Indian Real Estate: Investors Are Shopping, But Are They Buying Hype?

Drive through any of India's major cities and it will be impossible to go a mile without running into brightly colored cranes, construction rubble and men in yellow helmets scurrying up and down skyscrapers. Commercial high rises, residential townships, industrial parks and shopping malls are exploding into existence, encouraged by both long-term and speculative investors. Oversized private equity commitments by a growing number of foreign investors and home-grown financial institutions are helping to feed the frenzy.

But several astute industry watchers have begun poking big holes in that picture. For one, they say that many foreign investors have actually brought in only a small portion of their promised investments. Second, soaring land prices and price resistance from buyers are narrowing investors' margins significantly. Finally, they note that concerns continue to run high about the regulatory opaqueness for real estate ventures, bureaucratic red tape and the absence of title insurance, in addition to a host of other issues. India Knowledge@Wharton spoke with prominent private investors, property developers and brokerage firms to understand how these factors are tempering investors' appetites for Indian real estate.

With yields between 30% and 40% during the past two years, India's real estate industry has been the toast of global investment funds. But expectations for future returns have been sharply reduced to between 12% and 20% over the next few years. For many foreign investors, this means having to weigh Indian real estate opportunities against deals that offer comparable returns in other emerging markets like Eastern Europe or Latin America.

Fears of a real estate bubble and an overheated economy have led India's central bank to require a lender cutback on real estate loans. That move has pushed up interest rates, lowering consumers' appetites for home financing and simultaneously raising rents for apartments and offices. Most Indian real estate companies are privately held and their financial information is not readily available. The absence of comprehensive market data across product types like office, retail, industrial and residential properties further hurts the ability of investors to read the right signals, and the occasional rumor of a large deal going bust or a property developer resorting to a distress sale can damage investment sentiments far more than warranted.

More Hype than Actual Investments
Clearly, local investors understand the terrain far better than foreign investors. Much of the foreign capital committed to Indian real estate ventures has yet to be invested, says Aashish Kalra, co-founder and managing director of Trikona Capital, a private equity firm with offices in New York City, London and Mumbai. "Last year, less than $1 billion [was actually invested in] Indian real estate. That's less than the value of half a building in Times Square," he says. That compares with market estimates of between $15 billion and $20 billion in foreign capital headed for Indian real estate.

Kalra cited these figures during a panel discussion on real estate investing at a recent New York City event organized by The Indus Entrepreneurs (TiE), a network of entrepreneurs founded 15 years ago in Silicon Valley. "A negligible amount of foreign capital will get invested in Indian real estate in the next 24 months," he told the panel.

Sameer Nayar, managing director and head of real estate finance-Asia Pacific at Credit Suisse, offers a similar assessment. "There is a lot of hype about capital going into Indian real estate ... [but] not a lot of money is actually going in," he says. Extracting good returns from those investments calls for significant local market expertise in dealing with regulatory and other obstacles. "You make money because you can deal with the problems, and that's why your returns could be 50%," he adds. "If it were an easy market to work in, you would make only 15%."

Short-term Disenchantment
In April 2006, Trikona Capital group firm Trinity Capital raised 250 million pounds ($500 million) for Indian real estate investment in a public offering through London's Alternative Investment Market (AIM). Kalra says his company has deployed about $400 million in Indian real estate projects over the past year.

Including Trinity, about a dozen real estate funds targeting India have raised a combined $2 billion in the past year through listings on the AIM. Most of them are currently trading at levels significantly below their offer prices, revealing investor disenchantment. Trinity's share made its debut in April 2006 at one pound; it now trades at about 86 pence. Hirco, an Isle of Man-domiciled company promoted by the Mumbai-based Hiranandani Constructions group, raised about 382 million pounds ($755 million) from its IPO last December; since then, its shares have lost considerable sheen, down from 5 pounds to about 390 pence in the second week of May. Exceptions include Unitech Corporate Parks, which listed on the AIM last December at 93 pence and now trades at 96.25 pence.

"We see the opportunity [in Indian real estate], but we also see the risks and challenges involved," says Chanakya Chakravarti, managing director of real estate at Actis, a London-based private equity fund that manages assets of about $3.4 billion. Actis plans to set up a $300 million India real estate fund. It already has two other existing funds with an estimated equity of $475 million that have invested in Indian real estate, auto ancillaries and other industries. "Each fund has a unique risk-return profile, and we work with these. For us, India is a long-term story," he adds.

Chakravarti lists three main risks or challenges that real estate investors in India will be up against in the short term. The first, he says, is an oversupply of office space in the major and second-tier cities. A hazy regulatory framework fostering indecision and delayed investments is another concern. Finally, he notes, opaque deal-making processes that narrow the exit routes will deter serious investors.

