Monitored real estate cycle
Ends and beginnings: The end of the first-ever monitored real estate cycle in India is on.
The housing crisis is seeping into the credit markets and the global banking system, threatening to derail many heavyweight economies. While a number of governments are scampering to do damage control, it's difficult to say how fruitful their efforts will be.
Globally, economic systems are reeling under the impact of this epidemic-like financial squeeze. The Indian economy also has begun to feel the pressure. The massive correction in the stock market has left no doubt in anyone's mind that we are completely integrated with the global machinery. The decoupling theory has been debunked.
What goes up...
The intellectual within many of us has been tricked into turning a nervous speculator, from the well-balanced analyst. In the real estate sector, it is important to understand two things clearly. Firstly, India may just be witnessing the close of its first-ever monitored real estate cycle, with an end far more dramatic than what one would have predicted. Secondly, the basic elements, or the fundamentals, of the `India story' appear to be intact; it may, however, require government intervention and policy stimulus from time to time. It is nearly impossible that the Indian advantage will be dissolved in the medium- to long-term.
What began in the initial years of this decade, when the markets started gathering momentum, is now about to be concluded. This implies that we have now entered a phase where prices are getting flatter, with the prognosis of a downward trend. This, naturally, comes on the back of a decelerating demand base and a probable oversupply situation. Recent events in global capital markets and the banking industry might cause this ongoing trend to be a little more drastic or long-lasting, but the fundamental change remains the same.
Commercial real estate absorption is a good barometer to gauge the degree of vibrancy in an economy. However, the largest volume of real estate lies in the residential segment, of nearly 80%. It then follows that the largest impact segment has to be the residential segment. Various other ancillary real estate segments, including retail and hospitality, depend on activities in this segment.
As inflation and interest rates soar, a significant part of participants in the residential market--the end-users and owner-occupiers, who are predominantly mortgage dependent--are choosing to stay away from the market. A large section of buyers in this segment are first-time purchasers, several of whom belong to the middle-class and the lower middle-class. Over the past few years, most developments in the larger cities have been focusing on high-end residential property. This was partly the result of exorbitant land pricing and partly the outcome of the tendency of developers to `make hay while the sun shines'. In view of the above, and given the changing landscape, development projects that have created a balanced mix of real estate are likely to do well.
Under the circumstances, however, with investment capacity under strain, large volumes of high-priced residential stocks, as well as the supply pipeline, will need to re-align pricing. Currently, developers are facing significant trouble on two fronts: declining sales and unavailability of funds. They cannot raise equity when the stock market is crashing. Also, banks are unwilling to loosen their purse strings. The ensuing fund crunch will entail delays in execution of ongoing projects, as well as postponement of newer ones. Construction costs also don't seem to be declining.
Sanity returns
An economic downturn brings home the point of cash flow supremacy. The accent over the past two years was on land banks and speculative development. This downturn will hopefully make a lot of developers aware of the downside risk in real estate development. The silver lining is that private equity (PE) funds are still bullish on India in the long-term. The only paradigm shift is that they will increase scrutiny and cherry pick projects, having realised that the days of yield compression may be looming ahead.
This downturn will force developers to focus on quality, efficiency and delivery--things that got lost in the frenzy of the past few years. We may also see consolidation among developers. Most developers that don't have the scale or competence will either have to sell or merge with others, as they find it difficult to survive.
We must now turn our focus to land--the most interesting, but also probably the least understood of all elements comprising real estate. Land valuations have created widespread commotion in recent times, be it for real estate development companies' land-bank and fund-raising exercises, or for states' or private enterprises' land-acquisition activities for development and industrial set-ups. From a commercial standpoint, land valuations rose 100-300% over the past few years, as the markets went into a high-growth trajectory. This inflated the overall investment value each successive year, even at moderate initial yields and cap rates.
The sanitisation process is, in a way, being depicted by margin cuts and gradual price corrections for the finished product (ready-to-occupy real estate). As real estate markets continue this trend in the near future, the price-discovery process is likely to trickle down to the point of origin in due course--that is, the land stage of the market. When will this happen is difficult to predict. But, almost certainly, that should be the point from where the market will be ready to bounce back again. Of course, this will need to coincide with the overall upswing in the economic cycle and reinforced investment sentiment.
Policy initiatives
It will, however, be naive to believe that the property cycle and economic cycle will trigger the next upswing automatically. There is a lot of work to be done between now and then. Top priority needs to be given to continuing and speeding up infrastructure creation, improving logistics and supply chain arteries, increasing transparency in the markets, establishing codes and practices for valuation, ensuring that investor confidence remains high, and keeping a vigil on speculative money that creates a bubble.
We need to understand that the sub-prime mortgage problem that led to the precipitation of the current crisis in the US has limited possibilities of getting replicated in our economy (or so we would like to believe). Ironically, the unfortunate sequence of events in the West has provided a precedent and an advance warning to the financial system in the country. In any case, the RBI and Sebi have been highly vigilant of real estate activity over the last couple of years, rarely allowing unabated lending and laying down norms for public fund-raising, respectively. Looseness on either or both of those fronts could otherwise have played havoc on the domestic economy as soon as the bad news arrived.
Having said that, it does appear that we are heading for some troubled times in the short- to medium-term, and a number of pieces have to fall in place before we start to see the beginning of another cycle. Realignment of margins, flexible price-discovery mechanism and availability of affordable credit are some of the drivers that will make things easier. In many ways, the current downturn in the real estate sector may turn out to be a learning mechanism and blessing in disguise for industry players, given the unstructured growth that built up during the short period of the past few years.
