Head of Real Estate Services, Published May 16, 2016
Regulatory changes, easing entry barriers set to offer regular returns.
A few years ago, hoardings across Mumbai offered the last pieces of a green haven, just a hundred kilometres away from the metropolis. Non-Resident Indians (NRIs) were targeted with retirement homes and artistically designed dwellings that replicated well known western tourist destinations.
Years later, when a few chose to visit the locations, the picture at ground zero was a contrast to the promise communicated through glossy brochures. In fact, NRIs have always faced issues such as unclear land titles and dubious builders while dealing in India. This, however, is going to change.
Prospects for NRIs to invest in India’s domestic real estate market have brightened with the Real Estate Regulation & Development Bill getting approval in both houses of the Indian Parliament. This follows the Indian government’s recent move to accord further clarity to tax and entry-exit structures for Real Estate Investment Trusts (REITs), making the investment process more credible and transparent.
From every perspective, Indian real estate looks far more alluring for NRIs now. With most of the entry barriers to participate in Real Estate Securities like Alternative Investment Funds (AIFs), listed Non Convertible Debentures (NCDs) and FDI platforms (now being fairly relaxed in terms of area, amount and repatriation), NRIs can easily participate in structured realty investments in India. However, since NRIs have been waiting on the sideline to purchase immovable properties, they also ought to be aware of the right opportunities, procedures and limitations related to this sector.
Indeed, the Indian real estate sector has shown a fair amount of speculative growth in recent years with high supply and higher vacancy in metros across commercial and residential assets. Yet, timely delivery of the property remains the ultimate concern for all buyers. With the present enhancement in the regulatory environment, development risks will significantly reduce. Further, a rapid development of the infrastructure and a timely possession of real estate, especially homes, will assuredly enhance the long-term interest and confidence of NRIs.
Within residential properties, rental yields in India have hovered around 1%-2% in the last 2-3 years in contrast to 4%-6% in London, Singapore, Hong Kong, Dubai, etc. But the appreciation has been in the range of 6%-12% depending on the city, taking the average return over 10%, year on year. There are many examples wherein the debt(home loan) adjusted own-equity returns are in range of 15%-25%till date. As such, schemes that involve paying 10%-20% of the value upfront and the rest on possession (with or without the loan) will further put pressure on the developer to deliver on time.
Yet, there is merit in breaking investments into multiple assets (if not across multiple cities) to get the best possible hedge in overall investments.
With the Indian currency still remaining weak against the US Dollar and the British Pound, and property prices in these regions at near stagnant levels, NRIs have been seen showing active interest in Indian assets. Particularly those involving the commercial real estate segment which offers various asset classes such as small offices, IT/ITES spaces, malls, warehousing, high-street retail, private schools, etc. Pre-leased properties have emerged as a highly attractive asset class among NRIs. Unlike residential properties, commercial/IT spaces in India have been fetching a net yield of 8%-9% (post expenses) per annum.
However, recent research shows that prices for commercial real estate have clearly bottomed. For the first time in decades, capital values (rates per sq.ft.) for commercial and IT spaces are 15%-30% below residential property prices in the same vicinity, purely because commercial real estate has transformed itself from a mere speculative opportunity to a highly fundamental-driven investment option.
Simply put, appreciation in such assets is currently being pegged with its yield growth over the years. These trends are ideal for a REIT format – considered to be the most sophisticated investment vehicle in prime pre-leased properties globally (provided we have a fair tax and fees structure).
We foresee a yield of over 8% to be a certain hot pick. Such an appreciation will be driven by the escalation in rent and rent alone. As long as there is a lower vacancy in Category-A buildings of a city’s business district, the rent will only rise frequently, thus enhancing the overall return ranging between 10% and 16% for a 2-3-year horizon.
With pre-leased investments, it is vital to consider the quality of the tenant, fit-out costs incurred, market trends for monthly rentals, and the ongoing capital values (per sq. ft). In case a tenant incurs high fit-out costs (ranging from Rupees 1,500 to Rupees 2,000 per sq.ft. on the carpet area basis), there is a strong intent to stay on at the same premises for at least five to six years. This is because the opportunity cost of the capital invested and depreciation benefits are too significant for the lessee to consider a relocation, even if rents are 20% less in another location.
A pre-leased asset is often preferred for its higher yield, strong book value and superior leverage-generating opportunity. In fact, pre-leased assets have always been transacted for the right yield and a pre-identified appreciation since it is dependent on a timely escalation of rental income.
As discussed earlier, entry barriers to the opportunistic high yielding funds have eased up further, making them more secure, and realistic in valuations than before. Yet, if anything can go wrong, it would be the overall market absorption or the timely delivery of projects due to uncertain approval processes. Thus, one must consider the opportunity in light of complete sanction plans and a minimum of 20% sales.
Having said that, from an overall investment perspective, ready residential properties in prime and non-prime locations in metros as well as pre-leased assets with a moderate net return horizon (between 9%-10% per annum) can be considered for their lower risks.