A Guide to Investments in Indian Real Estate

Real estate has traditionally been an avenue for considerable investment per se and investment opportunity for High Net-worth Individuals, Financial institutions as well as individuals looking at viable alternatives for investing money among stocks, bullion, property and other avenues.

Money invested in property for its income and capital growth provides stable and predictable income returns, similar to that of bonds offering both a regular return on investment, if property is rented as well as possibility of capital appreciation. Like all other investment options, real estate investment also has certain risks attached to it, which is quite different from other investments. The available investment opportunities can broadly be categorized into residential, commercial office space and retail sectors.

Investment scenario in real estate

Any investor before considering real estate investments should consider the risk involved in it. This investment option demands a high entry price, suffers from lack of liquidity and an uncertain gestation period. To being illiquid, one cannot sell some units of his property (as one could have done by selling some units of equities, debts or even mutual funds) in case of urgent need of funds.

The maturity period of property investment is uncertain. Investor also has to check the clear property title, especially for the investments in India. The industry experts in this regard claim that property investment should be done by persons who have deeper pockets and longer-term view of their investments. From a long-term financial returns perspective, it is advisable to invest in higher-grade commercial properties.

The returns from property market are comparable to that of certain equities and index funds in longer term. Any investor looking for balancing his portfolio can now look at the real estate sector as a secure means of investment with a certain degree of volatility and risk. A right tenant, location, segmental categories of the Indian property market and individual risk preferences will hence forth prove to be key indicators in achieving the target yields from investments.

The proposed introduction of REMF (Real Estate Mutual Funds) and REIT (Real Estate Investment Trust) will boost these real estate investments from the small investors’ point of view. This will also allow small investors to enter the real estate market with contribution as less as INR 10,000.

There is also a demand and need from different market players of the property segment to gradually relax certain norms for FDI in this sector. These foreign investments would then mean higher standards of quality infrastructure and hence would change the entire market scenario in terms of competition and professionalism of market players.

Overall, real estate is expected to offer a good investment alternative to stocks and bonds over the coming years. This attractiveness of real estate investment would be further enhanced on account of favourable inflation and low interest rate regime.

Looking forward, it is possible that with the progress towards the possible opening up of the real estate mutual funds industry and the participation of financial institutions into property investment business, it will pave the way for more organized investment real estate in India, which would be an apt way for investors to get an alternative to invest in property portfolios at marginal level.

Investor’s Profile

The two most active investor segments are High Net Worth Individuals (HNIs) and Financial Institutions. While the institutions traditionally show a preference to commercial investment, the high net worth individuals show interest in investing in residential as well as commercial properties.

Apart from these, is the third category of Non-Resident Indians (NRIs). There is a clear bias towards investing in residential properties than commercial properties by the NRIs, the fact could be reasoned as emotional attachment and future security sought by the NRIs. As the necessary formalities and documentation for purchasing immovable properties other than agricultural and plantation properties are quite simple and the rental income is freely repatriable outside India, NRIs have increased their role as investors in real estate

Foreign direct investments (FDIs) in real estate form a small portion of the total investments as there are restrictions such as a minimum lock in period of three years, a minimum size of property to be developed and conditional exit. Besides the conditions, the foreign investor will have to deal with a number of government departments and interpret many complex laws/bylaws.

The concept of Real Estate Investment Trust (REIT) is on the verge of introduction in India. But like most other novel financial instruments, there are going to be problems for this new concept to be accepted.

Real Estate Investment Trust (REIT) would be structured as a company dedicated to owning and, in most cases, operating income-producing real estate, such as apartments, shopping centres, offices and warehouses. A REIT is a company that buys, develops, manages and sells real estate assets and allows participants to invest in a professionally managed portfolio of properties.

Some REITs also are engaged in financing real estate. REITs are pass-through entities or companies that are able to distribute the majority of income cash flows to investors, without taxation, at the corporate level. The main purpose of REITs is to pass the profits to the investors in as intact manner as possible. Hence initially, the REIT’s business activities would generally be restricted to generation of property rental income.

