Overview of the integration of real estate with capital markets

The integration of real estate markets with the financial markets

There is an interconnection that exists between real estate and capital markets.  The main purpose of the text presented here is to explore this integration, and we do this by breaking down the savings-investment-financial-capital-real estate markets sequence. 

The Real Estate Markets: The main participants of the realty markets who determine finance flows

The three main entities that drive finances into real estate are- a) the end users, b) builders and c) investors.

·         The end users buy a realty asset and use the same

·         Builders/ developers can be seen as manufacturers, who assemble the various inputs and sell the final product at a price.

·         The Investors

The last category becomes interesting in case of real estate assets. They may be either a) End-investors or b) investment vehicles that serve the end-investor. To elaborate, the end-investors are individuals or legal entities who buy real estate for their own investment purposes. The vehicles for investors are meant to facilitate the end-investors. As a comparison to enable better understanding, they can be seen as a unit in the industry which assembles the resources to give certain returns to its investors. Their input factors (compare to ‘equipment’ or ‘plant & machinery’) is real estate instead of machinery and special manpower which is skilled to handle the property investment aspects. The final product in this case is recurring returns as well as capital appreciation that is earned from the properties (factors of production) that are held and managed. This is distributed to all those who put in money in the investment vehicle.

The Financial Markets: Types of finances

The nature of finances is the same in any industry or asset. Therefore, the flow of finances into real estate can also be broadly classified as

·         Debt: Finances which are given for a fixed income with security, collateral etc.

·         Equity: Finances which are given in lieu of profits

·         Hybrids: Combinations of the above

To participate in real estate markets, the simplest way is for anyone to buy property with savings in their own name (as individuals). Also, property can be purchased with savings (equity), by various entities such as corporations, trusts, HUFs, partnerships etc. An increasingly important vehicle for purchase of real estate is by way of SPVs (Special Purpose vehicles or legal entities set up for specific purpose of realty investment). Money can also be borrowed and the realty asset can be financed by way of a loan. This is called debt finance in real estate. Additionally, there may be complex instruments and new names or definitions which may be products of financial innovation from time to time. However the basic nature of any type of finance is either debt or equity or a combination of these two only.

The capital markets: Enabling the flow of finances with several instruments

The flow of finances to any of the segments can be made possible efficiently, with the presence of a well-functioning capital market environment in the country. A capital market can be regarded as any place (physical/ virtual) which makes exchange of money possible. The exchange of money for a price which may be profits or interest as outlined (equity or debt).  The capital markets of any country must be adequately regulated in order to ensure transparency and fairness to the participants.

The government-regulated-exchanges of a country provide a conducive entry and exit route to the investors. They facilitate finance for any sector, including real estate. One of the primary benefits of investments being routed through exchanges is to make investment ticket sizes smaller and also more liquid. The stock exchanges are the final point which help reach a wide base of people who have funds and connect them with those who need the finances.

The capital markets (private or public) raises finances with the help of instruments, which are mainly variations of the traditional ‘promissory note’. The regulations impact the formulation and working of these instruments in any country.

The Integration: Real estate, finances and capital markets (for end-users, developers, investors)

End-users: The end-users, in erstwhile years (read ‘pre-2000 s’) were predisposed to equity financing in the case of their real estate purchases. The component of loans in funds that were driven into property was practically non-existent. However, for the past 2 decades, the real estate mortgage market has been extremely active in India. End users, especially home buyers, invariably finance their property with debt.  End users can get home loans, extension loans, loan against property, etc.

The finances which are tapped here are:

·         Equity: These is own equity or savings

·         Loans from the banking sector or savings of others

Defining the integration in case of end users: As seen above, the equity for the end user is own sources of finances. If the end user is a legal entity (say a corporation) the sources of equity finance can be the bourses. The debt finance in this case that the end-user gets is through banks. These loans are effectively, a means for several million people (depositors) who wish to lend money to someone, and banks help them do the same. The banks get finances through equity of the sponsors or the deposits of the public. In case the bank is listed on exchanges, the sponsor’s finances are sourced through equity issue to the public. Bank deposits may also be raised from exchanges with several debt instruments.

Developers: The builders behave just like any other manufacturing unit. Thus, the sources of finances from capital markets are open to them as they are for any other manufacturing unit. They can tap equity markets, they can issue NCDS (debt) and they can take loans from private funds also. However, lending norms as well as foreign finances to real estate are different and this must be taken into account while exploring the sources of funds for this category of ‘manufacturer’.

The nature of finances which can be listed here are:

·         Equity financing: A developer company that is limited by shares can raise money from public

·         Debt finance: These are in their nature loans to an industry. Can come from the banking sector or others. Issue of NCDs and promissory note by the company to raise debt finance from public or private entities is also possible

·         Hybrid structures and complex instruments: like mezzanine finance, customized loan solutions or even financing by way of securitizing assets.

Defining the integration in case of developers: As can be seen here, the capital market sources are open for equity finance, debt finance and hybrid finance.

Investors As outlined, the investors may be end-investors or investment vehicles who serve the end-investors’ needs. The first category of investors (investors who owns an asset in order to generate returns for self from the asset instead of putting it to end use) derive their funds in a manner similar to ‘end-user’ finance.

The linkage of these investors with finance markets can be listed as:

·         Equity financing: Can issue units to raise money (private mode or the public)

·         Debt finance:  From the banking sector, private entities, mutual funds etc. Issue of debt securities to raise debt finance from the public

·         Use of innovative structures: Securitization can help in a thriving mortgage finance industry for real estate (subject to caution, as seen during global crisis of 2008).

Defining the integration in case of investors: As can be seen here, in the case of second category (investment vehicles) the possibilities of finances expands in a considerable manner. Since they are like manufacturing units but with a focus on maximizing their input factors (in their case, real estate assets) many combinations may evolve. They have access to variations in equity and debt finance mentioned. Also, these investors have the advantage of patient long term capital in most cases. Thus, they can use equity finance, securitization, etc. far more innovatively and efficiently.  The avenues have been made possible only since there is opening of legislation in this regard.

Conclusion:

There is a very deep linkage between the real estate and capital markets. In order to understand the impact that real estate assets can have on the capital markets, it is beneficial to bifurcate and systematically examine the same. This effort has been made above and it may be seen that the linkage which exists is indeed very strong in its present state. The integration is only set to grow many-folds with advent of REITs (Real Estate Investment Trusts).  The Indian government had formalized REIT guidelines a couple of years ago but the same is yet to see appreciable acceptance. A start though, has already been made with Infrastructure Investment Trusts (or InvITs) wherein, IRB InvIT and Indi Grid InvIT have found their way to listing on the Indian stock exchanges in the year 2017.  It may well be expected that in coming times, whenever we analyse the assets that make up bulk of the capital markets, real estate will be a key factor apart from the manufacturing and service sector that is present today.