The world of business is fascinating. There are parts of it that are science – you can predict outcomes based upon the conditions and a set of rules. Or you know that you could if you knew enough about the rules and could measure all the conditions. And there are parts of it that aren’t science. Or if they are, they are more of a ‘social science’. I find joy in both CAPM and Leadership theory. Both make sense to me.
But then, I have another category – Things That Don’t Make Sense To Me. Over time I have generally found that most things in the TTDMSTM category don’t make sense to me only because I haven’t found the answer to my question, or haven’t found the right person to ask. But sometimes they just don’t make sense. The Indian Real Estate Funds question is one I have put to many people and haven’t yet found a satisfactory answer. So if anyone out there has a good answer I’ll be eager to hear from them. Here it is:
In the US there is a vehicle called REIT, which is essentially a publicly listed company that invests in real estate. Management fees are low and they are available to the public to invest in (both facts are linked in a way).
In India in the last few years real estate funds have been mushrooming like rabbits. Every company that has an asset management side of the house, and many that don’t, either has a real estate fund or is starting one. Which is not surprising, since the thesis that real estate is a good investment in a booming economy with crowded cities is reasonable. However, all these funds are structured so that they make a lot of money for the fund managers at the expense of the investors. Most of them have the economics of a Venture Fund – 2% Management Fees; 20% Carry. (20% Carry means that the Fund managers will keep 20% of the returns of the Fund over a certain hurdle rate of return).
There is a big difference between the risks in a Venture Fund and a Real Estate Fund. VC thumb rules say that a third of a VC’s investments go bust, a third are chart-busters with the remaining third somewhere in between. This is a high-risk business. It is also a business where the expertise of the fund managers in attracting and backing good ventures hugely determines the success of the fund.
Investing in real estate is not like that at all. The risk on individual properties is much more contained. Also, the level of expertise is not that high. A local real estate broker will know far more about a property than an MBA who manages the fund. I am not saying that the quality of management, the reputation of the firm and so on doesn’t add value, but 20% carry for just diversifying one’s real estate holdings sounds like a ‘get rich’ scheme – for the Fund managers.
As you may have guessed, I have so far not bought into any Indian real estate fund. If they come up with a REIT like instrument that is publicly traded, regulated and has low mutual fund like fees, I will gladly invest in that. Or if someone can explain what justifies the fees. If it is simply supply and demand for such funds, that’s not a good enough reason. I’ll wait.
Before you get influenced by this post, let me tell you about another TTDMSTM of mine – GOOG (Google). For a long time, my wife was on my case to buy GOOG. I didn’t. My reason – its P/E didn’t make sense to me. Where were they going to get that kind of growth from? Recently, when GOOG dropped over 20% from its high of $475, I told my wife that I felt vindicated about not buying GOOG. She sneered "I told you to buy it at $180!"
I came across your views on Indian Real Estate Funds and thought, I should attempt some answers to your questions.
1. First off REITs in general are mutual fund type units which have mature income producing assets (Rented properties) and are manadted to distribute 90% of OPerating income as dividend. They are tax free if they do so and therefore tend to trade on the basis of yield.
In India, organised Real estate portfoli doesnt exist. If you know Nariman Pt, the properties are held by multitude of investors and and dont lend themselves to redevelopment. Its only now that quality properties occupied by quality tenants (IT and BPO MNCs) are emerging as tenants which lend itself to REIt structure and even here most investment opportunity is towards development of the property which means you have development risk, approval risk, leasing risk and (In India – a huge regulatory Risk).
The above is true of most classes of real estate – be it Retail, Hospitality or healthcare. All of these are development risk assets. The developer industry is not organised and corp governance is still alein to the developers.
Hence Highre risk must translate to highre rewards whic is what these funds are about. the 2 and 20 structure is for targetting returns in early 20s.
REIts well, then you are talking about 6% returns!!
I am happy to chat in detail.
Srini, your points are well taken. But I will still maintain that the 2 and 20 fee structure is more a function of supernormal returns in a hot real estate market rather than what is deserved by the investment management skills required by this kind of asset class. You may be right that the risks today in India in real estate are many, but that is exactly my point – that the government must work towards taking much of this risk away so that what is left is largely market risk. I also don’t like the fact that approval risk and regulatory risk are important factors. The temptation for a fund to bend the rules is far too much.
your points are valid, but in a crazy bubble market…anything goes and people are able to charge some crazy fees.
There are several issues related to Indian Real Estate Investments. Examples:
1) adequacy of information about financial versus “entrpreneurial” equity (“sweat” would hardly be the right word) contributed by local ( India) developers;
2)the availability, terms, and use of mezzanine (construction) financing and how it affects returns calculation;
3)the “two sets of books” accounting ( anecdotal evidence suggests two sets of books still widely prevalent- even on the part of some large developers);
I believe mortgage based financing and “flips” offers the most conservative way for NRI’s to invest (passive) until suitable ADR’s become available.