"The property market today is rife with uncertainties. Prices as well as interest rates have been rising," says Anuj Puri, managing director of real estate services firm Trammell Crow Meghraj, the Indian joint venture of Dallas, Tex.-based real estate services firm Trammell Crow and the Meghraj Group, a financial services firm in London. "It is not advisable to expect any short-term gains; but of course, for long-term investors, India's strong fundamentals are still intact. A long-term investor can expect average returns of 15% to 20% per year."

Vikas Oberoi, managing director of Oberoi Constructions in Mumbai, says the risk-return profile for real estate investments is far brighter for those who have accumulated land inventory at prices much lower than prevailing levels. "The average net margin in today's market is 20% to 25%; we can easily do 15% better than the market," he says. Oberoi claims his company can achieve those higher returns because, among other reasons, "most of the land has been bought earlier."

Oberoi Constructions has an inventory of 15 million square feet of mostly prime land in Mumbai. At today's prices, Oberoi expects it to generate gross revenues of $2.2 billion. The company is focused mostly on for-sale residential apartments, although it dabbles in shopping malls, hotels and other commercial property lines. Oberoi expects his company to post $200 million in revenue this year, rising to $300 million in 2008.

This past January, Morgan Stanley's Special Situations Fund invested $152 million for a 10.75% stake in Oberoi Constructions, effectively valuing the company at about $1.4 billion. Oberoi says the untapped upside in his company's land bank was a major attraction for the institutional suitors it attracted. For instance, five years ago it bought a land lot with 8 million square feet in Mumbai's northwestern suburb of Goregaon for Rs. 100 crore ($24 million). Oberoi says the property would be worth 20 times more today.

"Where is the supply? There is only demand," says Oberoi. "In fact, I want the market to stabilize or [prices to] come down because then we would get land at cheaper prices. It is absolutely a seller's market."

Second-tier Migration
The most visible changes in the Indian real estate sector include the emergence of well defined product categories, the division of the market into tiered cities and a widening of financing options.

In the past, real estate was sold either as residential or as commercial property. With the maturing of the market and globalization of the investor base, the categories have been sharpened and new ones established. "Investors in the residential market are very different from the office and retail space investor," says Sanjeev Dasgupta, CFO and head of investments at Kshitij Investment Advisory Services, part of the Future Group, a large Mumbai-based owner of shopping malls across the country. In the residential sector, investors are in for high returns and are willing to take high risks, he says. This also allows for easy exit, although the risk of a mismatch between potential and real returns is high, he adds.

According to Poonam Mahtani, a national director of retail services firm Colliers International in India, "The investment risk is lower in the metros, but prices there are much higher than those in tier II cities." Several equity funds have consciously focused on tier II cities, because they believe that this offers the most potential. "Land prices are skyrocketing. Buying to sell is a very risky strategy. Land prices are way beyond levels that will generate a decent return. It doesn't make sense to invest any more unless you go to second- or third-tier markets."

Kalra, too, sees the markets outside of India's major cities as the most attractive, simply because they are not the low-hanging fruit sought by the early crop of investors with relatively lower risk appetites. "There are lots of opportunities outside the main metros. India has 30 cities with a population of a million people each," he says. Adds Dasgupta, "The returns are huge in tier II cities, where there is a large untapped potential." He believes that this sector will see a rental yield of 12% to 14% in the next few years.

In office space, experts see a migration towards second-tier cities. A recent report by Deutsche Bank on real estate trends notes, "As the demand for modern space has continually increased, new office locations have had to be developed in the south and east of the urban area (Mumbai and Delhi)." In Mumbai, secondary business districts have emerged in recent years, including the Bandra-Kurla complex in the central suburbs, 25 miles from the old commercial hubs in the southern end of the city.

Much-needed Transparency
For foreign investors, one troubling fact is a pan-India phenomenon: inadequate transparency in land valuations they use to price their investments. In an interview last month, M. Damodaran, chairman of the Securities and Exchange Board of India, discussed the lack of clarity in real estate companies' disclosures, especially with respect to their land banks. "We sought clarity ... on matters like, 'What does your land bank comprise, [and] what are the valuation aspects you have indicated?'" he told the India news wire service. "Where there is only an agreement to develop land, there must be complete disclosure. All such agreements are to be made available for inspection," he said, adding that he preferred land valuations to be made at current prices and not on the basis of future projections.

Trammell Crow Meghraj's Puri agrees. "There is a marked lack of transparency, corporate governance and accountability among India's real estate developers. There also continues to be a serious lack of quality infrastructure. In addition, India scores low in terms of congenial political environment in terms of the real estate sector. This means that there is a lack of clarity in pertinent policies."

But Puri also believes those issues will soon fade away as India's real estate markets mature. "Although real estate is a regional and highly location-specific industry, India will replicate the events that occurred in emerging markets like Mexico and Central Eastern Europe [including Russia, Bulgaria and Poland]," he says. "In these countries, too, foreign investments were the primary drivers for transparency, accountability and higher capital appreciation in the real estate sector."