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. 

Branded Residences - losing sheen

I can't put a finger on a person or entity that got this concept going. Was it Donald Trump or Adrian Zecha who fathered it? Or does the credit go to Four Seasons or some other marquee hotel brand for the same? Or, was it something that evolved as an outcome of the fractional ownership industry where top brands loathe to the road shark selling techniques of timeshare sold a residence with a name guarantee on it. All I do know is that it is an "ego" product that does deliver a quality living space at a hefty price tag and heftier running cost. 

Until some 10 years back; exclusive hotel brands marketed residences at equally exclusive resort locations. It did give a nice high to the buyer who felt that (s)he had acquired the whole resort-hotel by just acquiring one unit within it. And, it gave a bigger high knowing that it would not be used and abused by any other person - like a hotel room is - should the owner not wish to put the unit back on a sale and leaseback basis. For a resort developer, this was the perfect way to recover bulk of the cost (if not make a profit) of very expensive and exclusive developments ensuring the project's financial viability. 

As real estate markets boomed around the world in the last 10 years; branded residences increasingly became a marketing tool to differentiate exclusive developments from those that were labeled with adjectives like luxury, premium, and unique. The brag rights for owning a branded residence in the city where one lived, as compared to some far flung holiday destinations must have been much greater to warrant this concept being adopted by virtually every major luxury apartment developer around the globe. Soon "Trump Tower" was not only a New York feature and "Four Seasons Residences" could be found alongside virtually every new Four Seasons hotel and at certain locations the requirement of a hotel has been dispensed with altogether. It has in time become the path to viability on super expensive real estate as buyers are willing to pay 60%+ premium over similar unbranded assets. At least that is the story being sold by the brands to the developers; and in a country like India - where the people are very brand and brag conscious - this is God's own truth being said. Well - almost. 

The last 2 to 3 years, contrary to market belief; there has seen a dip in luxury apartment sales. The impact of slowdown has hurt this segment of real estate substantially. It is only the innovative off-plan selling by developers - that is -  to defer collection of profit and land cost to the end of the project completion (20:80 payment plans) that has facilitated offloading the US$ 1,000,000+  cost apartments. In addition, developers have had to bump up the percentages and fees paid to brokers and consultants to push sales. The selling community never had it so good. Yes, the falling rupee, new wealth, and ease of borrowing for residential inventory has made acquisition of premium goods much easier under the circumstances. But, there is a growing realization that many of these projects may see a longer than planned for project cycle (if at all); and, should the completion happen in a down cycle then those buying for an investment may get burned. 

Well, the solution for that is easy - have cash - will talk. If the above was not enough, developers are offering deep discounts to make investor exits less risky and the situation is that branded residences are possibly claiming not more than a 10% - 15% premium over similar class unbranded developments. With brands themselves taking away 10%+ as their fees to lend their names - does it make commercial sense anymore to build one? Buyers that have received delivery of such apartments are now questioning their decision to buy. The recent hike in municipal taxes and utility dues; service tax on maintenance bills; high maintenance costs in corrosive conditions of most Indian cities; inadequate water supply; a lack of quick and proper access to emergency services due to poor infrastructure conditions and emergency equipment; sharing of boundaries with undesirable real estate (slums, cemeteries, local markets); and most important inability to get tenants willing to pay that extra premium in rent has made buying a branded residence a big question for many. 

Yes, this land has ego written all over it; but hidden beneath that is a stronger attribute called cost consciousness - the "kitna deti hai" (how much does it average) attitude that overrides the former by miles. I remember the time when I was growing up - the sight of an occasional Mercedes or BMW was a head turner amongst the hundreds of shoddy built local cars. Today; there are hundreds of the big 3 German cars on road blending in unnoticed with thousands of well built cars from Japan, Korea, Europe, and even India. There lies my point that branded residences too will lose their sheen from an ownership brag point of view as more and more hit the RE turf. One would own them purely for self satisfaction and the superior quality and services they promise to deliver albeit at a very high cost. Will they deliver on the promise? Now that's another story and you may want to read my previous blog called "Shitty Shitty Big Brand"