Anoop Dave, a Wharton grad from the class of 2003 who is now a real estate consultant in Philadelphia, recalls a dinner conversation he had two years ago with a senior Goldman Sachs executive involved in the firm’s global real estate investments. This executive swore he would never invest in India, adding that his determination had been cemented by impressions formed after a recent visit to the country.

Times change. For about a year now, Goldman Sachs’ Whitehall Street Real Estate Funds have been exploring the Indian market and checking out potential investment partners. In March 2005, the firm announced it planned to invest up to $1 billion over the next two years in Indian private equity, real estate, private wealth management, and other businesses in India for its institutional clients. A month later, California Public Employees’ Retirement System (CalPERS) invested $100 million in a $400 million real estate fund promoted by India’s Infrastructure Leasing & Financial Services. The IL&FS-CalPERS fund plans to invest in the equity of Indian real estate companies. At last count, international funds had reportedly invested some $2.5 billion in Indian real estate. Nearly two dozen domestic funds have raised another $3.5 billion for similar investments.

Goldman Sachs and CalPERS — the world’s largest pension fund, with some $208 billion in assets under management — are not the only global investors looking at opportunities in Indian real estate. Others include Wall Street powerhouses such as J. P. Morgan, Warburg Pincus, Morgan Stanley Real Estate Funds, Merrill Lynch, Lehman Brothers, Warren Buffett’s Berkshire Hathaway, the Blackstone Group, Colony Capital, Starwood Capital, GE Capital and HSBC, among others. Dave’s consulting firm that goes by his name is currently advising the Hiranandani Group, a large developer based in Mumbai, on partnering with a U.S. private equity fund. Hines, a developer in Houston, and the Government of Singapore Investment Corporation plan to invest $1 billion in Indian real estate, according to media reports.

The excitement has also spread to top-tier U.S.-based real estate brokerage and services firms such as CB Richard Ellis, Cushman & Wakefield and Trammell Crow. Even design firm Hillier of Princeton, N.J., is looking at possible projects in India.

Rising Returns

All these companies are encouraged by Indian policy changes in February 2005 that allow foreign investment of up to 100% in construction development projects with fast-track approvals. The real attraction is investment returns of potentially 25% and more in Indian projects that might be hard to come by today in the U.S. and Western Europe. India’s urban office space market is tiny at about 60 million sq. ft., compared with New York City’s 400 million sq. ft. or New Jersey’s 175 million sq. ft. (Bangalore, in southern India, has 25 million sq. ft. of office and high-tech space, of which 9 million sq. ft. was built last year.) Investors could view that as a glass half-full or half-empty.

India’s commerce minister, Kamal Nath, who is spearheading the reforms, has been candid about why the reforms were necessary. The earlier policy permitted foreign investment of up to 100% in the development of townships, but only nine proposals had been approved. Investors told the Indian government that a 100-acre minimum project size was a hurdle; another was a requirement that it be part of a township project. The reforms reduced the minimum project size to 25 acres for housing, and about 8 acres (50,000 sq. meters) for other product types. In addition, investments in hotels, resorts and hospitals were permitted even if these were not part of a township.

Nath’s policy, however, does not give investors a free run. “They will have to construct within a specific time frame,” he said in February. That rule, he explained, was to ensure that foreign investors do not hold on to land for speculative purposes. Foreign investors need a minimum capitalization of $10 million for wholly-owned subsidiaries and $5 million for joint ventures with Indian partners — an attempt to attract only serious investors. Foreign investors cannot repatriate their investment before three years, although an early exit may be allowed in some cases. They also won’t be permitted to sell undeveloped lots, or those without roads, water supply, street lighting, and drainage and sewer connections.

In April, India’s central bank — the Reserve Bank of India — sought to plug a perceived loophole in the government’s February policy reforms. It said that foreign institutional investors (FIIs) can participate in the initial public offerings of real estate companies only if the latter fulfill the conditions specified in Nath’s policy for foreign direct investment. Put differently, it prevented foreign investment in real estate ventures — directly or through institutional investors — unless the projects adhered to the government’s FDI policy regime. FIIs are, however, permitted to invest in real estate companies through the secondary market, but such investments would be subject to the pre-existing cap of 24% of a company’s outstanding share capital.

