Cyclical nature of commercial real estate

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

This post deals with commercial real estate in India. For the last 2 years, one would have noticed that most real estate developers and private equity funds have focused their energies on development of residential real estate across India.

Why did this happen? Why did real estate developers in last 2 years solely focus on residential real estate? Well, the answer lies in global economic slowdown. Due to global economic slowdown, companies started to lay off employees and there was freeze on investment in new projects. And all of this resulted in lack of demand for commercial office space by companies. Due to lack of demand of office space, developers ignored the commercial real estate and that has resulted in tight supply of office space.

And now that, economy is starting to show signs of recovery, there is again demand for office space and therefore it is pushing up the prices of commercial real estate. So, the situation now is – demand is increasing but supply is tight. And in this condition, rentals are bound to go up.

Why does this happen? Why do we sometimes see oversupply of commercial real estate and sometimes tight supply? It is because of the cyclical nature of the real estate industry. Some underlying facts regarding the commercial real estate are:

1. It is a very large market and it is highly competitive
2. Ownership of commercial real estate is highly fragmented across the country

Why does commercial real estate development follow a cyclical pattern? During the boom time, when local real estate developers and investors sense that vacancy rates are declining and rents are rising, they believe more development may be feasible. Consequently, developers begin to analyze markets to determine if additional space, if developed, can be leased profitably. Because many competing developers may sense this opportunity simultaneously, they may all begin to develop at once in order to satisfy the demand. Even though there may be a definite need for additional space, the potential for over-development will exist as each developer rushes to deliver additional space to the market before competitors. There is no way to determine exactly how much space should be developed because the depth and extent of demand are difficult to predict. As a result, commercial real estate is sometimes said to be prone to periodic cycles of over-development.

One would have seen during the 2004-2008 boom time in India, when plethora of shopping malls came up in Mumbai, Delhi NCR, Bangalore, Chennai, and other economic centers in India. Because there was demand for retail space, developers jumped up and created an oversupply of malls across India. The important point to notice is that it is very difficult to predict the exact demand and therefore oversupply will happen in commercial real estate.

On the other hand, when economy is going down and growth is shrinking, developers may ignore the development of commercial real estate because of lack of demand from companies. However, as soon as, economy picks up, the tight supply of commercial real estate again pushes up the rentals and vacancy rates starts to fall.

And the cycle continues like this. There will be periods of oversupply and there will be periods of tight supply.

Let’s analyze this diagram above.

1. When economy is in recovery phase, the demand for commercial real estate increases which reduces the vacancy rates and rentals go up. 
2. Seeing the fall in vacancy rates and improving rentals, developers start developing the additional space. Rentals start to cool off because there is supply of additional space. 
3. However, because it is difficult to predict the actual demand, the oversupply of space is seen in the market. Rentals fall.
4. Increasing vacancy rates and falling rentals drive away the developers from developing the commercial real estate and supply is tightened.

One full cycle takes 5-6 years and all the 4 steps mentioned above repeat themselves.

With this in mind, can you time the market as far as investment is concerned??

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Can I time the real estate market?

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

During the period of 2003 to 2008, property prices appreciated sharply. Land prices almost tripled in most parts of the country on account of faster job creation, urbanization, and rising income levels. Were these the only reasons for sharp appreciation? No, say the experts. According to them, real estate is a cyclical industry and at the beginning of the last decade, real estate prices were at their nadir. The coupling effect of sharp GDP growth and cyclical nature of the real estate industry resulted in a sharp appreciation of property prices from 2003 to 2008.

However, as the world financial crisis hit the world economy in September 2008, the GDP growth of most emerging economies started to dwindle. India was no exception and government & RBI brought in policy measures. In fact, the advent of the global financial crisis in 2008 caused a resurgence in Keynesian thought. Interest rates were lowered and government-provided stimulus (total spending in the economy) to boost the economy. At one point in time, RBI’s repo rate came down to a low of 4.75% in April 2009.

The impact of the financial crisis was severe in the real estate market. Some of the large real estate developers started offering a discount to the tune of 20% in 2008. The sector began to recover on account of government policy initiatives and the lowering of repo rate. However, massive government spending and low-interest rates during the period of 2009-2011 resulted in inflationary pressures. And the focus now shifted to tame inflation and thus interest rates started to go up and that resulted in a decrease in investment by individuals and companies.

In the last 2 years, real estate transactions including office space absorption and home sales have come down. The prices have stagnated in most micro markets.

With this in the background, can you, the real estate investor really time the market? It’s highly unlikely; however, one can pay attention to the real estate investment strategies, demand drivers, and supply elements.

1. Real estate investment strategies

2. Demand drivers

Following are demand drivers for the real estate sector

• Industry

This is a no brainer; even my grandmom would say prices would appreciate more in cities/markets where there is all the likelihood of work or jobs creation or setting up of industries. Therefore, as an investor one should regularly visit the city development authority’s website and analyze the city’s master plan. A master plan would ideally comprise the road map for the city's development including the setting up of industries, educational institutes, recreational zones, and residential development. At the same time, pay attention to the news which highlights the setting up of a particular industry in your region. For example, the driving industries in Gurgaon are Auto and IT, and setting up these industries in the 80s and 90s has resulted in a real estate boom in the city.

