Over the years, several investors including domestic HNIs, NRIs and institutional funds (both domestic and foreign) have actively flocked to the real estate sector in India in search for superior returns. And deservedly so, as prudent investments made into this sector have time and again delivered substantial returns.

Since the liberalization of the Foreign Direct Investment (FDI) framework for real estate investments in India through Press Note 2 of 2005, the sector has witnessed large amounts of investments & capital inflows. By certain estimates, as much as ~$15 bn – $20 bn has been invested in this sector alone over the last 5 years. Given India’s growth story, emergence of a young and working middle class, rise in income levels and availability of end buyer financing, it has been relatively easy to sell the Indian real estate story atleast in power point presentations and excel models.

Almost 6 years have gone by since the first round of foreign investments and its thus about time we take stock of the situation and see how things have actually panned out. A closer look at things will revel that much to the dismay of investors (both foreign and domestic), their investments made into the sector have by and large not yet delivered the 20%+ IRRs as were expected. In this article, we take a closer look at ground realities across the various real estate asset classes (including residential, commercial, hospitality and retail) and share some thoughts on which of these asset classes are more likely to actually deliver real returns to investors in the future.

Residential Sector: The residential sector has proven to be the most resilient through the ups and downs of the previous financial crisis and the slowdown thereafter. Most of the demand drivers for real estate in India eluded to in the above paragraph such as rise in income levels, nuclearization of families, penetration of cheap home financing (yet no where near sub-prime conditions as was witnessed in parts of the western world) etc. are actually playing out in reality across various Tier I and Tier II cities in India. According to market data from PropEquity, almost 90% of all residential product that is built across major Tier I and Tier II cities in India (including Mumbai, NCR region, Chennai, Bangalore, Calcutta, Hyderabad, Pune and Ahemdabad) is sold. Furthermore almost 65% of all residential product that is currently under construction has also been sold (pre-sales)! Such high levels of sales and absorption bear testimony to the fact that the investment opportunity in the Indian residential real estate sector is actually quite real and will most likely continue as long as the demand drivers remain intact. Ofcourse, pricing does tend to be cyclical in nature as typically whenever sale volumes increase, developers leave no stone unturned in raising their prices. Subsequently, a noticeable increase in price then deters the home buyer from making purchase decisions leading to a decrease in sale volumes. And finally once developers realize that their sale volumes have dried up, they reluctantly drop their prices or offer clever financing schemes to lure the aspirant home buyer thereby once again kick starting the buying frenzy. While such cyclical movements in prices will continue to play out in the future as well, structurally atleast, the residential real estate sector in India will remain a favorable asset class going forward.

Commercial Sector:  A drive through key commercial pockets of most Tier I and Tier II cities such as Andheri & Bandra-Kurla Complex (BKC) in Mumbai, Whitefield in Bangalore, Hinjewadi in Pune, Old Mahabalipuram Road (OMR) in Chennai and Gachibowli in Hyderabad will shed light on prevailing high levels of oversupply in the commercial / office sector. One can easily identify several vacant floors in fully constructed office buildings or half finished and abandoned construction sites meant for commercial use. Had it been a handful of such projects or reasonable levels of vacancy, one might have disregarding this oversupply as a temporary phenomenon. However in certain Indian cities the oversupply levels is large enough to satisfy demand over the next 4 – 5 years based on current and historical levels of absorption.

So how did things go so horribly wrong for the commercial sector? Well, most of these projects were conceptualized during the golden years of 2006 – 2008. Developers (aka “FSI maximizers”) got lured in by FSI enhancing schemes such as the IT policy and the SEZ framework and opted to build commercial space without any understanding for demand and supply. A closer look at the demand side of the equation will revel that upto 70% of commercial space demand in India comes the IT/ITeS sector. Unfortunately clients in this sector, by and large, have no affinity to one particular location and typically seek to minimize their real estate costs. Given such harsh ground realities investors will do well to ignore the commercial sector for the time being, barring perhaps a trophy asset located in a prime CBD of say Mumbai or Delhi which might deserve a closer look.

Hospitality Sector:  On a macro level, the hospitality business is typically a business of famine and feast. When times are good and the economy is booming more people want to travel for both business and for leisure. However, when times are bad, travel budgets are the first to be cut back. Historically it has been seen that growth in the hospitality sector as measured by growth in RevPAR (revenue per available room) is closely correlated with growth in GDP levels. Thus on a macro level atleast the future for the hospitality sector in India looks bright. While the luxury segment within the hotel space is well catered across most India cities there is indeed a compelling opportunity within the mid-market and budget segments.

That said, this sector might not be for all investors as hotel developments are typically highly capital intensive and only deliver returns over longer periods of time. Additionally, prohibitive cost of land in most Tier I and Tier II cities, makes it difficult for investors to justify acquisition of land at today’s market prices for development of a mid-market / budget hotel from the perspective of ROE maximization. Thus even though there is a clear longer term opportunity within the hospitality sector in India, such greenfield investments may be available only to existing land owners who own land at a historical purchase price. That said, investors can always look to acquire existing hotels however there again very seldom do we find hotel owners in India who are ready to part with their hotel asset at valuations that would make sense to any financial buyer.

Retail Sector: The retail sector is one of the most misunderstood asset classes within real estate in India. Given the rising levels of disposable income for the middle class and modern Indian’s ever increasing propensity to consume, several industry pundits proclaimed that investments made into the retail sector (including malls and shopping complexes) would be good bets in India. Several developers went on to build large amounts of retail mall space across several Tier I and Tier II cities during the 2006-2008 era. However much like the commercial sector, large amounts of this retail space currently sits vacant.

So what went wrong here? People ignored the fact that planning and development of retail malls is a science by itself which requires careful understand of consumer behavior and how the consumer makes purchase decisions. Developers and planners in India, having burnt their fingers in previous retail related ventures are only now bothering to understand and implement this science. Hence, unless the investor brings to the table a strong background in the organized retail sector, it would be best to ignore this sector for the time being as it is still nascent and largely misunderstood in India.

(Vaibhav Jatia is the Managing Director of Rhythm Realty, a real estate development company engaged in residential and hospitality related developments in and around Mumbai. He was previously working in the real estate private equity industry in India as an investment professional first with Lehman Brothers (LBREP) and then with Westbrook Partners. Vaibhav graduated from the Wharton School of Business at the University of Pennsylvania.)

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