Investors from Asia have been among the earliest to jump into India’s construction development industry, firming up a presence established before the latest reforms. Large Singaporean development companies that already have projects underway in India are Ascendas, CapitaLand and Keppel Land. In June 2005, Ascendas launched its $350 million “Ascendas India IT Parks Fund,” with investments in two IT parks — the International Tech Park in Bangalore and the Vanenburg IT Park in Hyderabad. Keppel Land has stakes in several IT parks across the country. Indonesia’s biggest conglomerate, the Salim Group, has proposed four investment projects in West Bengal — a ‘health city,’ a ‘knowledge city,’ a special economic zone and an express highway that will account for 1,500 acres.

Kristin A. Gilbertson, chief investment officer of the University of Pennsylvania, has been watching these developments with interest. The university’s $4.4 billion endowment is among the largest among U.S. universities. “With all the legislative changes and economic incentives, we are certainly looking at real estate opportunities in India,” says Gilbertson. “We are not committed to doing anything, but we are interested and intrigued, and if the right opportunity were to come along, we would certainly look at it.”

Gilbertson says a major challenge is finding the right partner in India. “When you go overseas and deal with new operators, it is really an untested market.” She’s not comfortable discussing the likely size of her endowment’s investment in India, but reveals that it is unlikely to exceed $50 million.

JP Morgan, Morgan Stanley and Merrill Lynch are among the foreign funds that have committed capital to Indian real estate. In July, JP Morgan raised $360 million for investing in Indian property from high-net-worth investors and institutions in the U.S. and elsewhere. It is reportedly looking at a net internal rate of return of 20%. In March, Morgan Stanley announced an investment of Rs. 300 crore ($65 million) in Mantri Developers of Bangalore, a promoter of residential, office and retail projects. However, that is a relatively small deal compared to a typical Morgan Stanley investment in even a single portfolio in the U.S. All the same, the Mantri investment is now part of the $40 billion in real estate assets Morgan Stanley currently manages for clients.

Enter the Developer

Tishman Speyer is among the first U.S. developers to invest in India. In April 2005, the New York City-based firm formed a joint development company with ICICI Venture Funds of Mumbai that will have a war chest including leverage of up to $2.5 billion. Tishman Speyer and ICICI Venture Funds are bringing in $300 million each in equity and will invest equally in projects. Kishore Gotety, ICICI Venture Funds’ director of investments, says the internal rate of return net of developer margins and fees could be between 25% and 28%. He says returns were “in excess of 100%” in some markets such as Devanahalli in Bangalore, where a new international airport is being planned. He believes returns could be equally high in other locations earmarked for large infrastructure projects.

So far, the Tishman Speyer-ICICI Venture Funds company has signed memorandums of understanding for two ventures in India. One is a $200-million project for residential and commercial development on 42 acres in Bangalore’s prime Whitefield suburb. The project is in the final stages of due diligence, and the Tishman Speyer-ICICI Venture Funds company has struck a deal to buy the land. Gotety expects to break ground by the third quarter of 2006 and have the residential component ready for occupancy within two years. The commercial space is expected to be ready in five years. While it will initially be leased to tenants, plans are to sell it eventually. The second project is in Devanahalli, where Tishman Speyer and ICICI Venture Funds are buying a 25-acre lot whose final use has not yet been decided, says Gotety. An earlier plan for a development project in Pune, 100 miles south of Mumbai, has been shelved for now.

“This is a long-term partnership,” says Gotety about ICICI Venture Funds’ venture with Tishman Speyer. He explains that the U.S. developer has “relationships with large tenants that we find very valuable. We are able to contribute with our access to institutional land owners and banks and our local influence.” He believes that once the current fund with Tishman Speyer kicks off, “very shortly we will need more capital.”

Gotety has no complaints about the government’s revised construction development policy, though he worries that too much money could inflate short-term property prices to unjustifiable levels that will hurt later investors. He says it is important to ensure that price spikes are not driven by speculators. But that is not an immediate worry; he adds that most of the market is driven by users, and that about 70% of the bookings in residential projects “are made by the people who want to live in those houses.”

Gotety believes that Indian real estate is unlikely to face speculative bubbles like those in other Asian markets in the mid-to-late 1990s. He points to India’s conservative ratios for “floor space indices” (FAR or “floor area ratio” in the U.S.), which measure the relationship between the size of a lot and the total space that can be built on it. That index is between 1 and 2 in most Indian markets, while in land-constrained Hong Kong, it went up to more than 10.

New York City-based developer Vornado Realty Trust has teamed up with the Chatterjee Group, a venture capital firm also located in New York City. The Chatterjee Group has more than $1.5 billion in investments, including some in Indian real estate development projects and business process outsourcing operations. Vornado’s investments through this partnership are primarily in the booming market for information technology parks in cities like Bangalore, Hyderabad and Navi Mumbai.

