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. 

Hotels - It's BUY BUY for some and BYE BYE for many

Flashback circa 2006 - GRI - New Delhi. I was working as a consultant to a Real Estate Fund back then advising it on the hospitality sector, and attended this event on its behalf. All I heard there was that every known and unknown developer attending the conference was going to build more hotels than the number of  fingers and toes he had combined in the next 4 to 5 years. Such scale of development had eluded the best of the best in the Indian hospitality industry until then. Each one of them was sold on the story that the whole of India has lesser number of rooms than Bangkok. India had some 90,000 hotel rooms (of which some 50,000 were branded) back then and needed to double its inventory real quick - that is by 2010. Then, I heard a sane voice from one of the attendees (who was leading Accor's initiative in India at that time) that the real number is closer to 500,000 when all forms of temporary accommodation were added up and doubling the inventory was not really the answer. But like all sane voices; it was drowned by the noise created by every hotel and property consultant ridiculing that claim.  The great gold rush in the Indian hospitality sector had begun. Projects were being conceived at unheard of land rates with occupancy, average daily rate and valuation assumptions to justify the financial viability to the numerous bankers and private equity players waiting to pour money in this game.

Yesterday; 18th Nov. 2014, I was invited to attend a seminar organized by a leading law firm on "Issues affecting Indian hospitality sector". Got to hear some interesting facts; some amused me and others that got me thinking on what's in store for this sector next. I learnt that the industry compounded annual growth; charted for the last 15 years tells us that demand and supply have kept pace evenly at about 11% with the demand a tad ahead of supply. Then, all hotels should be theoretically clocking at least 80% + occupancy; which is far from the truth. The same statistician rolled out more numbers that the first year performance for new hotel openings has progressively declined from 47% in 2009  to 35% now on account of supply pressures. Occupancy percentages overall for the last 5 years has been stagnant at about 58% and average room rates (ARR) have actually shrunk 3% or more depending on segment. The dark horse holding up the gloom seem to be the 2 star hotel segment that has seen ARRs climb 7.7% in last 5 years with occupancies averaging around 62%. To put all these numbers in a better perspective; India today has some 180,000 hotel rooms across all categories of which 100,000 are branded; and wait; the next couple of years will see the total number cross 250,000 rooms with at least 150,000 of them in the branded category. I am not sure if these totals include the temporary accommodation units as my take is that by year 2016 - India would have close to 1 million units servicing this type of stay need.

As of today, the situation looks more than terrible. Travel around the country and one will see several hotel skeletons doting every city; as much as those of residential and commercial buildings. It's easy to understand why this situation is staring at our face. The nation has gone from a rising to a falling star status in the last 10 years as has its currency. Global economies have not done much better either. Unplanned developments with very little thought, study and planning fanned by developer egos and easy finance from all kinds of investors and lenders has not helped the cause either. From a hotel perspective, the only places that have a smile to show are Mumbai, Delhi (not NCR), Goa and kolkatta. Rest of the Country has over supply written all over it. Pune and Bangalore are inching back to survival from an occupancy but not a rate perspective. Thankfully, India's natural inefficiency in delivering project completion on time has saved the industry from a situation that could have been much worse than it is now. Despite all the technological developments in the construction sector; India still requires an average 29 months to deliver an affordable hotel at a cost of between 24 lakhs to 40 lakhs a room (without land) whereas the same hotel could be built in less than 14 months at the same cost per room inclusive of land. With occupancy and rates continuing to remain the way they are for the next couple of years, most hotels will find it very hard to justify their viability to money backing them. It is certainly going to be a time when a lot of owners holding completed and incomplete assets are going to check-out saying Bye Bye to this industry.

Yet, before the industry decides to cry tears of blood in unison; there is not only a glimmer of hope but a fantastic opportunity waiting out there. Hotel industry usually trails the spurt in economy by about 8 quarters and that means that by 2017-18 the industry should start correcting upward. Anyone committed to this sector and sitting on cash is in a driving position to acquire quality finished and unfinished assets. Specialization in hospitality, along with efficiency in executing projects, managing operations and a strong marketing backbone are keys to winning this game. While I doubt if the Indian REIT structure in its current context will help this sector; hotels being classified as infrastructure can certainly benefit from InvITs (Infrastructure Investment Trusts). Further, the entire lending industry is ready for a reshape and it is not impossible now to get financial institutions to commit longer duration money with repayment programs tailored to the health of the asset - as well as take a more rational approach to security and collateral. I am already hearing the call of Buy Buy getting louder on this street called the "hospitality world".