The role of the investor is instrumental in scenarios where the interest of the seller and the buyer do not match. For example, if the seller is keen to sell the property and the identified occupier intends to lease the property, between them, the deal will never be fructified; however, an investor can have competitive yields by buying the property and leasing it out to the occupier.

Rationale for real estate investment schemes

The activity of real estate includes a wide range of activities such as development and construction of townships, housing and commercial properties, maintenance of existing properties etc.

The construction sector is one the highest employment sector of the economy and directly or indirectly affects the fortunes of many other sectors. It provides employment to a large work force including a substantial proportion of unskilled labor. However for many reasons this sector does not have smooth access to institutional finance. This is perceived as one of the reasons for the sector not performing to its potential.

By channeling small savings into property, investments would greatly increase access to organized institutional finance. Improved activity in the property sector also improves the revenue flows to the State exchequer through-increased sales-tax, octroi and other collections.

Real estate is an important asset class, which is under conventional circumstances not a viable route for investors in India at present, except by means of direct ownership of properties. For many investors the time is ripe for introducing product to enable diversification by allocating some part of their investment portfolio to real estate investment products. This can be effectively achieved through real estate funds.

Property investment products provide opportunity for capital gains as well as regular periodic incomes. The capital gains may arise from properties developed for sale to actual users or direct investors and the income stream arises out of rentals, income from deposits and service charges for property maintenance.

Advantages of investment in real estate

The following are the advantages for investing in Real Estate Investment Schemes

• As an asset class, property is distinct from the other investment avenues available to a small as well as large investor. Investment in property has its own methodology, advantages, and risk factors that are unlike those for conventional investments. A completely different set of factors, including capital formation, economic performance and supply considerations, influence the realty market, leading to a low correlation in price behaviour vis-à-vis other asset classes.

• Historically, over a longer term, real estate provides returns that are comparable with returns on equities. However, the volatility in prices of realty is lower than equities leading to a better risk management to return trade-off for the investment.

• Real estate returns also show a high correlation with inflation. Therefore, real estate investments made over long periods of time provide an inflation hedge and yield real returns

Risks of investment in real estate

The risks involved in investing in real estate are primarily to do with future rental depreciation or general property market risk, liquidity, tenancy risk and property depreciation. The fundamental factors affecting the value of a specific property are:

Location – The location of a building is crucially important and a significant factor in determining its market value. A property investment is likely to be held for several years and the attractiveness of a given location may change over the holding period, for the better or worse. For example, part of a city may be undergoing regeneration, in which case the perception of the location is likely to improve. In contrast, a major new shopping center development may reduce the appeal of existing peaceful, residential properties.

Physical Characteristics – The type and utility of the building will affect its value, i.e. an office or a shop. By utility is meant the benefits an occupier gets from utilizing space within the building. The risk factor is depreciation. All buildings suffer wear and tear but advances in building technology or the requirements of tenants may also render buildings less attractive over time. For example, the need for large magnitude of under-floor cabling in modern city offices has changed the specifications of the required buildings’ space. Also, a building which is designed as an office block may not be usable as a Cineplex, though Cineplex may serve better returns than office space.

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Limited Liability Corportations and Foreign Investment in California Real Estate

There is some exciting news for foreign investors due to recent geo-political developments and the emergence of several financial factors. This coalescence of events, has at its core, the major drop in the price of US real estate, combined with the exodus of capital from Russia and China. Among foreign investors this has suddenly and significantly produced a demand for real estate in California.

Our research shows that China alone, spent $22 billion on U.S. housing in the last 12 months, much more than they spent the year before. Chinese in particular have a great advantage driven by their strong domestic economy, a stable exchange rate, increased access to credit and desire for diversification and secure investments.

