Rs 24,527 crore as on January 20, 2006, from Rs 13,302 crore at the end of March 31, 2005, according to the RBI’s report on macroeconomic and monetary developments in 2005-06.

There seem to be few takers for the belief that the real estate market in Mumbai, Bangalore and a few other cities could well be a bubble. 1For instance, the State Bank of India (SBI) has invested in excess of Rs 250 crore in HDFC’s real estate fund, HDFC Realty. Venture funds promoted by ICICI, HDFC, Kotak, and Pantaloon and foreign funds with NRI components such as Solitaire Investments have already built-up a portfolio of commercial realty that have established tenants. Morgan Stanley has invested $ 68 million in Mantri Developers. Siachen Capital is investing $ 30 million in a joint venture with Nitesh Estates, with the promise of an additional $ 70 million investment in the future. The DLF Group has announced a 50:50 joint venture with the UK-based infrastructure major Laing O’Rourke with an initial corpus of Rs 500 crore. Mumbai-based developer Runwal Group and Singapore-based CapitaLand Group have entered into a 51:49 joint venture to develop residential projects. Bangalore-based developer RMZ Corp appears close to sealing a private equity deal. The Brigade Group expects to have a foreign partner in place in six months. The Sobha Group’s immediate priority is its IPO, but it is also looking at FDI for particular projects.

Industry sources say leading builders meet 3-4 investors every week. While it has taken more than a year (since the government relaxed FDI rules in real estate) for the first agreement to fructify, deals are now expected to happen faster.

The opportunity can be seen in the performance of listed construction and property development companies. Some of the biggest stock market gains people have had is in these companies. Companies like IVRCL Infrastructure, Gammon India, HCC, ERA Constructions, Unitech, Mahindra Gesco, D S Kulkarni Developers and Ansals have all outperformed the sensex by huge margins.

For property developers too, the prospect of private equity is a huge attraction. It enables them to invest in larger projects and expand beyond traditional bases, and also increases their staying power. It comes in handy in the event of a market correction, for the partner too shares the costs.

But the benefit goes much beyond cash. Developers look for technical support in the form of processes and construction technology from the partners. International funding companies also bring with them their international relationships, which are of enormous value in getting clients for the properties that are built. Global technology can help address one of the biggest problems in the domestic construction sector, the lack of timely implementation of projects.

In this article, we have discussed evolution of Government Policy on Foreign Direct Investment (FDI) in townships, housing, built-up infrastructure and construction-development projects.

Acquisition and transfer of immovable property in India are Capital Account Transactions in terms of section 6(3)(i)2 of the Foreign Exchange Management Act, 1999 (FEMA). The Reserve Bank of India (RBI) is empowered to frame Regulations to prohibit, restrict or regulate the acquisition or transfer of immovable property in India by a person Resident outside India.

In exercise of these powers RBI, vide Notification No. FEMA 1 titled “Foreign Exchange Management (Permissible capital account transactions) Regulations, 2000”3 provided that no person resident outside India shall make investment in India, in any form, in any company or partnership firm or proprietary concern or any entity, whether incorporated or not, which is engaged or proposes to engage in real estate business, or construction of farm houses or in trading in Transferable Development Rights (TDRs).

In order to simplify acquisition and transfer of immovable property (other than Agricultural Land/Farm House/Plantation Property) in India by an Indian Citizen resident outside India (NRI) or a Person of Indian Origin (PIO), RBI simultaneously also framed “Foreign Exchange Management (Acquisition and Transfer of Immovable Property in India) Regulations, 2000” which have been notified vide Notification No. FEMA 21 / 2000 – RB dated 3rd May, 2000.

Though, Explanation to Regulation 4 of Notification No. FEMA 1 provided that “real estate business” shall not include development of townships, construction of residential/commercial premises, roads or bridges, in view of the policy restrictions, RBI did not make any regulations on the subject and the investment in real estate business was subject to the approvals from SIA/FIPB.

