There is a serious equity capital crunch going on the in the real estate sector for the last five years. You would never guess that to be the case if you attended any real estate conferences or looked at the headlines about the mega realty transactions. For the ever-optimistic real estate community, the next boom is always just round the corner. They have been waiting for the last five years with little luck. The reality is that flat to declining real estate prices, coupled with tepid sales volume, in most cities has led to a significant shortage of investment capital for the sector.
The advent of the Real Estate (Regulation and Development) Act, 2016, (RERA), although great for the consumer, has not helped either. It has disrupted the traditional business model for developers as they are unable to utilise customer advances for anything other than project execution. The availability of equity capital is clearly bifurcated for the haves and the have nots. The top 10-15 companies have great capital access, primarily from global sovereign wealth funds, whereas the remainder of the market has to resort to high priced debt capital from the non-banking financial companies (NBFCs).
Well, wait a minute, you’re telling me there is a serious liquidity crunch going on in this space. Shouldn’t that imply there are outsize returns to be had if you can fill that gap? Theoretically, that is correct. And, in any mature efficient ecosystem of capital allocation, that would be true.
Unfortunately, in India, foreign private equity capital is still looked at as free money and is generally at the bottom of the totem pole for the Indian promoter. Having been significantly burnt in the past, the global investor community is unwilling to overlook that simple investment truth. They want to be treated well for what they bring. Capital has a price that needs to be paid and that price is now very high for Indian real estate. The developers, unfortunately, have failed to recognise that and a majority are still living in la-la land, hoping the next Diwali or Christmas will bring the respective Laxmi or Santa Claus in the form of huge sales at their doorstep.
So, investors have done what they do best. They have voted with their feet and the results are pretty harsh. Less than $2 billion of segregated equity capital (not counting sovereign money) has been raised for real estate in India in the past eight years. And, if you take out the investments by Blackstone, Brookfield and the sovereign funds, we have barely a few hundred million of foreign capital that has been invested. The number of fund managers has shrunk to less than a dozen from a peak of over a hundred. There have been no IPOs of real estate companies in the past six years.
So, what is going to change this vicious cycle of low investment activity coupled with low returns? In a typical market cycle for real estate, one would expect to see a movement of capital as shown in the accompanying chart.
Entrepreneurs/developers are the first ones to move in, as they have the largest risk appetite. Private equity investors follow them, accepting a slightly lower return, and then come in the large pension funds and endowments. At the tail end of the cycle come the sovereign funds with the lowest return requirements.
This historical cycle has been upended in most markets and India is no stranger to it. The five biggies of the business—GIC, Abu Dhabi Investment Authority (ADIA), Qatar Investment Authority (QIA), Canada Pension Plan Investment Board (CPPIB) and APG—have all announced significant investment allocations for India, and in some cases have been making large investments already. This has disrupted the traditional cycle of capital flows and priced out all opportunity fund capital from the market. Most of the sovereign funds are from countries that have a historical and/or cultural affinity towards India that colours the investment decisions and allows them to put a different price on the risk associated with the market. They also tend to focus on very recognisable developer names in each of the cities they operate in, thus leaving out a large swath of medium to large players whose only access to capital today is non-bank (NBFC) funding.
This brings us to the most interesting part of the real estate capital markets currently, and that is the NBFC sector. Over the last few years, a number of large players have forayed into this space. The only player that has successfully created a sizeable business is Piramal Finance. They are now in the top-three real estate focused NBFCs, along with HDFC and Indiabulls. Following the three biggies are two smaller entities, Edelweiss and IIFL, both with seasoned management teams. They are expanding at a rapid pace as well, and have somewhat become the lender of last resort, a spot earlier occupied by Indiabulls. The rest of the players are dancing around the edges with no real core competency in the space. They generally tend to bring in hired guns that make silly investment decisions and are fired before the first round of loans are paid back or have defaulted. This cycle will continue for a while due to serious lack of availability of relevant talent in the market.
So, what is one to do as a serious India-focused investor? Bring out the popcorn and sit back and enjoy as to how the current crop of investments will do by way of returns.
Or you could be focused on building real capability on the ground, being involved with the next generation of entrepreneurs in this business. It is still a market with significant growth potential and progressive promoters will build large companies. Efficient use of capital and technology will be the leading indicator of such companies.
By Sameer Nayar, CEO of BuildSupply; previously the head of Real Estate Finance for Credit Suisse in Asia-Pacific.