India’s real estate sector has been witnessing critical changes since the last few years, including the promulgation of the Real Estate (Regulation and Development) Act, 2016 (the “RERA Act”). The implementation of the RERA Act has pushed the sector to organise and standardise operations and management of real estate entities. The checks and balances imposed by the RERA Act and liquidity crunch faced by the real estate market has forced the dislodgment of small and unorganised players. Owing to such changes, the real estate market is now witnessing a phase of consolidation and collaboration.
‘Consolidation’ and ‘collaboration’ have been the key themes for developers under the RERA regime. Developers and promoters are largely focussed on playing to their advantages by collaborating with each other, rather than taking risks by launching new projects all by themselves. Such collaborations may be between individual land owners or land owning entities and developers wherein the landowner/ land owning entities possess capital resources in the form of land bank; with the financial and technical capabilities, distinctive skills in construction and architecture, market access, etc., coming from the developer. More often than not, such collaborations are an outcome of a single participant possessing abundant land resources, but at the same time there is a lack of construction expertise, risk appetite, shortage of capital, obsolete technology, time constraints, etc. Such collaborations can be explained as symbiotic business relationships, wherein the advantages of each player can be harnessed to the maximum and limitations (if any) can be mitigated.
Forms of collaboration
Given that collaborations are flexible in nature, they may be modelled in various forms, depending on the understanding among parties involved. A few models of collaboration prevalent in the Indian real estate sector are as follows:
- Revenue/ Profit Sharing Model
In such an arrangement, the title to the constructed area remains with the owner of the land. The developer undertakes the sale of the constructed area on behalf of the owner and the owner agrees to pay the developer a share of the revenues collected. The share attributable to the developer and the owner are pre-determined under the collaboration/ joint development agreement.
- Area Sharing Arrangement
In such an arrangement, the parties decide to divide the constructed space between each other in a pre-determined ratio. Once such a division is demarcated under the collaboration/ joint development agreement, the respective party shall only deal with its demarcated space. This also gives the parties the right to either sell their demarcated constructed space to third parties or retain the same for the purposes of leasing or otherwise. Unlike a revenue/ profit share model, wherein the sale proceeds of the constructed space are divided between the parties, in an area sharing arrangement, the proceeds of the demarcated constructed space are apportioned to the landowner or the developer, as the case may be. Under this kind of a collaboration, the title of the mutually agreed demarcated space is transferred in favour of the developer in order for it to be able to deal with the same.
- Project Management/ Consultancy Arrangement
In recent times, this model has gained a lot of prominence in the Indian real estate market. The current liquidity crisis has paralysed a lot of landowners from developing their respective land parcels into marketable projects. Hence, landowners collaborate with developers to develop their lands. Under such arrangements, developers acquire the right to construct, market, advertise, manage customers, sell and otherwise deal with the project in consideration of an ascertained fee. Such a fee is usually computed by taking into consideration various costs pertaining to construction, marketing, branding, labour, overheads, customer management, finance, etc. Although under such an arrangement, no title to the land involved in the development of the project is transferred to the developer, however, the developer exercises greater control over the project as compared to the landowner.
Corporate Due Diligence – Significance in such real estate collaboration?
It is interesting to note that post the promulgation of the RERA Act, the definition of a ‘promoter’ includes a person ‘who constructs’ or ‘causes to construct’ a real estate project. These two expressions ‘who constructs’ or ‘causes to construct’ are of wide significance and have far reaching impact since it brings within its ambit both the landowner as well as the developer.
Under the RERA framework, a developer or a landowner cannot be said to have a passive or a dormant role in the development of the real estate project, and be able to pass on the liability to the other party for any wrongdoings or mishap in relation thereto. Both the developer and the landowner will be construed as ‘promoters’ under the RERA Act, and accordingly they will have to comply with the obligations and face the consequences of non-compliance as spelt out under the aforesaid legislation.
Hence, when a developer collaborates with a landowner under any of the above models, especially when such a landowner is a real estate company, it becomes imperative for the developer to have knowledge of the function of the company, since any impact on the land owning company will have a rippling impact on the development rights of the project in question.