Source: Outlook Business, November 14-29, 2008 issue
The housing crisis is seeping into the credit markets and the global banking system, threatening to derail many heavyweight economies. While a number of governments are scampering to do damage control, it's difficult to say how fruitful their efforts will be.
Globally, economic systems are reeling under the impact of this epidemic-like financial squeeze. The Indian economy also has begun to feel the pressure. The massive correction in the stock market has left no doubt in anyone's mind that we are completely integrated with the global machinery. The decoupling theory has been debunked.
What goes up...
The intellectual within many of us has been tricked into turning a nervous speculator, from the well-balanced analyst. In the real estate sector, it is important to understand two things clearly. Firstly, India may just be witnessing the close of its first-ever monitored real estate cycle, with an end far more dramatic than what one would have predicted. Secondly, the basic elements, or the fundamentals, of the `India story' appear to be intact; it may, however, require government intervention and policy stimulus from time to time. It is nearly impossible that the Indian advantage will be dissolved in the medium- to long-term.
What began in the initial years of this decade, when the markets started gathering momentum, is now about to be concluded. This implies that we have now entered a phase where prices are getting flatter, with the prognosis of a downward trend. This, naturally, comes on the back of a decelerating demand base and a probable oversupply situation. Recent events in global capital markets and the banking industry might cause this ongoing trend to be a little more drastic or long-lasting, but the fundamental change remains the same.
Commercial real estate absorption is a good barometer to gauge the degree of vibrancy in an economy. However, the largest volume of real estate lies in the residential segment, of nearly 80%. It then follows that the largest impact segment has to be the residential segment. Various other ancillary real estate segments, including retail and hospitality, depend on activities in this segment.
As inflation and interest rates soar, a significant part of participants in the residential market--the end-users and owner-occupiers, who are predominantly mortgage dependent--are choosing to stay away from the market. A large section of buyers in this segment are first-time purchasers, several of whom belong to the middle-class and the lower middle-class. Over the past few years, most developments in the larger cities have been focusing on high-end residential property. This was partly the result of exorbitant land pricing and partly the outcome of the tendency of developers to `make hay while the sun shines'. In view of the above, and given the changing landscape, development projects that have created a balanced mix of real estate are likely to do well.
Under the circumstances, however, with investment capacity under strain, large volumes of high-priced residential stocks, as well as the supply pipeline, will need to re-align pricing. Currently, developers are facing significant trouble on two fronts: declining sales and unavailability of funds. They cannot raise equity when the stock market is crashing. Also, banks are unwilling to loosen their purse strings. The ensuing fund crunch will entail delays in execution of ongoing projects, as well as postponement of newer ones. Construction costs also don't seem to be declining.
Sanity returns
An economic downturn brings home the point of cash flow supremacy. The accent over the past two years was on land banks and speculative development. This downturn will hopefully make a lot of developers aware of the downside risk in real estate development. The silver lining is that private equity (PE) funds are still bullish on India in the long-term. The only paradigm shift is that they will increase scrutiny and cherry pick projects, having realised that the days of yield compression may be looming ahead.
This downturn will force developers to focus on quality, efficiency and delivery--things that got lost in the frenzy of the past few years. We may also see consolidation among developers. Most developers that don't have the scale or competence will either have to sell or merge with others, as they find it difficult to survive.
We must now turn our focus to land--the most interesting, but also probably the least understood of all elements comprising real estate. Land valuations have created widespread commotion in recent times, be it for real estate development companies' land-bank and fund-raising exercises, or for states' or private enterprises' land-acquisition activities for development and industrial set-ups. From a commercial standpoint, land valuations rose 100-300% over the past few years, as the markets went into a high-growth trajectory. This inflated the overall investment value each successive year, even at moderate initial yields and cap rates.
The sanitisation process is, in a way, being depicted by margin cuts and gradual price corrections for the finished product (ready-to-occupy real estate). As real estate markets continue this trend in the near future, the price-discovery process is likely to trickle down to the point of origin in due course--that is, the land stage of the market. When will this happen is difficult to predict. But, almost certainly, that should be the point from where the market will be ready to bounce back again. Of course, this will need to coincide with the overall upswing in the economic cycle and reinforced investment sentiment.
Policy initiatives
It will, however, be naive to believe that the property cycle and economic cycle will trigger the next upswing automatically. There is a lot of work to be done between now and then. Top priority needs to be given to continuing and speeding up infrastructure creation, improving logistics and supply chain arteries, increasing transparency in the markets, establishing codes and practices for valuation, ensuring that investor confidence remains high, and keeping a vigil on speculative money that creates a bubble.
We need to understand that the sub-prime mortgage problem that led to the precipitation of the current crisis in the US has limited possibilities of getting replicated in our economy (or so we would like to believe). Ironically, the unfortunate sequence of events in the West has provided a precedent and an advance warning to the financial system in the country. In any case, the RBI and Sebi have been highly vigilant of real estate activity over the last couple of years, rarely allowing unabated lending and laying down norms for public fund-raising, respectively. Looseness on either or both of those fronts could otherwise have played havoc on the domestic economy as soon as the bad news arrived.
Having said that, it does appear that we are heading for some troubled times in the short- to medium-term, and a number of pieces have to fall in place before we start to see the beginning of another cycle. Realignment of margins, flexible price-discovery mechanism and availability of affordable credit are some of the drivers that will make things easier. In many ways, the current downturn in the real estate sector may turn out to be a learning mechanism and blessing in disguise for industry players, given the unstructured growth that built up during the short period of the past few years.
Source: Outlook Business, November 14-29, 2008 issue