Finding Mr. Right (Developer) in the Wrong market

Now that investing in debt instruments is really not such a great idea in India (as a result of the revised taxation norms announced by the FM in July this year); my banker suggested I look at investing in a real estate (RE) fund as a diversification strategy. My answer to his suggestion was a plain and simple "No". My experience with having worked for a RE fund; then, having invested in a RE fund; and also having heard disaster stories of various RE funds; I was quite convinced that I had better chances of enjoying a swim with the sharks in the Red Sea than investing in any RE fund in India. A banker does not remain a banker for too long unless he is a good salesman and his suggestion was that I at least meet with the CEO of the fund and understand his investment ideology before giving up the idea. He was quite certain that I would change my view after hearing what the fund manager had to say as the fund's strategy was designed to succeed in a depressed market and deliver better than alpha return on an upswing. Well I thought - why not - if nothing else, I would learn something new from a fund manager who was confident of raising money for real estate in a market that is just beginning to shy away from it.

I am not a great fan of Indian developers in the RE space and I have lost quite a bit of my respect for PE funds in this space too. Between them; they have succeeded in hyper inflating values of land and building (any use) making housing a dream for the common man in addition to making the cost of living in India prohibitive. In their pursuit to extract super returns from the Indian markets the PE funds have created their own "Frankenstein".  When the era of PE in RE space set-in sometime 2005-6; I felt it would usher in a positive change in the way the real estate sector works in India. Transactions in "black" would gradually disappear; quality of construction would improve; planning of developments would improve; and the nexus between developer and non kosher source of funds would reduce. What I see happening is just the contrary - at an even grander scale - at least in the majority of projects. By no means am I saying that all developers are guilty of these sins. But to find the few good men in this market; is like finding a needle in a haystack. The biggest sufferers in this whole game apart from the consumer have been the foreign investors invested in the PE funds. The General Partners and managers running the fund have almost always walked away with heavy fees on a year on year basis whereas the investors have seen their investments return low single digit returns taking into account the rupee depreciation and developer defaults. No wonder Indian real estate has not been a good word in foreign money markets for quite some time now. Even our own rising stock markets seem to be treating listed RE development companies with bit of caution, knowing well that most of them may look good on the surface, but may have strong negative undercurrents beneath. 

So in this bleak market of real estate where there is an increasing murmur of "overbuilt and overpriced" being heard - what strategy would a fund manager employ to deliver great returns ethically? I asked this gentleman who visited me for his secret sauce recipe. He said that his rules were quite simple - 5 rules of Do's and 5 rules of Don'ts :

The Do list:
1. Involve the anchor investors in the decision making so that the smaller investors know that their interests are also taken care of.
2. Find projects in new growth corridors and stay away as far as possible from established development zones.
3. Deal with Developers having a size-able track record of quality completion, along with a near "clean" record with consumers; and, are also willing to sell transparently in what is called "all white" transactions. (I did not know this breed existed - but apparently it does).
4. Get in at land stage with step in clauses in case of developer default.
5. Most important - find developers that are real developers in terms of them having their own (in house) asset management, project management and design teams; sales team; liaison team; and all such people required to ensure the right, timely and quality end product.

The Don't List:
1. Stay away from luxury developments - be it retail, commercial or residential.
2. Stay away from Developers that have over committed themselves on large and/or super grand projects and he rattled a few names which made absolute sense to me but would scare the living daylights from most would be investors.
3. Stay away from projects where the land values are hyper-inflated.
4. Keep away from Developers that have received significant funding from foreign PE Funds by way of equity and/or quasi debt.
5. Don't do deals with developers offering exceptionally high returns or are agreeing to terms where very high returns are expected.

I almost reached for my cheque book, as I was certain that if the above investment ideology is followed, the fund would most certainly make money for its investors. Tempted as I was - I did not participate as the commitment expected was much larger than what my risk appetite could afford in terms of both quantum and time. My own investment ideology tells me that investing in the equity of listed RE development companies that meet the above norms makes better sense as most of them are totally undervalued  and also allow for self timed exits as per market conditions. Alternatively, wait a while for some REITs to list as in the current market; the acquisition price will have to correct itself to get the right returns expected by investors in this space. It is said that in India the price of real estate will never fall and that's the reason its an investment better than even gold. But, I think, like gold, it too should see a massive correction to bring back a balance that is distorted as of now and showing signs of developing into a sub-prime type of crisis. 

