Indian Real Estate on a growth path

THE INDIAN ECONOMY

In 1991, the Government of India initiated a series of major macroeconomic and structural reforms to promote economic stability and growth. The key reforms were focused on implementing fundamental economic reforms, deregulating industry, accelerating foreign investment and pushing forward privatisation programs in various public sector operations. Partly as a result of the reform program, India’s economy has recently registered significant growth, with GDP growth of 9.4% over the year ended March 31, 2007. The following table demonstrates the growth in real GDP since 2001.

OVERVIEW OF REAL ESTATE SECTOR IN INDIA

The term “real estate” connotes land, including the air above it and the ground below it, and any building or structures on it. It covers residential housing, commercial offices, trading spaces such as theatres, hotels and restaurants, retail outlets and industrial buildings such as factories and government buildings. Real estate involves the purchase, sale and development of land and residential and non-residential buildings. The activities of the real estate sector encompass the housing and construction sector as well.

The Indian real estate sector can be divided into the organised and unorganised segments. The unorganised segment accounts for the majority of the housing units constructed. The organised segment consists of private real estate developers and government or government-affiliated entities.

The industry is highly fragmented with most of the real estate developers having a city-specific or region specific presence. The unorganised sector comprises small builders and contractors, who primarily construct houses on a contract basis with individuals. Real estate developers in the organised sector are actively considering townships, multiplexes and shopping malls as future projects to drive their business prospects. Regional real estate players dominate the industry because there are no strong national players in the sector. Some of the developers in Pune are Kumar Builders, Magarpattacity, Panchshil, Runwal Group, Vascon and Paranjape Schemes, while developers in Bangalore include Sobha, Purvankara Developers, Mantri Builders, Brigade, Prestige and Adarsh.

Most established players in the industry fund their projects through promoters’ contributions and intra-group loans. The developer’s ability to sell a large portion of its project in advance enables the projects to be largely self-financed, even at an early stage. The developer’s reputation also plays an important role in influencing the selling price of the projects. Secondary information on the financials of developers is generally not available. However, according to industry sources, the margins on a residential property vary, depending upon the location of the project, the amenities provided and the developer’s reputation. Amenities have an impact on construction costs, while the location of the project affects land costs and selling prices.

Industry Characteristics
The real estate industry in India has the following characteristics:
􀁺 Capital Structure: Presently, most real estate companies are closely held companies. Construction activities are often funded by the client, who typically makes cash advances at various stages of construction.
􀁺 Leasing is an option for commercial properties: Unlike the residential properties (which are sold outright), commercial space is either leased or sold outright. Under the leasing option, the rent received from tenants form a source of recurring cash flow for the developer. Additionally, the property rights remain with the developer, enabling the property to be disposed of subsequently, if required.􀁺 Contingent Liabilities: Due to project-based work, real estate companies often carry substantial contingent liabilities in the form of guarantees in order to comply with specific client requirements. 􀁺 Development Risks: Profitability of each project is subject to risks of mis-pricing, conditions adverse to the real estate market, geological conditions, management of specification changes and the outcome of competition with rival real estate companies.
􀁺 Credit Risk: The strength of clients from whom the receivables are being generated is important. Real estate developers usually secure project advances from clients to keep them committed to the projects.
􀁺 Approvals required for real estate projects: A number of approvals are required from regulatory authorities for real estate projects.

CURRENT SCENARIO & FUTURE OUTLOOK

The real estate sector in India has assumed growing importance with the liberalisation of the economy. Developments in the real estate sector as a whole are being driven by: 􀁺 Increasing demand for more housing units in cities and towns because of growing urbanisation of the Indian population, a burgeoning middle class, increased disposable income, easy availability of housing finance at cheaper rates and tax incentives;
􀁺 Increasing demand for office space from the growing IT/ITES industry, especially BPO;
􀁺 Increasing demand for shopping malls from the growing retail segment;
􀁺 Increasing demand for multiplexes from the evolving entertainment sector; and
􀁺 Increasing demand for hotels and resorts from the growing tourism industry and business travellers.
􀁺 These factors are also present regionally in the Pune and Bangalore real estate market.
The Residential Sector

India continues to face an acute shortage of housing units. Based on the 10th GoI Five Year Plan (2002-2007), the housing shortage is estimated at approximately 22 million units. The prime reasons behind the growth in volume in the housing segment are population growth and urbanisation. Further, there is a boom in the organised urban housing segment extending to relatively prosperous rural belts. The census of 2001 indicates an urbanisation rate of 27.78%, which is expected to go up to 41% in the next 20 years (based on a population of 1.35 billion by 2021). This growing trend of urbanisation together with factors like faster growth in incomes in the middle and higher income categories, the decline in EMIs due to the fall in housing finance rates and the availability of tax incentives on housing loans are increasing the need for housing units in cities and towns. (Source: 10th Five Year Plan (2002-07))

The cost of housing as a multiple of the annual income of buyers has come down in recent years mainly because income levels have risen, while tax rates have fallen. With less tax and more income there is a greater surplus of money for people to spend. Moreover, even though interest rates have shown signs of increasing in recent months and most of the leading financial institutions have recently raised interest rates on loans, (Source: RBI First Quarter Review of Annual Statement of Monetary Policy for the Year 2007-08 dated July 31, 2007), prevailing interest rates remain lower than previous historic levels.