Pain is good - and like it signals healing in our body - it's also a sign of healing in the industry. Everyone has learnt lessons in the last few years. No longer are hotel brands and operators (new or old) spoiling the developers by offering them ridiculously high fixed leases or making investments in shells that the former do not own or control. Leases and investments are increasingly linked with performance and secured by contracts that make operators virtual owners of the property. Developers have understood that hotels are not the classic real estate business with a build-sell-value formula. Building hotels requires sustainable quality which they don't care for when making inventory to sell; and running hotels needs micro attention which can sap a lot of time from their super profitable construction business - which means finding operators to run their properties. Hiring an operator is not the same as hiring a contractor as developers have learnt and getting away with under performance is now increasing unacceptable as operators have learnt. Recognizing "Prefered Owner Returns"; subordination of fees to debt service; linking fees to operating results are increasingly making life difficult for international brands to conclude business in India and better for domestic operators who understand these issues well - and are ready to commit money if need be to ensure the health of the hotel they put their name on. The best is that most developers are now understanding that the land pricing for and yields from hotels are just not the same as commercial or residential or retail. But, the long term value that wellrun hotels command are unmatched by other spaces they build - and that's driving committed developers into this segment; ones who understand that the pain experienced in the first few years is more than made up by the gain that hotels deliver thereafter.

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.

Disruption in the Real Estate World - Part 1 (Retail)

When the moon is in the Seventh Heaven
And Earth aligns with Mars
Then disruption will guide the planets
And the e-age will steer the stars

No, I have not turned to astrology as a profession; though God knows I would probably make more money professing speculative information that can be never be tested and the listener lapping it up as words from God. Having attended a conference called "What's new: Predictions for the future - Trends shaping Indian Real estate" I am perhaps in a crystal ball gazing mood.

One of the arguments I heard concerned the retail industry. The big question being would e-tailing kill shopping malls. Until a few years back; e-tailing in India was the David and malls the Goliath. Suddenly, the roles seemed to have reversed with e-tailers that were gasping for breath for survival were suddenly valued as billion dollar properties and malls that were demanding billion dollar valuations yesterday are struggling to survive. There are some 500+ malls in India of which only 25% have earned the title of success. Rest are being titled monstrosities ill conceived by egoistic developers and crazy architects who have no idea of where or what they were building or designing, and to what end except for one blinkered thought that India will someday allow FDI in retail and the nation will become the shopping destination of the world.

e-Tailing extracted laughter from these great builders. "People trust only what they can see or touch and will deal only with people they can talk to. After all what fun is shopping if you cannot bargain? Everyone does not have access to the net and those who have don't trust it. This is India my friend not America or Europe" is what I often heard. But, that was before the cheap smartphone wave and suddenly everyone had the net in their palms. Regulation made it compulsory for credit and debit cards to go for higher levels of security and today India has one of the best encryption and secured systems for e-transactions. e-tailers took the feel and touch bit quite seriously and introduced Cash on Delivery, return if not satisfied policies, compare and shop policies. Soon, local retailers suffering from low marketing reach, thin margins and high rents started cutting deals with e-tailers to push their wares.

Air conditioned fancy malls realizing that they had become nothing more than picnic spots for window shoppers started losing tenancies. After all the cost of the high rent is buried in the product you buy. Over the years the smart mall owners learnt to switch from high fixed rents to variable plus thin fixed or no fixed formats to keep good names inside. For many malls, even this was not an alternative. A mall developer today must be thinking that had he invested that same USD 25+ million in developing an e-selling platform rather than the concrete structure he would probably be valued at 10X his investment instead of current land value (that has not changed much) minus 10% (for demolition it) -  which is what I heard a large ticket investor say when asked how much he would pay to acquire a distressed mall.

In this David and Goliath war; the new David seems to be making the same mistake - but on the other extreme. Selling goods below cost with an eye on customer acquisition. Sustainable? I don't know. I still feel e-tailing cannot offer the smell of printed books of a bookstore or the smell of bakes and coffee at a coffee shop or any of the sensory and social experiences of a mall. Malls are and will be the place for E(xperience)-tailing. The way they are built may change over time as well as the way business is transacted. Maybe each of the e-tailers will end up owning its own mall in every City or town or maybe they will be defined by a product range they sell. But they will survive and even flourish. India cannot keep FDI in retail out for long and global pressures will force it to happen.

It is very clear however that Real Estate is no longer immune to disruption. Its happened in retail and its happening in office spaces too (Part 2). It's time for developers to open their eyes and realize that they have to change the way they build and do business.

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.