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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Shall I invest in commercial properties with 12% assured returns scheme in India?

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

Recently in the month of May 2014, the managing director of Vigneshwara Group and two of his family members were arrested for multi crore alleged fraud. What was the fraud? Well, the group is in the business of real estate. Ohhh…real estate…yea, most of the frauds happen in this sector only. In this case, the group had received money from investors (around 700 of them) for commercial office space properties in Gurgaon and Manesar. What was the selling point of this group? This group isn't a household name like DLF, or Unitech. So, what was the selling point which brought in these many investors? Well, the selling point was ‘12% assured return on investment, till the possession of the property’. So, if an investor invested about 1 crore rupees for 1000-1200 square feet of office space, then he/she will continue to get 12 Lacs rupees per year as investment returns till the property is handed over. And the builders normally in India claim to handover the property in 3 years.

However, Vigneshwara Group despite taking money from around 700 investors for properties in and around Gurgaon in 2006-07, and promising assured returns till possession, the group allegedly didn't begin construction of some projects and defaulted on payments to investors. And that was the reason "The three members were booked under sections 420 (cheating), 406 (breach of trust), 120B (criminal conspiracy) and 34 (common intent) of the IPC".

On the surface, the 12% assured return is not a bad deal. For an investment of Rupees 1 crore, one would get 36 lacs rupees back in 3 years as assured returns. And at the end of 3 year period, the property is handed over which can be leased to earn decent income. And of course, there will be capital appreciation gains as well. So, on the surface, it looks a good deal.

However, as is the case in life, one needs to scratch the surface to fully comprehend the deal. Let’s do it here:

Why do real estate developers come up with such fancy schemes?

1. Bank money is not available or is very expensive: What do you think? The builder did not try to raise money for the project through banks or formal channels? Yes, of course, he did…but the money was expensive, i.e. @ 17 or 18%. And he found the easy goats in form of unsuspecting investors who have plenty of cash with them.
2. These schemes ensure project is sold off at early stage: Real Estate is a risky business, but a builder is always carrying out financial engineering calculations to make sure his interests are safe. When a developer launches a new project especially in commercial category, he wants to play it safe and sell the project to investors along with the incentives of schemes like 12% assured returns. Selling a residential project is rather easy because of demand in India; however, selling a commercial project takes financial engineering skills.
3. Lack of other funding options: Why can’t builders raise money from other sources such as Private Equity funds or other institutional funds? Well, all these funds carry out comprehensive due-diligence before investing in any project. And the due-diligence process also involves supply-demand analysis for the commercial property along with builder’s track record, etc. And based on their analysis they decide not to invest in such projects if supply of such kind of property is high or demand is low. Because at the end of the day, the commercial property will be valued on the basis of monthly income it can generate once leased.

Why do builders fail to deliver?

Well, all is not lost for investors who invest in such projects provided builder delivers on his promises. But a real estate developer seldom delivers on his promises and that’s why these issues of fraud and money laundering keep on sprouting every now and then.

Why do builders fail to deliver? ‘Greed’ is word that best describes the failure of the builder to deliver on time. Having successfully launched and sold the commercial project on the back of 12% assured returns scheme to fallible goats, he begins to start acquiring land parcels for new projects with similar schemes.  If one project can be successful, why can’t other projects be successful? And in doing so, he diverts funds received from first project to acquire land parcels. The construction progress of first project is delayed, and there is no money left to pay the assured returns as well.

If the builder has remained disciplined, the 12% assured return scheme would have worked. But that is a Utopian scenario.

Are schemes like 12% assured returns good for investors?

1. Stay away from such schemes if you are a first time investor.
2. If you have propensity to invest in real estate and can carry out due-diligence, then one can consider such schemes. Due diligence involves carrying out supply-demand analysis, builder’s track record, income levels of the people in the city, etc. It is a challenging task and one should look at if banks or institutional funds have invested money in the project or not? These banks or institutional funds will not invest money in any project without carrying out the due-diligence.

Good Luck with Real Estate Investment!

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The rise of India’s commercial real estate market

While talks about the residential real estate sector have got people gripped, commercial property is not far behind. Thankfully, good days have returned for office real estate property in India, with lots of domestic and foreign companies looking for space and many businesses in expansion mode. Bangalore being the prime location for office spaces, many companies are purchasing apartments in Bannerghatta road Bangalore and converting them into office spaces.

• Change in government

One of the most stabilizing factors is last year’s general election and that was one of the reasons behind the upswing of the real estate. It brought with it new confidence in the country’s economic development. Though, the country witnessed uncertain times in the first quarter of 2014, and market morale was low, sentiment improved gradually following the elections. Apart from buying apartments in Bannerghatta road Bangalore, the city of Mumbai, for example, witnessed 65 per cent appreciation in average deal sizes between the second quarter of 2014 and the second quarter of 2015.

The growth of the real estate sector can also be attributed to expanding businesses, especially due to India’s emergence as an attractive offshore destination. The government’s decision to introduce incentives to attract foreign investors plays a role. Also, the availability of a large pool of highly skilled technicians and engineers, customer-friendly banks and housing finance companies, the country’s favorable demographics, and increasing purchasing power. Increasing professionalism among real estate brokers is also cited as an advantage.