Aided by additional factors such as the increase availability of housing finance and favourable tax structures, the housing segment is expected to grow as shown in the table below. (Source: CRIS INFAC) In volume terms, the number of houses added by the middle and higher income housing groups, a category referred to as the urban-pucca-non-slum (UPNS) segment, which was estimated at 1.6 million in Fiscal 2005,is expected to grow at a CAGR of 4.1% and increase to approximately 1.93 million by Fiscal 2010. Similarly, the declared spending on new houses in the UPNS segment, which was estimated at Rs.1,718 million in 2004-05, is expected to grow at a CAGR of 18.60% to Rs. 4,034 billion in Fiscal 2010. (CRIS INFAC Annual Review on Housing Industry, January 2006)

The demand drivers in the residential segment are:

Changing demographics and growth in disposable incomes: Changing demographics and rising disposable incomes have spurred demand for real estate in India. Urban population has increased from approximately 220 million in 1991 to 290 million in 2001 and is expected to continue to grow at a similar pace. By 2013, India is expected to add 91 million people to the working population (aged 25-44 yrs). Over the next 20 years, the working age population is projected to grow at 1.9% per annum. (Source: Ministry of Urban Affairs, Government of India).
Favourable economic environment has led to a change in the income distribution pattern with an increasing concentration of families in the middle and higher income groups. Rising income levels and greater job creation, particularly in sectors such as business process outsourcing and insurance, is also resulting in enhanced demand for quality housing.

Shift in consumer preferences from rentals to home ownership: Due to the changing demographic profile in India, there has been a steady decline in the proportion of households staying in rented premises over the years. To a certain extent, this change may be attributed to the rising income levels of the population. However, with fewer properties available to rent today and an increase in the rent charged, consumers have found it more prudent to invest in property. An upward movement in the standard of living and increased availability of housing finance are expected to fuel this trend toward a declining proportion of households staying in rented premises. (Source: Cris Infac Annual Review of Housing Industry, January 2006)

Shrinking household size: The joint family system in India is gradually giving way to nuclear families. Factors such as increasing urbanization and migration for employment opportunities are expected to cause a decrease in the size of the average Indian household. Given India’s increasing population, the contraction in the size of the average household offers a positive outlook for housing demand.

Fiscal Incentives: Another major contributing factor in boosting the growth of residential housing property is income tax incentives on housing loans.

The Commercial Segment:
The commercial real estate market in India has evolved in response to a number of changes in the business environment. The IT/ITES/BPO sectors have been the drivers of the commercial real estate demand in the country. Large space requirements by the IT/ITES/BPO sectors have led to real estate growth being spread beyond the chief business locations to the suburban and peripheral locations of major cities. As a result, over recent years, locations such as Pune, Bangalore and other cities such as Gurgaon, Hyderabad, Chennai and Kolkata have evolved and have established themselves as emerging business destinations, increasingly competing with the traditional business destinations of Mumbai and Delhi as far as commercial real estate occupancy is concerned. The key to the growth of these destinations has been their ability to provide the necessary human resources base with the required skill sets, competitive business environment, operating cost advantages and quality of urban infrastructure offered.
It is expected that India will continue to be one of the preferred destinations for setting up back office operations. Consequently, the growth in the sector is expected to translate into substantially higher demand for commercial space, adding to the overall investment in real estate activities.

Investment in commercial construction is expected to increase threefold over the next 5 years from Rs. 408 billion in Fiscal 2007 to Rs. 1,179 billion in Fiscal 2011 as shown in the table below. Investments in the commercial segment are likely to be driven by office space projects, which are expected to go up from Rs. 737 billion over the next 5 years compared to Rs. 174 billion worth of investments made over the previous 5 years. Within office space construction, 70-75% of the demand comes from IT/BPO/call centres. Other key demand drivers include banking and financial services, fast-moving consumer goods (FMCG) and telecom. This dependency on IT/ITES is expected to continue due to India’s emergence as a preferred outsourcing destination, despite the emergence of China and Russia as strong contenders. Hospitals are expected to generate total construction demand worth Rs. 267 billion over the next 5 years. (Source: CRIS INFAC CONSTRUCTION REVIEW: MAY 2007)

The Retail Segment
The increase in disposable incomes, demographic changes (such as the increasing number of working women, who spend more, the rising number of nuclear families and higher income levels within the urban population), the change in the perception of branded products, the growth in retail malls, the entry of international players and the availability of cheap finance will drive the growth in organised retail.