We can cite several reasons for this rise in demand for US Real Estate by foreign Investors, but the primary attraction is the global recognition of the fact that the United States is currently enjoying an economy that is growing relative to other developed nations. Couple that growth and stability with the fact that the US has a transparent legal system which creates an easy avenue for non-U.S. citizens to invest, and what we have is a perfect alignment of both timing and financial law… creating prime opportunity! The US also imposes no currency controls, making it easy to divest, which makes the prospect of Investment in US Real Estate even more attractive.

Here, we provide a few facts that will be useful for those considering investment in Real Estate in the US and Califonia in particular. We will take the sometimes difficult language of these topics and attempt to make them easy to understand.

This article will touch briefly on some of the following topics: Taxation of foreign entities and international investors. U.S. trade or businessTaxation of U.S. entities and individuals. Effectively connected income. Non-effectively connected income. Branch Profits Tax. Tax on excess interest. U.S. withholding tax on payments made to the foreign investor. Foreign corporations. Partnerships. Real Estate Investment Trusts. Treaty protection from taxation. Branch Profits Tax Interest income. Business profits. Income from real property. Capitol gains and third-country use of treaties/limitation on benefits.

We will also briefly highlight dispositions of U.S. real estate investments, including U.S. real property interests, the definition of a U.S. real property holding corporation “USRPHC”, U.S. tax consequences of investing in United States Real Property Interests ” USRPIs” through foreign corporations, Foreign Investment Real Property Tax Act “FIRPTA” withholding and withholding exceptions.

Non-U.S. citizens choose to invest in US real estate for many different reasons and they will have a diverse range of aims and goals. Many will want to insure that all processes are handled quickly, expeditiously and correctly as well as privately and in some cases with complete anonymity. Secondly, the issue of privacy in regards to your investment is extremely important. With the rise of the internet, private information is becoming more and more public. Although you may be required to reveal information for tax purposes, you are not required, and should not, disclose property ownership for all the world to see. One purpose for privacy is legitimate asset protection from questionable creditor claims or lawsuits. Generally, the less individuals, businesses or government agencies know about your private affairs, the better.

Reducing taxes on your U.S. investments is also a major consideration. When investing in U.S. real estate, one must consider whether property is income-producing and whether or not that income is ‘passive income’ or income produced by trade or business. Another concern, especially for older investors, is whether the investor is a U.S. resident for estate tax purposes.

The purpose of an LLC, Corporation or Limited Partnership is to form a shield of protection between you personally for any liability arising from the activities of the entity. LLCs offer greater structuring flexibility and better creditor protection than limited partnerships, and are generally preferred over corporations for holding smaller real estate properties. LLC’s aren’t subject to the record-keeping formalities that corporations are.

If an investor uses a corporation or an LLC to hold real property, the entity will have to register with the California Secretary of State. In doing so, articles of incorporation or the statement of information become visible to the world, including the identity of the corporate officers and directors or the LLC manager.

An great example is the formation of a two-tier structure to help protect you by creating a California LLC to own the real estate, and a Delaware LLC to act as the manager of the California LLC. The benefits to using this two-tier structure are simple and effective but must one must be precise in implementation of this strategy.

In the state of Delaware, the name of the LLC manager is not required to be disclosed, subsequently, the only proprietary information that will appear on California form is the name of the Delaware LLC as the manager. Great care is exercised so that the Delaware LLC is not deemed to be doing business in California and this perfectly legal technical loophole is one of many great tools for acquiring Real Estate with minimal Tax and other liability.

Regarding using a trust to hold real property, the actual name of the trustee and the name of the trust must appear on the recorded deed. Accordingly, If using a trust, the investor might not want to be the trustee, and the trust need not include the investor’s name. To insure privacy, a generic name can be used for the entity.

In the case of any real estate investment that happens to be encumbered by debt, the borrower’s name will appear on the recorded deed of trust, even if title is taken in the name of a trust or an LLC. But when the investor personally guarantees the loan by acting AS the borrower through the trust entity, THEN the borrower’s name may be kept private! At this point the Trust entity becomes the borrower and the owner of the property. This insures that the investor’s name does not appear on any recorded documents.

