Real estate market – is it heading south?

Chennai: The real estate industry had a decent run during 2007 with market witnessing upbeat demand for products across all segments – office space, residential, retail, etc. Naturally, corporates managed to garner good realisations. Enthused by their success, a positive sentiment reflected in the IPO market, where major real estate companies raised around Rs 14,600 crore during the last year.

The scene was no different in the private equity space, where real estate (or realty) topped the list of all PE deals by value. But that was 2007. Year 2008 has begun on a subdued note. Buyers are waiting for prices to fall further as sellers are waiting for the downturn to be temporary. Home loans getting costlier hasn’t helped, neither has inflation. Property Plus talked to Mr Venu Gopal, Associate Director and Mr Ganapathiraman, Associate Vice President part of Transaction Advisory Services, Ernst & Young.

They feel projects having a limited time frame of 2-3 years may face a crisis. However, they also note that any project having a life of 5 years and above may not be affected in the long run as the current slowdown in the market is temporary. They advice landowners to be cognisant of the fact that markets are slowing down and it is surely not what it was in the last 2-3 years. “In the given circumstances, land owners looking for an exit in the immediate future should be moderate in their price expectations otherwise they may find it difficult to justify their valuations,” the experts feel. For more insightful advice, read the email interview…

Edited excerpts.

What do you think are the major factors affecting the real estate market today?

To understand that, one has to be aware of the six angles from where real estate developers are facing the problem. Firstly, high land prices combined with increased input prices (steel) makes the product costs high. The result: the developer has to face slowing down of sales and shrinking margins.

Secondly, significant supply hitting the market at the same time (in suburban areas) creates pressure to sustain competition. Naturally, there is a decline in booking and advances from customers as they go into a ‘wait-n-watch’ mode. The developer is hit again!

Thirdly, rising inflation has made the central bank proactive. The hikes in Cash Reserve Ratio as well as other monetary measures have had a telling effect on the money available for lending. No doubt, lending rates have also risen. This has made the borrower shell out a higher EMI for home loan. The sidekick comes in form of a pronounced decline in bookings. The developer is at the receiving end.

Fourthly, bank funding for real estate projects is becoming tough due to stringent norms laid down by RBI. Coupled with volatile capital market conditions and private equity investors exercising caution, funding routes for developers have dried up. The result – the developer who wants to create properties but doesn’t have the funding has to stall plans for the time being.

The fifth factor is surrounding the confusion over extending tax benefits to Software Technology Parks of India (STPI) units and the ensuing slowdown in leasing activities of non-SEZ space.

Lastly, the developers are also suffering from the gloom in the financial world. Factors such as sub-prime fears, crude oil shock, global slowdown fears, liquidity crisis and sloth in FII inflows have engulfed the minds of many businesses; real estate is no different.

What is the reason behind the sudden slow down in residential bookings as witnessed in the last few months?

Specific segments of the suburban/peripheral areas are showing signs of a slow down in residential bookings in the last few months. Major reasons that one can attribute is significant supply (targeting premium / high end segment) hitting the market, increase in housing loan interest rates, unaffordable prices even for the customers of the target segment etc.

To explain this further, let’s consider the case of Old Mahabalipuram Road (OMR). Located on the southern outskirts of Chennai, where significant residential developments are in progress targeting the workforce employed with IT/ITES companies in and around Siruseri, which is estimated to be around 1,00,000 by end of the 2008.

According to internal research done by Ernst & Young, currently almost 20 residential projects, under different stages of development on and off OMR, are selling in the range of Rs 3,000 – Rs 4,500 per square feet. Effective cost per unit for a customer is anywhere between Rs 40 lakhs and Rs 1 crore — depending upon other factors like unit size, floor level, car parks, club house facilities offered etc.

Here comes the conundrum. Developers are clearly targeting a miniscule lot of the total target population. Almost all the residential developments are catering to only 16 per cent of the target population. Even for the junior management category, an investment of close to Rs 45 – 50 lakhs (which is the approximate price range) with most of the current projects, becomes unattractive / unaffordable.

Will the current scenario have an equal impact on the developers?

We feel that the current slowdown in the market is temporary and any project having a life of 5 years and above may not be affected in the long run.

However, projects having a limited time frame of 2-3 years may face a crisis depending upon factors like Floor Space Index (FSI) land cost, sustainability of the developer to hold on to the stock and the prices, fund availability for completing the development, cost of servicing the debt, pressure to meet investor returns (if any) etc.

A slowdown in the customer advances (from what was projected earlier) means money available for funding the resultant gap, has become a serious concern now. That money will decide the fate of several projects, which are currently under development. The market may also witness a consolidation phase, whereby small developers unable to meet their commitments may exit the project in favor of major developers.

What should be the ideal strategy to be adopted by developers in the current scenario?

Developers can look at the possibility of smaller unit sizes, cutting down on special features (like providing club house facilities, swimming pool etc.) and target the segment which can afford a budget of Rs 30 – 45 lakhs.

Developers, who were hitherto planning to fund their projects through customer advances, can look at the option of raising private equity (assuming that the project is already leveraged) to fund the development.

However, in the present scenario the developers will have to be reasonable in their assumptions and strike a deal that will be a win-win situation for both the parties.

Does the scenario dampen the mood for private equity investors / real estate funds?

Real Estate Funds / Private Equity investors still have a huge scope for investment in the Indian real estate market. In the current scenario, PE investors / RE funds will be keen to look at entity level funding to spread the risk across projects and asset classes.

In case of specific projects, investors may tend to be conservative and may not favour an opportunity entailing promoter to cash out on their investment (unless the exit route for the investor is adequately provided for). They would also be comfortable in looking at opportunities that offer a minimum guarantee / preferred return structure on their investments, promote structures where the promoter will be eligible for a higher share of the cash flows after achieving the minimum return expectations of the investor.

What is your advice for land owners? Should they hold or sell in the current scheme of things?

Land owners should be cognisant of the fact that the markets are slowing down and it is not what it was in the last 2-3 years.

In the given circumstances, land owners looking for an exit in the immediate future should be moderate in their price expectations, otherwise they may find it difficult to justify their valuations.

Alternatively, if they believe that valuation is much more than what is being offered, they can look at the option of doing a joint development with the prospective investor. Even in such a scenario, the joint development ratio offered by the investor is expected to be conservative and it finally boils down to the keenness shown by either party to close the deal.

Nevertheless, the land owners can always hold on to the asset and develop it at the most opportune time.

Do you see any emerging opportunities for developers in the immediate future?

The current real estate boom can be mostly attributed to the phenomenal growth witnessed in the IT/ITES industry in the last 3 – 4 years. Most of the residential developments were high end premium apartments/villas targeting the IT/ITES crowd.

Now with IT/ITES market slowing down, developers can look at avenues of catering to the significant demand emanating from the manufacturing sector – develop projects that can cater to the Rs. 15–30 lakh budget segment.

Telecom/industrial corridors like Sriperumbudur, Oragadam will witness tremendous potential for such developments over the next few years. Increasing manufacturing activity has also increased the demand for high-quality warehousing space. It is estimated that around 200 million square feet of warehousing space will be required to meet the demand over the next 5 years.

Developing warehousing/logistics parks requires lesser investments, when compared to commercial projects and will help the developer to earn a reasonable return on their investment.

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