Thus, a developer intending to acquire such development rights from a land owing company must have a clear understanding of the day-to-day management and affairs of the land-owning entities so as to ensure seamless enjoyment of its development rights.
To help the developer navigate through the affairs of the land-owning company, the process of corporate due diligence plays a vital role.
Why to conduct corporate due diligence of real estate companies?
It is usually seen that a developer, while entering into such a collaboration, only restricts himself to conducting title investigation of the subject land. This results in overlooking certain crucial aspects related to such real estate companies, such as financial and regulatory irregularities in the company, failure to procure necessary licences and approvals, default in repayment of loans, major litigations surrounding the company, etc., which could have a huge impact on the enjoyment of the development rights by a developer.
For proper implementation of the terms and conditions of the joint development/ collaboration agreement, it is necessary for the party seeking to acquire development rights to know the past deeds and misgivings of the land-owning company. In such a situation, corporate due diligence of the land-owning company gains paramount importance.
As depicted in the chart above, a corporate due diligence entails detailed review of the documents pertaining to the corporate affairs of a company, filings made with various government and statutory authorities, the licences and approvals obtained by the company, debts obtained by the company and the securities created by the company in lieu of such debts, agreements executed by the company, affairs relating to human resource, litigations surrounding the company and all the ancillary aspects related thereto.
Additionally, if the land-owning company has foreign investments in it, it becomes particularly critical for the developer to ensure that provisions relating to Foreign Exchange Management Act, 1999, and rules and regulations framed thereunder have been adhered to in receiving foreign investments into the company. It is important to keep in mind that receipt of foreign investment in real estate companies is highly regulated. Any non-compliances/ irregularities in relation to the above can only be highlighted if a detailed corporate due diligence is undertaken with respect to the land-owning company.
This ensures that all aspects of the company are carefully evaluated and all potential liabilities and risks to a proposed transaction are appropriately weighed.
This is particularly important because if major irregularities exist in the company then the interest of the developer over the land could get jeopardised to a great extent. If the irregularities are along the lines of violation of Exchange Control Regulations, violation of regulations related to External Commercial Borrowings, violation of provisions of the Indian Companies Act, default in repayment of loan, etc., then the rights over the assets of the company can be called into questioned by the regulators/ authorities.
The cases of authorities issuing attachment orders against the assets of a company due to irregularities in the company, is not unknown. In the recent past, we have witnessed garnishee orders being issued against assets of a company due to legal, regulatory and financial irregularities being committed by the land-owning companies.
In case of a land-owning company, since the only asset is the land bank, the land bank is under tremendous risk in the event there are grave irregularities in the day-to-day operations and management of the land owning company. Therefore, unless the developer, who intends to acquire development rights in the land-owning company, is aware of the risks and liabilities attached in such a scenario, it will not be in a position to duly evaluate such risks and limitations and undertake measures to adequately protect its interest under the joint development/ collaboration agreement.
Depending upon the nature of irregularities, such protection can be by way of value adjustments or obtaining adequate indemnities from the land-owning company and their promoters in joint development/ collaboration agreement.
In certain cases, the developer may also ask the land-owning company to rectify such irregularities as a condition precedent to acquisition of development rights.
However, if the irregularities are of such a nature that they can neither be rectified nor the interest of the developer can be adequately protected by value adjustment or indemnities in the joint development/ collaboration agreement, then in such a scenario, the developer shall have the ability to make an informed decision of not acquiring development rights of such real estate projects.
Developers should consider undertaking detailed corporate due diligence on the land-owning company as a mandatory pre-requisite to acquiring development rights over a particular property, in order to ensure proper enjoyment of its development rights as well as timely completion of the project in question.
This gains further significance in light of the fact that under the RERA Act, the developer is equally liable for delay in completion of projects. If the project in which the developer has purchased development rights gets stalled due to an attachment order over the land being passed by any court, tribunal or any regulatory authority, then it is the developer who shall stand liable to the end customers, along with the land owners.
Hence, the significance of corporate due diligence in real estate collaborations.