Distressed residential real estate in the metro cities like Delhi, Mumbai, Bengaluru, Kolkata, Chennai and others, needs to be looked at as an investment opportunity by patient and innovative institutional investors.
Distressed residential real estate in the metro cities like Delhi, Mumbai, Bengaluru, Kolkata, Chennai and others, needs to be looked at as an investment opportunity by patient and innovative institutional investors. Such large institutional investors can potentially create value from distressed residential real estate on the lines of what Invitation Homes did with residential real estate in the US. Invitation Homes (an institutional homeowner) in the US bought a large portfolio of distressed residential real estate, improved on the properties and rented them out. For sure there are distinct differences between the US and Indian markets, but the business model used by Invitation Homes, that of a large institutional owner of residential homes offers a basic framework that can be explored in India.
The investor looks for residential real estate that is both completely built and meets the basic criteria in terms of location and usage, criteria that makes the real estate worth renting. This will require local operational work at the property level. The next step is to acquire the residential real estate at a substantial discount to “replacement cost”. In common parlance “replacement cost” is the cost of construction of a residential property at current market prices. For an institutional investor, there are two factors that will assist them to acquire real estate at a substantial discount to “replacement cost” in the Metro cities of India today. First is the oversupply of residential real estate in the market and second is the capacity of the investor to purchase a large portfolio of residential real estate, thereby giving the investor the capacity to negotiate a discount from the real estate developer. Such a bulk purchase of residential real estate by an institutional investor creates value for the entire ecosystem. Builders and developers get access to much needed capital and the opportunity to reduce inventory and perhaps save on interest cost and litigation. Creditors of these builders get an opportunity to get repaid at least partially for the loans and hence can exit distressed investments. Being able to buy at a substantial discount to “replacement cost” will be crucial for the investor to generate returns. Post-acquisition the investor will decide at a property level as to whether to invest in any possible improvements on the property. Given that most of the residential real estate is relatively new such investments are anticipated to be on the lower side.
The debt-equity mix used to finance the portfolio of assets will be important. In the US, one can access debt that is less expensive than the return on the underlying residential real estate asset to improve returns. In India, such a strategy of using relatively inexpensive debt might not work. According to an estimate by globalpropertyguide.com, residential rental returns range in the 2-3.5% of asset price in India. For the investor, it will not be possible to borrow cheaper than the 2-3.5% in India to improve returns. This is where the Indian scenario demands innovation. The investor needs to look at convertible bond like structures as a source of funding. Convertible bonds provide the bond holder some interest return and the right to participate in any upside in the value of the underlying asset once the asset price goes over a certain level. Because the convertible bond holder can participate in the upside, the bond holder demands a lower interest rate for the bond. The institutional investor needs to use relatively low interest rate convertible bonds to fund the residential real estate portfolio. Once the investor acquires the portfolio of assets, the next step is to create an operational and property management business to rent out the portfolio of assets. With increasing urbanization and non-cyclical migration into metro cities, there is substantial demand for rented residential property even if home affordability isn’t high, hence the demand for the rental asset. In the medium term the investor will also look to divest the well-developed residential real estate units on a piecemeal basis to individual buyers. This strategy will require them to further leverage their operational and property management business, and allow them to start monetizing a significant part of their investment as the residential real estate market recovers and residential home prices start moving above their “replacement cost”.
A strategy of effectively creating an asset class out of residential real estate will no doubt require significant operational and management expertise to deal with the fragmented nature of the market. Only an institutional investor with both the financial capacity and operational knowhow can execute this strategy. However distressed residential real estate in India must be looked at as outlined above, a variant of which has seen success on foreign shores.
(The views expressed in this article are personal and that of the author. The author heads Development Tracks, an infrastructure advisory firm.)