Offices or Happy Work Spaces? Disruption in the Real Estate World - Part 2

It's an age of experimentation which allows for disruption. No set rules for how you live, work and play. Ownership is passe - shared is in (almost) - and it even applies to spaces that we thought we had control over. Applying this theorem to workplaces; from cabins and cubicles; to an open work station format; to team benches - the office is evolving. Coffee bar, snooze room, recreation and relax zone, kids pen and many such concepts have moved from being a novelty to a regular feature in large format offices. Innovation is guiding design and prospective employees are making decisions on where they will work and where not despite high unemployment. The new generation is more sure of its capabilities and there is a growing shift away from making lots of money to more in life.

Richard Branson recently announced a work as you please policy allowing his employees to take holidays at will and in return give their best on the days they are working. Such examples are showcasing the extent to which organizations are willing to go to to retain trained employees and get the best out of them. How is that going to impact the way offices are built in India?

Well, if the work environment needs to bring in a fun environment then the decision cannot be driven by bums per square foot seated - which is the case at high cost locations. Mumbai ranks No. 3 in the world for the highest office rents and probably somewhere there for the worst office quality in general. If employers had they ability; they would double deck employees to average out the high costs. But that is changing, If studies are any indication of the truth in the market; then there is a gradual increase in office vacancies happening all over the Country. The national average is about 30% and that's a scary number when one factors in the millions of unfinished square feet waiting to be clad and put on offer. Apart from a few sectors high rents sought in the CBD and SBD locations of this Country are not conducive to running a business. The low cost advantage that India once enjoyed in terms of land and labour is history. We have over inflated our own worth and become globally uncompetitive and that's probably why our real worth has been corrected down 50% in terms of the currencies of measure.

Economics is forcing organizations to down size offices or shift the middle and lower bulk to more economic back room locations. As a result transportation, time and productivity parameters of an employee are being impacted. It's a different matter that many of the office complexes built in remote zones are at wrong locations; the bigger worry is that they have been built wrong too. Then, to top it, to make up for the high cost elements included by the developers to make these swank campuses the rents are off the mark too even though they are less than half of what one would see in CBD and SBD of Metros and T1 cities. In a way, with the aid of technology; its easier to work from home to cut down cost of living and improve quality of life. But in a city like Mumbai where 2 to 3 generations of a family are packed in less than a 1000 ft2 of real and fictitious area - that too is not much of an option.

Gated work-stay campuses are on the rise but that is great for new age sectors. Old world structures cannot easily adapt to such set ups. Ask any developer and he will blame the Government, Goons Global woes and God for the high cost of creating and selling a foot square. His Greed is never a factor. Each time the Government increases the Floor Space Index or FSI (area allowed to be constructed on a ft2 of land) to drive down the overall cost of land; the cost actually goes up because the prevailing land rate is multiplied by the new higher FSI. Redevelopment and regeneration of areas were supposedly planned to usher in lower prices and more open spaces have actually done the reverse as well. Ultimately there will be a situation where the Developer and or his investors will have to go near bald with heavy haircuts to sell or let the spaces not wanting to see a deserted edifice. Private Equity operators believe that REITs are the only hope left to bring in better construction standards and decent rates as the very nature of how a REIT is run depends on these two factors. I disagree as I think that the chain is as strong as its weakest link and REIT's will be run by more or less the same guys who created a mess in the first place.

If it could happen in New York and London - it will happen in Mumbai too. Someday, employees will sing the "Happy" song at happy workplaces because the problem now is an opportunity for a major disruption - and the seed for it must be germinating in some brilliant minds as I write this blog.

REITs and RIET of Real Estate

There seems to be a heady buzz in the Real Estate (RE) sector on the back of the new FDI (Foreign Direct Investment) policy and the new reality of Real Estate Investment Trusts (REITs) announced by the current government. This excitement was clearly evident at a conference that I attended on real estate organized by the Royal Institute of Chartered Surveyors (RICS).  I am always keen to hear where this sector is headed as hotels are an integral and important part of this core sector.  The theme stated "What's New: Predictions for the future - Trends shaping Indian Real Estate". It covered residential, retail, commercial segments; and nothing about hotels. Nothing; not even a mention in any one of the topics discussed. So, from being the super star - flavour of the season - and what not a few years back; this segment seems to have seriously fallen to the bottom of the barrel for the RE guys. I took consolation in the thought that maybe hospitality now truly belongs to the Infrastructure sector and not "Real Estate" and will probably get better visibility at larger - more important - forums. In all honesty, even I know that hospitality is no longer hot property with RE given the number of deals falling on my table for rescue. But, this is not a blog on hotels. (Guys! eggs and tomatoes are expensive so think before you toss them at anyone - especially someone who can do miracles with them).