Movement towards smaller cities
India has four major metropolitan areas: Mumbai, Delhi, Kolkata and Chennai. Initially, most retail players launched their ventures in these metros. However, recently, the retail phenomenon is spreading to smaller metropolitan areas and smaller cities. Players are entering these cities early to gain a first-mover advantage, that is, a larger customer base and a higher share of loyal customers. Over the past few years, these cities’ share of organised retail has been growing steadily.

Of the total malls space expected to be available by 2010, Mumbai, Pune, NCR (including Gurgaon, Noida, Greater Noida, Faridabad and Ghaziabad), Bangalore and Hyderabad will have a major share. The balance will be made up by less developed cities such as Kolkata, Chennai, Ahmedabad, Jaipur, Nagpur, Lucknow, Indore, Ludhiana and Chandigarh.

Rising income levels and a changing outlook towards branded goods is expected to translate into higher demand for shopping mall space, fueling strong growth in mall development activities. CRISIL research expects an investment of Rs. 176 billion in organized retailing over the next 5 years (1). Even though mall development activity was initially restricted to a few major cities like Mumbai and Gurgaon, it is now expected to extend to other cities like Surat, Pune and Ahmedabad, thus causing increases in real estate activity in those cities. (Source(1): CRIS INFAC CONSTRUCTION REVIEW: MAY 2007)

Hotels
The increase of disposable income in the hands of an upwardly mobile Indian middle class has led to a growing propensity to spend a larger portion of income on tours and travel. This factor, coupled with the changing lifestyle of the Indian population, has created demand for quality hotels across India. In addition, India is also emerging as a major destination for global tourism and business travel, which in turn is increasing the demand for hotels across India. This increasing demand for hotels across India is offering another opportunity for real estate development.

The Hospitality industry is witnessing significant changes in its dynamics with increases in both tourists and business travellers to India. As per the World Travel and Tourism Council, 2006 (“WTTC”), India’s travel & tourism industry was expected to grow 8.4% in 2006 and by 8% per annum, in real terms, between 2007 and 2016. WTTC has also recognized India as one of the emerging tourism markets having the potential to earn US$24 billion in annual foreign exchange through tourism by 2015.

With the industry having been expected to grow at 8-9% in 2006, the number of business travelers to the country was also likely to increase. (Source: Central Statistical Organisation)

CHALLENGES FACING THE INDIAN REAL ESTATE SECTOR

􀁺 Lack of national reach of existing players. Considering the peculiar features of the real estate sector such as the differing tastes of population across various geographies, difficulties with respect to mass land acquisition in unfamiliar locations, absence of business infrastructure to market projects in new locations, wide number of approvals to be obtained from different authorities at various stages of construction under the local laws and the long gestation period of projects, most real estate developers in India are regionally based and active in areas where the conditions are most familiar to them. As a result, currently there are very few players in the country who can claim to have a national area of operations.

􀁺 Majority of market belonging to unorganised segment. The Indian real estate sector is highly fragmented with a disorganised segment made up of the small builders and contractors, who account for a majority of the housing units constructed. As a result, there is a lesser degree of transparency in dealings or sharing of data across players.

􀁺 Demand dependent on many factors. A challenge that real estate developers face is generating the requisite demand for the properties constructed. The factors that influence a customer’s choice in property is not restricted to quality alone, but is dependent on a number of other external factors, including proximity to urban areas, amenities such as schools, roads and water supply, each of which are often beyond the developer’s control. Demand for housing units is also influenced by policy decisions relating to housing incentives.

􀁺 Increasing raw material prices. Construction activities are often funded by the client, who makes cash advances at different stages of construction. In other words, the final amount of revenue from a project is pre-determined and the realisation of this revenue is scattered across the period of construction. A significant challenge that real estate developers face is dealing with adverse movements in costs. The real estate sector is dependent on a number of components such as cement, steel, bricks, wood, sand, gravel and paints. As the revenues from sale of units are pre-determined, adverse price changes in any of the raw materials directly affect the bottom line of the developers.

􀁺 Interest rates. One of the main drivers of the growth in demand for housing units is the availability of finance at low rates. Interest rates, however, have shown signs of increasing in recent months and most of the leading financial institutions have recently raised interest rates on loans (Source: RBI First Quarter Review of Annual Statement of Monetary Policy for the Year 2007-08 dated July 31, 2007). This trend of rising interest rates may dampen the growth of demand for housing units.

􀁺 Tax incentives. The existing tax incentives available for housing loans are one of the major factors influencing demand. These tax incentives, however, based on recommendations of various committees and panels, are likely to be withdrawn.

Source: RHP of Kolte Patil Developers Limited