Sourav Goswami, Managing Director
Walton Street Capital India
After the excesses of investing at dizzying valuations throughout 2007, many of us in the Indian real estate private equity arena are now taking stock of where we are and where we are going in the year ahead in 2008.
The year 2007 was a banner year, with estimates of more than US$5 billion (Rs20,050 crore) of foreign funds flowing into projects sponsored by rapidly growing developers.
Another theme for the year was initial public offerings. With the DLF Ltd listing energising the market, several developers proceeded to go public in India, creating a robust marketplace for retail investors to participate in the growth story while also offering ability for promoters and investors to project forward into yet another exit strategy. This is expected to be broadened in 2008 with the advent of the Reit (real estate investment trust) structure, which market participants hope will create more tax or structurally efficient structures for yield-oriented investors to participate in the real estate market. In most markets, the Reits offer pass-through vehicles which allow rental incomes to be distributed as dividends and taxed in the hands of the individual investors rather than at the corporate level. The final structure of Reits in India, including ownership structure, portfolio weightage and tax treatment, is still being debated.
Several challenges also emerged throughout 2007 – rapidly rising prices of commodities, currency fluctuations, interest rates rising by 250 basis points over the year (in India) and the global spectre of the credit crisis – all managed to put fund managers on defensive footing towards the end of the year.
Now, as we stand in 2008, the picture has never been murkier. With fears of a looming (if not already in place) US recession putting the brakes on a long period of global growth and its resultant liquidity, a choppy market seems to be ahead. In recent weeks, several high-profile IPOs have been put on hold, creating concerns of pricing and the ability to list for several developers with private equity-backing which had anticipated public offerings in 2008. Among fund managers, some will view the turbulence as an indication to restrain investing in historically volatile emerging markets. Others will view it as an opportunity to deploy equity into Indian markets, which still show some resilience.
In any case, as international real estate investors determine their strategy for 2008, it seems that four key trends are emerging that will help shape the strategy for many fund managers.
One, there is an increasing amount of attention to execution risk and physical underwriting. In the flurry of deals that occurred in the trailing 12-18 months, the velocity for decision-making created an environment that encouraged cutting corners. Sometimes, timelines and costs were plugged into Excel models, and the numbers being generated were viewed as sacrosanct. Excel is a wonderful tool, but that is all it is – a tool. But now funds are taking greater care to analyse the execution risks of a proposed project with careful input from in-house civil engineers, architects, quantity surveyors and research professionals. This is increasingly important as projects are being delayed due to a dearth of qualified project management companies to provide oversight in the development process.
Two, funds are looking to blend the risk profile of their investments by coupling execution and timing risk with price and valuation risk. Funds may look at investing in a suburban township, in which case the basis on the land is low and therefore the pricing risk is mitigated. However, such a project is typically larger in terms of square footage and requirement of new infrastructure, and would require phasing and more diligent project management. Such an investment might be coupled with a core investment in a city centre, where although there is greater price risk in terms of concentration of value (high floor space index or FSI cost; FSI defines the area of building that can be developed on a particular piece of land), the ability and time to build are greatly reduced.
Three, funds are increasingly looking to invest in mixed-use development projects, whether in townships or in integrated high-rise buildings in CBD (central business district) locations. Investors have found that there are synergistic benefits to having different asset types co-located. For example, proximity of retail and office can drive revenues in a hotel while also boosting residential pricing.
Finally, funds have begun to syndicate large transactions and partner, rather than compete. Much of this is driven by a pragmatic approach towards underwriting – the old adage of “two sets of eyes are better than one” has become a mantra as firms realise that the amount of due diligence needed in Indian development deals can require the efforts of multiple teams. Another significant benefit is that such sharing of deals allows collaborative fund managers to diversify risk among several transactions while also avoiding valuation escalations, which are sure to arise from competition. It helps that the real estate fund community is fairly tight-knit, with long-standing friendships among many members of various deal teams.