FDI in construction development sector
Regulatory regime
India allows foreign direct investment (FDI) of up to 100%, under the automatic route, in the construction development sector, which includes projects such as townships, residential/commercial premises and hospitals and the like.
With 100% FDI allowed, investors can exit on completion of the project or after development of trunk infrastructure, namely roads, water supply, street lighting, drainage and sewerage in such a project. Each phase is considered a separate project. This means investors can exit and repatriate their foreign investment before completion of the entire project, subject to a lock-in period of three years, calculated with reference to each tranche of the FDI. However, these exit restrictions are not applicable to investments in hotels, tourist resorts, hospitals and educational institutions.
Transfer of a stake by one non-resident Indian to another without repatriation of the investment is also allowed, without lock-in period or government approval.
But it is pertinent to note that FDI is not permitted in an Indian company engaged in construction of farmhouses, trading in transferable development rights or ‘real estate business’, defined as dealing in land and immovable property to earn profit. The said ‘real estate business’ does not include development of townships, residential or commercial premises, roads or bridges, REITs, educational institutions, recreational facilities, city and regional level infrastructure, and earnings from rent or income on lease of a property not amounting to a transfer.
Recent trends
In the recent past, FDI is made in this sector across all classes of real estate, including warehousing and data centres as well. Some of the large investment transactions also took place in co-living and co-working companies.
Further, with increase in interest rates in the economy, India has witnessed structure debt transactions in the real estate sector, where large private equity funds, foreign investment portfolio investors and alternate investment funds focused on bond financing, interim finance, listed debt securities and mortgaged back securities investments with high yield coupons.
There is robust demand for residential sector on the ground and the sector is going through a bull run as of now!
Investment trusts
Another recent development for the real estate sector is adoption of the REIT model by both retail and institutional investors. There are presently five registered REITs, including three together owning over 10% of grade A office space, a sector projected to soar by up to 68% in the coming years. Amongst the large foreign institutional real estate investors, both Blackstone and Brookfield had their maiden REIT listed in India. Residential properties are not part of Indian REIT portfolios as of now.
REITs offer tax advantages in India. Dividends issued by REITs are exempt from tax in the hands of the investors. However, other tax implications may apply depending on the nature of income and investor type.
REITs are principally governed by the Securities and Exchange Board of India (SEBI) REIT Regulations and they are constituted as a trust under the Indian Trusts Act 1982, generally comprising of a designated sponsor, manager, trustee and unit holders.
The REIT Regulations prescribe that at least 80% of the value of REIT assets must be invested in completed and rent and/or income-generating properties. The remaining 20% must be invested in properties under construction or completed, but not rent-generating, properties. As per the REIT Regulations, REITs are permitted to invest only in assets situated in India. Further, the balance 20% of the REIT assets may only be invested in listed or unlisted debt of companies or bodies corporate in the real estate sector, mortgage-backed securities, equity shares of the listed and unlisted companies deriving at least 75% of their operating income from real estate activities, government securities and money market instruments.
It is pertinent to note that a REIT must not invest in vacant land or agricultural land or mortgages other than mortgage-backed securities. However, this restriction does not apply to any land that is contiguous with and involves an extension of an existing project that is being implemented in stages.
To safeguard investor interests – enabling them to make well-informed decisions for their REIT investments – the regulations prescribe certain periodic valuations, including full valuation of all REIT assets on an annual basis, through a registered valuer.
Recently, SEBI amended the regulatory framework to allow small and medium real estate investment trusts to induce a spirit of fractional ownership among a pool of investors with a lower asset base value (ie Rs. 50 crores as against Rs. 500 crores in the existing REIT regime) and opportunities for leveraging separate holding schemes through special purpose vehicle structures.
Insolvency and bankruptcy
The Insolvency and Bankruptcy Code, 2016 (IBC) codifies the existing framework of insolvency and bankruptcy laws, streamlining processes for insolvency and liquidation. The IBC enables any financial creditor, operational creditor, or the corporate debtor to initiate an insolvency resolution process upon the event of default by the corporate debtor. This must be resolved within 180 days from submission of application for initiation of the insolvency resolution process.
The IBC has had a crucial impact on real estate insolvency for Indian real estate companies involving interests of both homebuyers and real estate developers as stakeholders. Homebuyers are also afforded greater rights through recent amendments and decisions of the Supreme Court.