Subsequently, while expanding the list of industries/activities eligible for automatic route4, Government permitted Non Resident Indian (NRI) and Overseas Corporate Body (OCB)5 to make investment in certain sectors of Housing and Real Estate. In accordance with the policy, RBI, through Notification No. 94 permitted6 Non Resident Indians to invest in the below listed areas up to 100%: -

1. Development of serviced plots and construction of built-up residential premises.
    

2. Investment in real estate covering construction of residential and commercial premises including business centres and offices.
    

3. Development of townships.
    

4. City and regional level urban infrastructure facilities, including both roads and bridges.
    

5. Investment in manufacture of building materials.
    

6. Investment in participatory ventures in (a) to (e) above.
    

7. Investment in Housing finance institutions, which is also opened to FDI as an NBFC.

However, FDI in “real estate business” was still not permitted.

In a major liberalization, the Government of India for the first time vide Press Note7 dated 21st May, 2001 permitted FDI up to 100% for development of integrated townships, including housing, commercial premises, hotels, resorts, city and regional level urban infrastructure facilities such as roads and bridges, mass rapid transit systems; and manufacture of building materials. According to the Press Note, development of land and providing allied infrastructure also formed an integral part of township’s development.

It took almost eight months for the Government to prescribe necessary guidelines/norms8 relating to minimum capitalisation, minimum land area, etc. FDI in this sector was permissible up to 100% but only with prior approval of the Government for development of integrated townships, including housing, commercial premises, hotels, resorts, city and regional level urban infrastructure facilities such as roads and bridges, mass rapid transit systems; and manufacture of building materials. The minimum area to be developed by such a company was 100 acres or a minimum of two thousand dwelling units for about ten thousand population. The core business of the company seeking to make investment should have been development of integrated townships and there was a lock in period of three years for repatriation of original investment.

However, the above ceilings were quite unrealistic and therefore, there was no FDI in construction and development projects. The Government therefore decided to further liberalise FDI policy in Real Estate and finally allowed9 FDI up to 100% under the automatic route in townships, housing, built-up infrastructure and construction-development projects (which would include, but not restricted to, housing, commercial premises, hotels, resorts, hospitals, educational institutions, recreational facilities, city and regional level infrastructure), subject to the following guidelines:

1. Minimum area to be developed under each project would be as under:

1. In case of development of serviced housing plots, a minimum land area of 10 hectares.
    

2. In case of construction-development projects, minimum built-up area of 50,000 sq. mts.
    

3. In case of a combination project, anyone of the above two conditions would suffice.

2. The investment would further be subject to the following conditions:

1. Minimum capitalization of US $ 10 million for wholly owned subsidiaries and US $ 5 million for joint ventures with Indian partners. The funds would have to be brought in within six months of commencement of business of the Company.
    

2. Original investment cannot be repatriated before a period of three years from completion of minimum capitalization. However, the investor may be permitted to exit earlier with prior approval of the Government through the FIPB.

3. At least 50% of the project must be developed within a period of five years from the date of obtaining all statutory clearances. The investor would not be permitted to sell undeveloped plots. For the purpose of these guidelines, “undeveloped plots” will mean where roads, water supply, street lighting, drainage, sewerage, and other conveniences, as applicable under prescribed regulations, have not been made available. It will be necessary that the investor provides this infrastructure and obtains the completion certificate from the concerned local body/service agency before he would be allowed to dispose of the serviced housing plots.
    

4. The project shall conform to the norms and standards, including land use requirements and provision of community amenities and common facilities, as laid down in the applicable building control regulations, bye-laws, rules, and other regulations of the State Government/Municipal/Local Body concerned.
    

5. The investor shall be responsible for obtaining all necessary approvals, including those of the building/layout plans, developing internal and peripheral areas and other infrastructure facilities, payment of development, external development and other charges and complying with all other requirements as prescribed under applicable rules/bye-Iaws/regulations of the State Government/Municipal/Local Body concerned.
    

6. The State Government/Municipal/ Local Body concerned, which approves the building/development plans, would monitor compliance of the above conditions by the developer.