Back to the topic. The new FDI policy has considerably reduced the project qualification requirements to allow much smaller projects to be consider for funding. Idea being to encourage growth in T2 and T3 towns with a larger agenda to promote SMART cities in those locations. There seems to be a lot of scepticism if it will actually achieve it's goal as FDI of now will rarely chase high risk. The beneficiaries may be smaller projects in Metro and T1 Cities and small to medium size developers with a good track record in delivery and with a professional team that treats that money with respect will end up as the real winners. But, there is a social change emerging in the way the younger generation perceives life. No longer is there a thirst to go Urban with the high cost and high stress lifestyle associated with it; rather go RURBAN where the lifestyle is relaxed; costs of living are low and where one does not live in a pigeon hole. That is the real SMART city of tomorrow and I have come across examples of villages that have transformed themselves into clean, green, eco-sensitive, reliant on renewable energy, with 100% literacy, completely net connected and so on.
http://www.scoopwhoop.com/inothernews/mera-gaon-mahaan/?ref=social&type=fb&b=0

I actually hope that FDI becomes the RIET choice (Rural India's Economic Thrust). However, attracting FDI today may be a bit of challenge. Yes, there is a strong case for India to attract capital for real estate - afterall there are very few places left in the whole wide world that actually can. But, the real returns on capital that had come into India between 2006-7 to 2009-10 (good times) is barely in single digits when one considers that the Rupee has depreciated 50% in the last 4 years and that it is hard to quote successful exits to begin with. Moreover, the end of  "Quantitative Easing" in the USA - the interest rates overseas may slowly and steadily inch up making investments in emerging markets a tad more unattractive. Then, do we need foreign money when there is so much money in India itself? That is exactly the belief many fund managers have - having raised tons of money locally for the RE sector. Investors, both big and small believe that deploying money in RE through an institution is a lot better given its better abilities to conduct the due diligence much  as well as secure the property as tightly a bank would. So, Indian money raised has been more structured debt at high interest rather than pure risk high return private equity. Most FDI post 2009 has also come in the same form to ensure a year on year return at a rate when adjusted would match the high interest rates charged by banks.

The developers were the happiest when they got PE money as there was no pressure to guarantee any form of return. Guess they were not the only greedy ones and those in control of giving out development permissions joined the party and no one really cared as playing on "Other People's Money" was always fun. No transparency, no reporting requirements, no project takeover threats either, and with local litigation laws being the way they are; the developer was under no threat at all. I know of cases where developers have asked Board Members representing their PE investors to exit at super low returns or not see a single rupee be returned for the next 100 years. Well wisdom does catch up and that's the reason why nearly 60% of the money brought in by PE from overseas sits undeployed.

The money sitting on the fence is waiting for the final brushes on the REITs policy to facilitate purchase a portfolio of good quality, income earning assets at good locations and get the required returns on capital through listing exits. While there is excitement that it will improve quality of construction, bring in transparency and become a source for raising funds for those with a proven track record; REITs will compete more with debt instruments in terms of returns; and with equities returning into the favourable zone with investors - will find it hard to attract capital to itself.

As a sector, real estate in India is suffering from "premature obesity" created by over inflated valuations by the greedy few that control the market. The actual user is still not the buyer and inventory meant to make housing and commerce more affordable is actually being bought by the very people who should not. Luckily for all, India is looking to enter its growth cycle and the excess inventory in all segments may soon find actual buyers. A massive correction will help; but that's not happening anytime soon as most developments have come up on no-pressure money. That in itself will keep new money away from the sector as at current values most acquisitions are unable to give healthy returns. Property Consultants and Developers believe that Indian RE sector is still an infant given the rising population and wealth in India. They have no choice but to believe that. Yet across the border a more populous and richer nation has swanky vacant dead cities that no one wants to go to.

I will not put a wreath on Real Estate anytime soon; but it's time the arrogance of this industry took a hard beating before it becomes to look like a snake eating its own tail - where one does not know if it is reinventing or killing itself.