Previously their role was limited to being recognised as ‘other creditors’. But since amendments in 2018, homebuyers are now recognised as financial creditors, with the right to initiate the insolvency process against defaulting real estate companies. This right is subject to a minimum threshold on the required number of homebuyers to initiate the process.
Real estate developers are also afforded greater flexibility by the Insolvency and Bankruptcy Board of India in seeking and passing resolution plans of real estate companies. The Insolvency Resolution Process for Corporate Persons Regulations, updated in 2022, enables the committee of creditors to seek a fresh resolution plan in respect of one or more assets of the corporate debtor, where no resolution plan was received for the corporate debtor as a whole.
A resolution professional can also allocate a budget towards a marketing strategy directed at maximising valuation of the corporate debtor’s assets. This amendment allows resolutions designed specifically for individual real estate projects of a corporate debtor, which can also vary based on factors including project size, development type, stage of completion and location.
Protection of interests
Apart from the IBC, another prime avenue for lenders to recover their debts is governed by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act).
If a borrower fails to repay a secured debt, the secured creditor may classify the borrower’s account as a non-performing asset and initiate proceedings to enforce its security interest and take possession of the secured assets; a faster process for debt recovery compared to the civil court process.
A prior notice must be sent to the borrower to discharge the liability in full within the stipulated period, upon failure of which enforcement proceedings may commence under SARFAESI Act provisions.
While the SARFAESI Act controls and facilitates enforcement of financial agreements between real estate developers, homebuyers and banks, the Real Estate (Regulation and Development Act), 2016 (RERA) is the principal legislation balancing the interests of allottees and promoters in construction, development and marketing of real estate projects.
Under the RERA, certain liabilities are imposed on promoters and allottees of the real estate projects. Promoters are required to disclose pertinent information such as sanctioned plans and schedules for completion of the real estate project to allottees.
On the other hand, allottees are primarily liable for making payments in accordance with the sales agreement with the project promoter, along with any financing agreement with a secured creditor, and paying interest in the event of default.
In Union Bank of India v Rajasthan Real Estate Regulatory Authority and Ors, the Supreme Court upheld the decision of Rajasthan High Court, reiterating the principle that the RERA is a special legislation that prevails over provisions of the SARFAESI Act in the event of conflict.
Critically, it further held that RERA authorities had jurisdiction to entertain complaints from homebuyers against banks as secured creditors if the bank takes recourse to any provisions in section 13(4) of the SARFAESI Act.
Debt financing
Lenders from foreign jurisdictions are also subject to the master direction on external commercial borrowings, trade credits and structured obligations (ECB framework), updated from time to time by the RBI. This framework provides for certain conditions that must be satisfied by borrowers and lenders in cases where the loan falls under the automatic or approval route.
Alternatively, another route that foreign lenders and investors use is through subscription to secured non-convertible debentures of Indian companies, listed or not, in accordance with the SEBI (Issue and Listing of Debt Securities) Regulations, 2008.
The security interest is created in favour of a debenture trustee responsible for holding the security on behalf of the non-resident lenders and overseeing compliance by the borrower. The non-resident subscriber must be registered with SEBI as a foreign portfolio investor.
Pursuant to amendments in 2021, the RBI amended the Foreign Exchange Management (Debt Instrument) Regulations, 2019 to allow foreign portfolio investors (FPIs) to invest in debt securities issued by REITs and infrastructure investment trusts under the medium-term framework or voluntary retention route. The maximum unit holding of an FPI in a single REIT has, however, been capped at 10%.
Environmental, social, and governance (ESG)
ESG considerations are becoming increasingly relevant and important in the real estate sector in India. Historically, real estate companies in India have been involved in development and construction of affordable housing projects in both plotted and group housing sectors, as their primary contribution to ESG. Another convention ESG focus area in India has been towards construction of green buildings, which are more energy and water-efficient, driven primarily owing to regulatory concessions where incremental floor area ratio is granted to such green buildings.
With growing awareness about climate change and sustainability, real estate developers in India are also focusing on environmentally friendly practices. This includes using sustainable materials, incorporating energy-efficient designs, and ensuring better waste management and better working conditions.