Jurisdiction - India
India – NCD Through The NBFC Route: Hot Pie Of The Real Estate Sector.

6 October, 2014


In the last decade, the real estate sector has grown rapidly in India and has moved in the direction of being a more organized sector, though a lot more needs to be done. The government has allowed Foreign Direct Investment (“FDI“) in the real estate sector in 2005 and put in place regulations governing the influx of the FDI. With the opening up of the FDI in real estate in 2005 there has been a significant rise of Private Equity/FII investment in this sector. 

Pursuant to the partial liberalization, several investments by both domestic and foreign funds took place at entity levels and project levels. However, the real estate sector has been struggling to raise capital post 2009 as FDI has slackened due to the global economic meltdown. The current environment is also not conducive for raising new funds from the public market. With the increase in the Non-Performing Assets (“NPA“), the banks too are not readily lending finance to the real estate sector. To add to the woes, since external commercial borrowing is not allowed in the real estate sector, borrowing money from outside India is not an option. Pending further liberalization, the industry has evolved itself and the investments have changed from equity to structured debt primarily through issue of non-convertible debentures (“NCD“).

Over the last couple of years, there has been an increasing dependence on Non-Banking Financial Companies (“NBFC“) for funding in the real estate sector. Typically in a NBFC structure an offshore investment fund sets up a NBFC as a loan company in India, which then lends to the real estate companies. These NBFCs usually lend through loans or through NCDs.

NBFC are considered secured lending vehicles since they are registered with the Reserve Bank of India and governed under the RBI Act, 1934. In order to qualify as a NBFC, the Indian company needs to undertake certain specified activities such as receiving deposits, lending, financing, acquisition of shares or other securities, hire-purchase, etc. RBI has laid down certain key criteria’s which NBFCs are required to comply with, which inter alia includes:


  • Maintenance of minimum Net Owned Funds (NOF);
  • Requirement for creation of a Reserve Fund; and
  • Compliance with Capital Adequacy Norms/ Group Concentration norms.

As per the extant laws, foreign investment in NBFC up to 100% is allowed under the automatic route. However, where such NBFCs are engaged in undertaking certain specified activity in India (as listed in the FDI Policy) they need to comply with minimum capitalization norms as set out below:


FDI in (%) Minimum Foreign Investment 
Up to 51% USD 0.5m, to be brought upfront 
Above 51% up to 75% USD 5m, to be brought upfront 
Above 75% up to 100% USD 50m, of which USD 7.5m to be brought up front and the balance in 24 months.


NBFC being incorporated as domestic entity encounters less regulatory uncertainty as compared to the regulatory approach towards foreign investment. This also allows an NBFC the flexibility to lend to any sector without any sectoral restriction.

The investment in real estate sector through the NBFC route has been advantageous to the investors. As unlike the Compulsorily Convertible Debentures (CCDs) structure where there is a cap on interest rate i.e. SBI PLR plus 300 basis points, there are no such restrictions on the interest rate on NCDs. In addition these NCDS are structured in such a manner that it would provide fixed rate of return to the investors, which in turns allows a steady flow of income to investors through regular interest payout. The Investors are also able to capture the upside in a deal by having a redemption premium on the NCDs upon exit. Further, the current FEMA regulations do not permit security creation in favour of non-residents without prior government approval. On the other hand, in the case of a NBFC even though owned by a non-resident creation of security against NCD is permitted since it is a domestic entity.

The repatriation lock-in on the investment amount being brought in as FDI are not applicable to the NBFCs and thereby giving it free accessibility and easy exits into the markets. Further, other conditions such as minimum development requirements are not applicable to NBFC. For instance, NBFC could invest in listed NCDs in a real estate project which has a development potential of only 20,000 sq. mtrs. which under the current FDI regulation needs to have a minimum development potential of 50,000 sq.mtrs.

NBFC being a domestic entity, is taxed under the Income Tax Act, 1961 (“IT Act”). NBFC itself is subjected to tax to the extent of interest income so received on the loans/NCDs subject to deductions that the NBFC may be eligible in respect of interest pay-outs made by NBFC on the instruments issued to its offshore parent.

The requirement for adhering to the strict credit concentration norms as set out in Regulation 18 of the Non-Banking Finance (Non- deposit Accepting) Directions, 2007, which vary depending on the type of NBFC, can also be challenging for an NBFC to leverage the capital available to them for the purpose of making loans and investment. As per these regulations a systematically important NBFC (being an NBFC not holding public assets and having total assets of Rs. 100 Crores and above in its last audited balance sheet) is not permitted to lend or invest in any single company exceeding 15% of its owned funds and in single group company exceeding 25% of its owned fund. However, if a systematically important NBFC is lending and investing (both together) then the limit is increased to 25% of its owned fund to a single party and 40% of its owned fund to single group of parties. These concentration norms can be dispensed with by an application to the RBI subject to the NBFC not accessing public funds and not being in the business of issuing guarantees.
Unlike in equity deals where the investor rights are well protected with adequate affirmative voting rights, management control etc., in NBFCs funding through the NCD route only mere lending rights in the developer company are available. The NBFC invested through the NCD generally do not get any management right or veto rights. However, it could possibly secure certain veto rights under the terms of the loan/subscription agreement.
Though investment in NCD through the NBFC route is a win-win situation for both the developers and the NBFC, there are certain challenges in order to achieve a 100% viable mode of investment. NBFCs cannot seek enforcement of their rights under SARFAESI Act. Accordingly, NBFCs have to follow the rigours of court process to enforce their security interest.

With every investor concerned with a desired exit, the exit needs to be well formulated and planned. The offshore investor invested through its NBFC can plan its exit from the NBFC without the intervention of the local real estate developer as would have been required in case the offshore investor had directly invested in the entity of the developer. The offshore investor can part from the fund through strategically selling its shares to another resident or non-resident, buy-back of shares of the foreign investor by the NBFC, by getting the NBFC listed or finally by liquidating the NBFC.




For further information, please contact:


Ronak Dave, Partner, Rajani Singhania & Partners

Construction & Real Estate Law Firms in India 

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