• Population growth

Growth in population requires the development of housing. Other societal changes such as the rise of nuclear families, the movement of skilled workers from other parts of the country again require the development of housing. Analyze the population growth in your city by following census reports along with indicators for urbanization.

• Income levels

It’s true that setting up an industry in your region would result in direct and indirect job creation which will lead to a variety of real estate development. However, pay attention to what kind of industry is this? And what are the income levels of people in your region? For example, real estate prices in Gurgaon have appreciated more because of high-income levels of people in the city as opposed to say Bhiwadi (primarily a manufacturing town being developed under the Make in India program) where income levels are low.

3. Supply elements

Following are the supply elements that affect the real estate sector:

• Interest rates

As explained above, interest rates have a direct impact on the supply of real estate. High-interest rates bring down the overall supply. On the other hand, low-interest rates encourage investment by both individuals and companies.

• Land availability

Again one should look at the city’s master plan for availability of land. If land supply is limited, it is a good indicator that real estate prices will shoot up faster than expected. And if there is plenty of lands available with the city development authority; it will mean price appreciation will be linear. For example, in Delhi, due to limited land parcels, property prices appreciated sharply. However, now, DDA has initiated the land pooling policy and has demarcated new land parcels. It is now expected that the availability of this new land will put pressure on existing property prices in the city and city outskirts. Raising the FSI/FAR can also result in the softening of property prices. Track those developments.

• Physical and social infrastructure

One should also pay attention to the existing supply of physical and social infrastructure in the city. In certain cities such as Greater Noida, physical infrastructure is in excellent shape. But property prices have not appreciated sharply. This is because social infrastructure which includes industrial development is minimal.

Equilibrium

As long as supply and demand are in equilibrium, the returns from real estate investment will be linear. Therefore, as an investor, one should look for distortion in demand and supply curves. If demand is expected to be higher than the supply, it calls for investment in real estate to make windfall profits. If supply outdoes demand then it will yield low returns on your investment. 

Can I time the real estate market?

No, it’s not possible to gather data to time the real estate market. Instead, one should solely focus on 3 broad ideas as explained above and only then one should make a bet on real estate investment.

Did you follow these 3 principle ideas for real estate investment?

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Reasons why NRIs prefer investment in Indian Real Estate over stock market, NRE/NRO accounts, and bonds

Author: Sachin Gupta | Find me on Twitter Follow @sach_gupta

Continuing with the discussion about Non Resident Indians and their propensity for investing in various investment classes, we recently conducted a survey among NRIs and asked the following question:

“Fall of rupee opens up new vistas for NRIs to invest in India. Which asset class is more likely to see increased investment activity?”

About 43 people responded and 27 chose real estate as the preferred investment asset class, the second preferred choice was NRE/NRO account with 12 people opting for it.

What could be the possible reasons for these results?

Also, have a look at our research report showing returns on investment classes such as real estate, gold, bond, and stocks.

• Volatile stock markets

Let’s face it. For last 2 years, the stock markets have been volatile to say the least. With growth slowing down and investment climate at its low due to poor policy making on part of the government of India, investors are looking for assets that are less risky. Unless, the investment climate gradually improves, we may continue to see retail investors abandoning stock markets and invest in relatively risk free asset class such as real estate or bonds.

• Low returns on bond markets

Bonds are risk free and therefore, returns are lower. However, bonds continue to provide stable return over a period of time and many prefer stability over high returns. With volatile stock markets, Indian investors are either preferring real estate or bond market. Non Resident Indians have been no exception to this rule.

• Rupee depreciation

In last 2 years, rupee has fallen substantially. This presents NRIs with an opportunity to invest in Indian real estate. Because of falling rupee, real estate looks attractive to NRIs and they are able to get property at almost 20% discount. For example, if one were to invest rupees 1 crore in commercial real estate such as Office Space in Gurgaon or housing in Chennai, he/she would have paid about 200000 USD. And since the falling of rupee, the same real estate would cost 170000 USD to an NRI. This is a major factor why real estate prices are still not coming down in India despite the sluggish demand at home. With money flowing in from NRIs, real estate prices are stable, if not appreciating.

• Family considerations

For people living abroad, there is the comfort factor that some of their relatives either parents, siblings are in India. And this leads them to buy a piece of real estate, which can be used in times of need for parents or siblings. Many also cherish the dream of returning to India one day and investment in real estate gives them the luxury to come back without worrying about housing or relocation.

• Hedge against inflation

Real estate has always been a preferred investment destination for Indians. It not only provides them with the availability of land or housing, but at the same time hedges ones savings against inflation. With low interest rates offered in deposit accounts, many prefer locking their money in real estate in order to hedge against inflation.

Our research shows that of all the various kind of investment vehicles, returns on gold and real estate have yielded better results over a 6 year period.

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