Vornado’s president Michael Fascitelli declines to detail the company’s investments in India, but says that it plans to create a fund that will co-invest with its Indian partner. Initially, Vornado will be a minority partner in the fund. “It will buy and develop corporate properties all over India,” says Fascitelli. “We are encouraged by the growth of India and the opportunistic play in that market.” He adds that while his company has targeted China and India as the top destinations among emerging markets for real estate investments, India scores higher marks. “We feel more comfortable about India than we feel about China,” he says.

The lay of land for development in India has improved in several other areas over the years, according to Marja Hoek-Smit, director of the International Housing Finance Program at Wharton’s Samuel Zell and Robert Lurie Real Estate Center. “You have to lower the transaction costs,” she says. “India has had a problem with high stamp duties, and they are addressing it state by state.” She says land assembly procedures have been simplified with the removal of India’s land ceiling act. “The land ceiling act made it difficult for private investors to accumulate land for development, and governments in different states have eliminated the law.” Hoek-Smit says zoning and permitting regulations, while having been simplified, “are still major constraints for development both because of the rules themselves but also because so many different agencies have overlapping jurisdictions. Simplifying the process is as important as improving the zoning, planning and subdivision rules.”

Big Indian developers who are on the radar screen of U.S. investors include DLF of New Delhi, Unitech of Haryana, K. Raheja and Hiranandani of Mumbai, Mantri Housing of Pune and TCG of New Delhi. India’s second-largest business conglomerate, Reliance Industries, is also setting up a venture capital fund to invest in real estate. That could be a massive program, as it is expected to piggyback on the Reliance group’s proposed countrywide retail foray. “The project will boast of a seamless supply chain infrastructure, unprecedented even by world standards,” says a Reliance statement. “Through multiple formats and a wide range of categories, Reliance is aiming to touch almost every Indian customer and supplier.” The program’s outlay is estimated at about $750 million in the initial phase, rising to $5 billion with the nationwide rollout.

Reliance hasn’t yet announced any plans to invite foreign investors to participate in its retail or real estate ventures. But Dave says the scales are for now tilted in favor of large Indian developers being courted by U.S. private equity funds. Ready access to capital is attractive for Indian developers because it allows them to take on more projects, but they are reluctant to cede too much control or comply with the reporting requirements of private equity funds. “Right now developers in India report to their banks, but not in the same kind of detail that some of the private equity funds want,” says Dave. “When you are a successful developer, you are not used to reporting to others. It’s not in your DNA.”

Another sticking point in negotiations is the flexibility U.S. investors want to exit a partnership if project milestones and other contractual commitments are not met. Dave says while U.S. investors want exit options like taking their joint ventures public or selling to others who may show interest, many Indian developers don’t easily buy into that.

Wharton real estate professor Peter Linneman discussed some of these challenges in a 2001 paper titled, “International Real Estate Investing.” According to the paper, “One of the most difficult questions faced when deciding to enter a local real estate market is whether to use a local partner.” Linneman acknowledges that local partners bring knowledge and expertise, but they also play by a different set of rules. “All too often foreign investors find that their local partners use their powers to re-strike their partnership, and that there is little that can be done to stop them.” Linneman says an alternative is for foreign investors to build their own “deep local infrastructure,” but that requires a much greater commitment of capital and managerial effort.

Choosing the right investment vehicle is also difficult. U.S. investors who weigh buying equity in an existing Indian developer worry about control and their downside exposure if the company defaults. Another option is to set up special purpose vehicles, but here the Indian developer could cherry-pick the more lucrative projects for its own firm, and leave the riskier ones for the joint venture. Dave says U.S. private equity funds are trying to deal with such situations with an array of contractual restrictions.

Brokerage Deals

While many U.S. investors are still testing the waters, real estate services firms with existing operations in India are on a roll. Anshuman Magazine, managing director of CB Richard Ellis (CBRE) South Asia based in New Delhi, joined CBRE in 1994 to launch its Indian operations – the first by a foreign brokerage firm. Today, he runs operations in 66 cities in India, Pakistan, Bangladesh, Sri Lanka and Nepal from his New Delhi base, with 600 employees in seven cities. It has property management contracts totaling 25 million sq. ft. in 14 cities, and has advised on construction projects of more than 10 million sq. ft. in just the last two years.

CBRE South Asia is also structuring deals for some of the newer investors. Magazine notes that one involves GE’s investment in two information technology parks in Bangalore and Hyderabad. GE bought that stake in the summer of 2005 from Singapore’s Ascendas. In another deal CBRE structured around the same time, a New York City fund co-invested in a mixed-use development project of 8 million sq. ft. with the Panchsheel Group in Pune.