• The big three cities

Major shares in the profit are gained from tier 1 cities such as Bengaluru, Mumbai, and New Delhi. These cities are technological, commercial, and political hubs respectively. According to a survey, these cities even outperformed global commercial property market when it comes to annual rental yields. The Indian office market has been maintaining a healthy traction in 2014 and has clocked office space transactions of 18 million square feet in the first six months of 2015.

It is a record year for Bengaluru, which is expected to transact office space to the tune of about 12 million square feet in 2015. The three cities have also endured the largest individual transactions in the sector, with big corporations and expansive start-ups such as Flipkart and Snapdeal picking up a lot of office space. Some of them are purchasing apartments in Bannerghatta road Bangalore and expanding them to set up their offices. And with the growth in office activity, other commercial spaces follows suit, particularly retail, as well as hospitality due to increasing demand for lodging in the trade hubs from business travelers.

• REITs on their way

The Real Estate Investment Trusts (REITs) is expected to come up with a future boost. However, due to some legal barriers, the scope of taxation proceeds from such trusts remains unresolved. Foreign investors will be allowed to buy units. It will help reduce pressure and stress on the banking system to fund the real estate sector as REITs will enable the industry to propose fresh equity by attracting long-term finance from domestic and foreign investors. The Indian REIT sector is expected to give a further push to commercial real estate and is tipped to attract investments. So far, REITs worth a total of $20 billion in assets are mainly focusing on Grade A office space and parks, logistic space and warehouses, malls and shopping centers, hotels and other commercial space.

Today, the potential of the Indian real estate sector is enormous, but there needs to be a clear solution with regards to REIT taxation. Among other trends, there's been a steady growth of the commercial sector, which is favorable for organizations.







This is a guest post by Deepak Yewle

Commercial office market shines in real estate sector

Although the residential market continues to dip, stable lease rentals, high absorption levels, worldwide investor’s interest and insufficient supply have paved the way for commercial real estate market.

Unlike the disintegrated residential sector, a few distinguished developers, with the support of investors, are building quality office spaces in the central cities.

The chief operating officer of JLL India said, “While demand for good quality office space remains high, absorption will be lower this year because there isn’t adequate supply in the market. Also, demand is high but relevant supply, which depends on location and other advantages, is restricted. We expect the sector to continue to do well.”

As per the property advisory CBRE, Bengaluru is riding high on the demand and the supply of office space and the vacancy level of its office buildings is the lowest. In Pune region, the scarcity of good supply has led to many people showing interest in Grade B buildings as well. One of the worst hit areas was the National Capital Region, grabbing only 37% of the 5 million sq. ft of office space or leasing.

Post the economic dip in 2008, many builders ceased to invest in capital-intensive projects and started showing interest in the residential market. The next few years saw many large apartment projects, resulting in a glut. The market, therefore, experienced a slowdown in the year 2012-2013.

The leading developers in building office projects are RMZ Corp, Embassy Group, Panchshil Realty and DLF Ltd. Most of these names have the support of global investors. Over 80% of the commercial office spaces are occupied by information technology (IT) and IT-enabled services (ITES) clients, the left ones are for the e-commerce firms and banking and financial services.

Panchshil Realty, backed by Blackstone group has added 5 million sq.ft of a new area in Pune for three projects. The Panchshil Reality Chairman Atul Chordia said, “We lease around 1.5 million sq. ft. office space every year, so we just have to keep building because the demand is high.”

DLF doesn’t have any residential launch this year, but the largest developer of India as per the market value plans to cover two-three million sq.ft office area in its lease/rental portfolio. The real estate giant seeks to repeat its success in developing a nearly 30 million sq. ft commercial portfolio over the past decade.

DLF has begun to work on a 2 million sq. ft office project in Gurgaon this year and is also going to cover 1 million sq.ft of the IT Park in Chennai. Chennai is seeing an investment from DLF in the commercial market, and increased investment in apartments in Chennai OMR by the House of Hiranandani.

K. Raheja Corp group based in Mumbai is also planning to spend about INR 2000 crore in purchasing land and building 6 million sq. ft of office space in the area of Navi Mumbai.

Vinod Rohira, the MD, and chief executive of commercial real estate and REIT, K Raheja Corp said,“ Growth and consolidation, particularly in the IT and ITES sectors, are driving the demand for big commercial office spaces. Demand for commercial real estate is growing at 20-22% on a year-on-year basis,”

The year 2016 is likely to observe two massive private equity investments in the commercial sector. While DLF is in the course of selling a 40% stake in its lease assets arm to get about $2 Billion, another $1 Billion investment is being invested by Brookfield Asset Management Inc. to purchase the office and reality assets of Hiranandani Developers in suburban Mumbai.

Like the developers switched focus to the residential market post the financial crisis of 2008, the commercial office projects are gaining popularity now. Some developers are rearranging their portfolios to build more office spaces.

Bijay Agarwal, MD of Salarpuria Sattva Group said, “While entry barriers are low in residential and there are too many developers, office development is not easy and as a result, we have a few serious developers building good projects,”

This is a guest post by Deepak Yewle