Castles in the air

Written by Rajeev Bairathi | Updated: Oct 19 2011, 08:50am hrs
The Indian real estate industry has seen spectacular growth during the past five years. Various estimates indicate a compounded annual growth rate of 25-30% during this period, leading to the industry size being pegged at $12-15 billion. This growth has been driven by a combination of factors such as favourable demographics, rapid urbanisation and a steady growth in per capita income. These factors were aided by a benign macro-economic environment of high GDP growth driven by a rapid expansion of services sector, easy availability of financing and low interest rates during a major part of the past five years.

The governments new policy on foreign direct investment (FDI) in 2005 also aided the growth process. A liberalised FDI policy encouraged Indian real estate-dedicated private equity funds with an investment corpus $50 million-$1billion to set up shop in the country. Consequently, the sector saw a massive inflow of foreign capital across virtually every segmentresidential, commercial, retail, hospitality, logistics, SEZs etc.

The first half of fiscal 2011 marked the completion of the first cycle of foreign PE investments into the sector, with many investors exploring opportunities to exit from projects they backed a few years ago. The pace of private equity investments into the sector has considerably slowed down since, with investors waiting for the system to get rid of excesses caused by years of speculative activity.

The current corrective cycle is expected to reverse in the next few quarters as the long-term fundamentals of the industry based on the latent demand are intact. As the investment community waits for the cycle to show a signal of reversal, it is a good time to reflect on the experience gained in recent years to avoid similar pitfalls in the next phase.

The hygiene factor: A successful business is not only about a great strategy but also about an effective implementation team. This holds true in real estate also, where location and great product ideas are extremely important but equally important is the execution capability of the developer/promoter. During the early phase, a lot of capital was chasing a few good projects and consequently some private equity funds got carried away by location factors without caring about the developers track record, management bandwidth and flexibility.

Margin of safety: The real estate sector is greatly influenced by macro-economic cycles and general business sentiments. The financial projections and return on capital that look fantastic during a bullish phase could look ugly and orphaned with a small reversal of cycles. Astute investors, who understood this phenomenon of fickle macro economic cycles, insisted that they entered projects at valuations with adequate safety margins in terms of price points, execution time lines, and construction costs. But many blind investors got stuck with lemons, having entered the projects at valuations 50 to 60% higher than todays. These investors are desperate to exit out.

Know your customer: Many PE funded real estate developments were announced without understanding the end-user need or the business model of occupiers (tenants) from the product pricing standpoint. For instance, a huge pipeline of luxury hotels is going to hit the market over next 12 to 18 months even though research reports indicated a greater need for mid-scale hotels. Similarly, unrealistic rental calculations have seen many malls going vacant or residential townships remaining unsold.

Herd mentality leading to oversupply: Our research indicates impending supply overhang in various micro markets in key some cities that private equity investors had targeted for investments. The development segment facing an oversupply may vary from one market to another but the broader story remains the sameinvestors followed one another, creating more capacities than what the market could absorb. Projects in these pockets of over-supply are witnessing a huge erosion of rentals and capital values.

Lessons from the past should guide investors in the next phase, as the cycle turns.

The author is directorinvestment advisory with DTZ and can be reached at