Investment in Special Economic Zones, Hotels & Hospitals

FDI up to 100% has been allowed under the automatic route in the “Hotel and Tourism Sector” vide Press Note 4 (2001 Series) and in the Hospital sector vide Press Note 2 (2000 Series). Special Economic Zones are separately regulated under the Special Economic Zone Act, 2005. However, some confusion had arisen due to inclusion of the “hospitality and hotel sector” in the Press Note No. 2 (2005 Series) as to whether the restrictions mentioned in the said Press Note are applicable to these sectors and that whether the automatic route has been dispensed with?

In response to the clarifications sought by investors from various quarters, 10it is clarified by the Government that the provisions of Press Note 2 (2005 Series) shall not apply to Special Economic Zones, establishment and operation of hotels and hospitals, which shall continue to be governed by Press Note 4 (2001 Series) and Press Note 2 (2000 Series) respectively. Therefore, various restrictions contained in Press Note 2 (2005 Series) such as minimum area, minimum capitalization, lock in period etc. shall not apply to these sectors.

Investment in Real Estate by ‘Foreign Venture Capital Investors’ (FVCI):

As per 11Schedule 6 to Notification No. 20, a registered Foreign Venture Capital Investor (FVCI) may, through the Securities and Exchange Board of India, apply to the Reserve Bank for permission to invest in Indian Venture Capital Undertaking (IVCU) or in a VCF or in a Scheme floated by such VCFs. Permission may be granted by Reserve Bank subject to such terms and conditions as may be considered necessary.

The registered FVCI permitted by the Reserve Bank may purchase equity / equity linked instruments/debt/debt instruments, debentures of a IVCU or of a VCF through Initial Public Offer or Private Placement or in units of schemes/funds set up by a VCF.

The amount of consideration for investment in VCFs/IVCUs shall be paid out of inward remittance from abroad through normal banking channels or out of funds held in an account maintained with the designated branch of an authorised dealer in India in accordance with Para 2.

According to some reports12, the RBI have effectively stalled the approvals of about 25 foreign venture funds who have applied for Foreign Venture Capital investment licences to SEBI and RBI few months ago and not a single venture fund has received its licence.

The reason being differences in interpretation in the guidelines for Investment in real estate by “Foreign Venture Capital Investors” (FVCI). RBI is of the opinion, and perhaps rightly so, that Schedule 6 should be read together with Press Note No. 2. This effectively means that FVCI will have to get involved in the development and construction of the projects subject to lock in period of three years.

Foreign VC funds by their very nature are interested in only picking up equity stakes in real estate companies. Sources say that Trinity Capital of UK has raised 250 million pounds and has a mandate of 18 months to deploy the money and Trinity is waiting eagerly for the RBI approval. Another VC fund “Warburg Pincus” is also in a similar situation.

Domestic real estate venture funds are likely to benefit from foreign funds not getting approval from the RBI.

Reserve Bank’s Uneasiness:

Reserve Bank’s uneasiness about a build up of an asset price bubble seems to have prompted it to put curbs on banks investing in real estate venture capital funds (VCFs). Banks have now been told to reduce their investment exposure in real estate VCFs substantially. The warning note on investment exposure in VC funds follows the recent decision of the RBI to treat all exposures of banks to VCFs on par with equity. The total exposure of banks to VCFs now forms part of a bank’s capital market exposure thus attracting a higher risk weight of 150%. The RBI has made it clear that it wants to ensure quality of credit. These measures are expected to act as a dampener to the trend of rising exposure by banks to the real estate segment. Over the last year, there has been exponential rise in the number of real estate sector funds.

Conclusion

13FDI has played a crucial role in several economies, including China, where half of its FDI is in real estate. The new guidelines for India can trigger investment of few billion dollars every year. Demand is on an upswing. IT and IT-enabled services would require an estimated 50-70 million sq. ft. of space in the next two to three years, while the nationwide housing shortage is estimated at 20 million residential units.