Cushman & Wakefield of New York City entered India in 1997, and the firm has since grown to offices in four cities with 350 employees. Many of its global clients have significant operations in India, including HSBC, Verizon, IBM, Lucent Technologies and Boeing. Arshpreet Chaudhry, managing director of client solutions at Cushman & Wakefield in New York City, who oversees his firm’s India strategy sees big gains around the corner. “Real estate and construction development in India will have availability of cheaper, long-term capital from international lenders,” he says. “Foreign developers will encourage implementation of international best practices, and prices will get competitive for better quality.”

Trammell Crow is a recent entrant, but its acquisition of a 30% stake in an Indian joint venture is its first direct equity investment in any emerging market; it operates in other developing countries through affiliates. Alex Darragh, its Chicago-based managing director of international operations, says India was in his sights for about a year before the February policy reforms, driven mainly by clients’ requirements. He is concerned, however, about how India plans to invest in infrastructure to support its growth.

Like Trammell Crow, architecture firm Hillier’s interest in India is driven by its clients. “Many of our clients are investing in projects in India, and we want to see if we can add any value with our experience in mixed-use development and redevelopment, particularly in urban design,” says Anish Kumar, Hillier’s director of urban design based in Philadelphia. Kumar says his firm has responded to a couple of RFPs (“requests for proposals” to bid on projects) in India. He sees niches in India for Hillier such as designing facilities for higher education, health care, research facilities and laboratories, master planning of town centers and corporate architecture.

The $5-Billion Question

Depending on whom you ask, the total equity capital headed for Indian real estate is between $3 billion and $5 billion — and that could be just the beginning.

What lessons can India learn from similar reforms in other emerging markets? Wharton’s Hoek-Smit believes there are many. She points to Thailand as an example of well-executed real estate policy reforms. Thailand adjusted its regulations and approval procedures related to urban development to facilitate moderate income housing development. The second measure it took was to make housing finance more widely available. Hoek-Smit says Thailand started that process with reforms at its state housing bank, which before the mid-1980s “was hindering the creation of a competitive playing field for mortgage lending.” The Thai government revamped the bank’s management in the late 1980s, which pegged its rates just below the rest of the market. “They gradually teased the market down into serving a lower income clientele as spreads came down,” she says.

Soon, the resulting competition lowered the average mortgage lending rate from 15% to between 7% and 8%. The newly energized state housing bank works on other fronts as well such as improving borrowers’ credit information and setting up a credit bureau. Hoek-Smit says Thailand carried its reforms across the system, making it easier to get development rights and smaller plot sizes to build affordable housing.

When Hoek-Smit revisited Thailand in 2000 after the real estate crisis had blown over, she saw the net positive effect. “If you were at the 20th percentile of income distribution, you could buy a small new apartment and receive mortgage finance to pay for it, and that is unique,” she says. “In most emerging economies, the lowest priced new construction is affordable only for the 60th and 70th percentile of the income distribution.”

But Thailand also made mistakes that India should avoid, says Hoek-Smit. “Thailand’s offshore banking policies contributed to a real estate crisis in the 1990s,” she says. “Allowing offshore foreign capital without limitation into Thailand contributed to deepening its [real estate market] cycle,” she says. “The lesson is to regulate offshore capital inflows and keep track of investment patterns.” India has recognized that danger and has not allowed offshore banking.

Hoek-Smit says India needs to pull up its socks on some other fronts to make its real estate finance reforms work. “Risk management will ultimately drive this market,” she says. “Risk can be understood and priced when you have information; without data, investors cannot make the right decisions.” She says there is a need to “stimulate information” on credit monitoring, collateral and real estate transactions. That will enable the market’s players to understand risk as it relates to borrowers and asset quality, and bring transparency to transactions.

Many players try to price those shortcomings into their returns calculations. Vornado’s Fascitelli says he expects high returns from investments in India “because of the risks.” He admits that he has “tons of concerns” about investing in India. “It is a developing market, and global business practices are being established slowly,” he says. “It’s a high-growth, developing economy, like a child becoming an adult.”

Whatever the temptations, there are some who won’t allow themselves to be swayed. Wharton’s Linneman says there’s certainly money to be made from investing in Indian real estate, but he is convinced that “developing is for locals.” “India is a place where Indians will make money but I am not sure Americans will; it’s the same thing with China,” he says. “I don’t even want to develop in St. Louis, much less in Bangalore.”