Because formalities, like holding annual meetings of shareholders and maintaining annual minutes, are not required in the case of limited partnerships and LLCs, they are often preferred over corporations. Failing to observe corporate formalities can lead to failure of the liability shield between the individual investor and the corporation. This failure in legal terms is called “piercing the corporate veil”.

Limited partnerships and LLCs may create a more effective asset protection stronghold than corporations, because interests and assets may be more difficult to reach by creditors to the investor.

To illustrate this, let’s assume an individual in a corporation owns, say, an apartment complex and this corporation receives a judgment against it by a creditor. The creditor can now force the debtor to turn over the stock of the corporation which can result in a devastating loss of corporate assets.

However, when the debtor owns the apartment building through either a Limited Partnership or an LLC the creditor’s recourse is limited to a simple charging order, which places a lien on distributions from the LLC or limited partnership, but keeps the creditor from seizing partnership assets and keeps the creditor out the affairs of the LLC or Partnership.

Income Taxation of Real Estate

For the purposes of Federal Income tax a foreigner is referred to as nonresident alien (NRA). An NRA can be defined as a foreign corporation or a person who either;

A) Physically is present in the United States for less than 183 days in any given year. B) Physically is present less than 31 days in the current year. C) Physically is present for less than 183 total days for a three-year period (using a weighing formula) and does not hold a green card.

The applicable Income tax rules associated to NRAs can be quite complex, but as a general rule, the income that IS subject to withholding is a 30 percent flat tax on “fixed or determinable” – “annual or periodical” (FDAP) income (originating in the US), that is not effectively connected to a U.S. trade or business that is subject to withholding. Important point there, which we will address momentarily.

Tax rates imposed on NRAs may be reduced by any applicable treaties and the Gross income is what gets taxed with almost not offsetting deductions. So here, we need to address exactly what FDAP income includes. FDAP is considered to include; interest, dividends, royalties, and rents.

Simply put, NRAs are subject to a 30 percent tax when receiving interest income from U.S. sources. Included within the definitions of FDAP are some miscellaneous categories of income such as; annuity payments, certain insurance premiums, gambling winnings, and alimony.

Capital gains from U.S. sources, however, are generally not taxable unless: A)The NRA is present in the United States for more than 183 days. B) The gains can be effectively connected to a U.S. trade or business. C) The gains are from the sale of certain timber, coal, or domestic iron ore assets.

NRA’s can and will be taxed on capital gains (originating in the US) at the rate of 30 percent when these exceptions apply.Because NRA’s are taxed on income in the same manner as a US taxpayers when that income can effectively be connected to a US trade or business, then it becomes necessary to define what constitutes; “U.S. trade or business” and to what “effectively connected” means. This is where we can limit the taxable liability.

There are several ways in which the US defines “US trade or Business” but there is no set and specific code definition. The term “US Trade or Business” can be seen as: selling products in the United States (either directly or through an agent), soliciting orders for merchandise from the US and those goods out of the US, providing personal services in the United States, manufacturing, maintaining a retail store, and maintaining corporate offices in the United States.Conversely, there are highly specific and complex definitions for “effectively connected” involving the “force of attraction” and “asset-use” rules, as well as “business-activities” tests.

Generally and for simplistic explanation, an NRA is “effectively connected” if he or she is engaged as a General or limited partner in a U.S. trade or business. Similarly, if the estate or trust is so engaged in trade or business then any beneficiary of said trust or estate is also engaged

For real estate, the nature of the rental income becomes the critical concern. The Real Estate becomes passive if it is generated by a triple-net lease or from lease of unimproved land. When held in this manner and considered passive the rental income is taxed on a gross basis, at a flat rate of 30 percent with applicable withholding and no deductions.

Investors should consider electing to treat their passive real property in

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