The Hindu Business Line : Crunch time for players, opportunity for buyers

None in the real estate sector can be completely immune to the effects of the current situation; developers may have to therefore think hard before deciding on the phasing and pricing of their projects.

— Paul Noronha

Developers face sky-high challenges.

Ramesh Nair

While we have been living with the credit squeeze for several quarters now, September was a bizarre month in the global financial markets, with every day bringing one financial catastrophe after another. A number of global financial institutions went bankrupt or were forced into mergers or were rescued by governments.

Real estate and financial markets are closely linked the world over, and so, these financial developments will definitely impact the Indian realty market.

This financial meltdown is expected to further lead to a pullback of debt, resulting in lower transaction velocities and cap rate (capitalisation rate is the ratio of net operating income produced by an asset to its capital cost or market value) expansions. In projects where the developer has received funds, there may not be much to worry.

However, in cases where the term sheets have been signed and funds are yet to come, the developers could find themselves in trouble.

The effect of crisis

The events of the last few months will further curtail credit availability and market liquidity, impacting the real estate markets. Already, in the last few months, many private equity funds have started insisting on 25 per cent plus IRR deals.

It is also expected to lead to dramatic reduction of investment sales volumes. Yields are expected to further rise by 50-75 basis points. The credit situation is also affecting lending to corporates, which are increasingly delaying commitments to real estate. Banks and institutional lenders are capital challenged and underwriting will become a lot more rigorous. Loan-to-value ratios may decrease and banking spreads could widen.

Some banks are in a dilemma whether to fund even creditworthy developers given their own fund crunch. This will lead even creditworthy developers to cut back on investing in new projects. Some developers who lack access to new funds could also sell their assets at distressed values.

Many occupiers today are in space and cost control mode and many corporates will ‘renew’ rather than ‘relocate’.

Prices are not, however, expected to drop drastically, as many sellers are still only ‘stressed’, and not yet ‘distressed’.

As development finance and construction costs have increased dramatically, the quantum of construction is expected to marginally reduce. With a number of software companies relying on US financial services firms for business, office demand is expected to come under pressure. After four years of rapid growth, rents across most realty asset classes may slow down.

Changed circumstances

Four years ago, in the Indian real estate market, development was restrained, vacancy across asset classes were low, inflation was low, and most real estate demand-supply fundamentals were strong. Thanks to this environment, we saw record levels of transactions each year from 2003 to 2006. Residential values increased 50-75 per cent a year and yields fell from 12 per cent to 9 per cent. Also, high amounts of low-cost debt and private equity became available leading to significant increase in construction activity across the city.

Over the last five years, entry barriers have been low and a lot of new developers have entered the Indian real estate market. But with the complete change in the macro scenario, developers need to figure out their competitive advantage and differentiation strategy and not diversify into all asset classes where they see a deal.

The ongoing financial pressures may also prompt anxious sellers of real estate to lower their price expectations and complete sales at realistic market prices. From a private equity funds’ point of view, funds dependent on global capital may be forced to renegotiate on the catch up percentage (a higher proportion of profits received during a limited time is called catch-up period), hurdle rate and management fees with their investors.

Funds will also be choosy and look for quality assets which are smaller, more prime and with strong credentials in prominent areas.

Long-term growth

However, no financial trend continues forever. The housing prices in the US markets ought to stop declining sooner or later, thus bringing about some stability. A number of new regulations governing the financial sector are expected to be announced in the US with the elections over.

Real estate is a cyclical market but definitely has long-term underlying growth. Unlike in the US, no significant defaults in home loans, triggering massive fall in property prices, is expected here as a majority of Indians still buy homes for self-use and the banks have stringent lending norms. Also, even as there is a drop in property prices, the prices remain far higher than what they were two years ago.

The brighter side of the crisis is that the current market poses an opportunity for cash-rich buyers to buy assets at reduced prices. Potential buyers need to realise that if one buys and holds for the long term, one isn’t likely to lose. Real estate values have generally gone up in the long run, with very few exceptions.

(The author is Managing Director – Chennai region with Jones Lang LaSalle Meghraj.)