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RealtyRealityInsights for Real Estate and Infrastructure industry leadersA newsletter under Grant Thornton Insights series | Issue 5Grant ThorntonINSIGHTS Series
About Grant Thornton Insights SeriesGrant Thornton Insights Series brings to you a set oftri-annual thought-leadership newsletters such as:• Aspire: Insights for dynamic business owners• India Ahead: A snapshot of emerging economic and business environment in India• HealthScope: Insights for Healthcare and Life Sciences Industry leaders• RealtyReality: Insights for Real Estate and Infrastructure Industry leaders• TechEdge: Insights for Information and Communication Technology Industry leadersThis series of publications draws on our industry expertise,clients‟ experiences and our commercial know-how. Itdiscusses the underlying issues, challenges, and industry andmarket dynamics that impact Indian businesses over mediumto long term.More about RealtyRealityPublished tri-annually by Grant Thornton India, RealtyRealityis a thought-leadership newsletter focused on providingleading-edge insights on the Real Estate and Infrastructureindustry of India.Acknowledgement: Neeraj Sharma & Misbah HussainEditor: Vikram Jethwaniwww.wcgt.in/publications
PrefaceThe weakness in global economy has created In other cases, however, lenders are selectivelyconsiderable levels of distressed real estate in a ignoring the issue in order to avoid writing down loannumber of markets around the world. In all but a few values, which would potentially compromise theirlocations, reduced economic activity and growth own balance sheets and capital adequacyprospects have led to falling rental incomes, collapsing requirements. In effect, these institutions areproperty values and construction projects being put essentially hoping that the economy will right itselfon hold. and their loan portfolios will recover without the need of significant additional capital injections into theThis in turn has turned many previously „performing‟ bank.commercial real estate loans and investments into„underperforming‟ or „non-performing‟ assets. Banksand other lenders are increasingly being exposed tothese assets.This situation is further complicated by the reality thatmany lenders are themselves in varying states of"distress", and are trying to resolve their portfolios ofdistressed loans. Faced with significant regulatorypressure, banks are tightening lending criteria,reassessing loan to value ratios, and trying to shore uptheir RE&C loan portfolios in order to preserve theirown financial independence.Some banks have become less willing (and possiblyunable) to negotiate better terms from the perspectiveof the distressed asset holder. RealtyReality | 4
"Though many observers believe that the recession officially endedin the summer of 2009, most industries, including commercial realestate, continue to feel its effects. CRE industry fundamentalsremain subdued and according to industry estimates, no meaningfulrecovery in the West, can be expected soon. This is not surprisinggiven that the CRE industry usually lags behind the generaleconomy by 12 to 18 months. The extent and timing of upswing inCRE will largely depend upon geographic market and asset class." Vishesh Chandiok National Managing Partner Grant Thornton India RealtyReality | 5
Global landscape The US: • As per industry estimates, over US$1.4 trillion of debt in real estate assets will become mature by 2014, creating immense pressure on banks for coming up with solutions to resolve troubled loan issues. • This scenario can have a delimiting effect on the recovery of the US economy, owing to the pressure on banks to sell loans at a price lower than their face value, in order to prevent losses. • Driven by the assumption that valuations will increase in 2011, Real Estate Investment Trusts (REITs) will begin to look out for opportunities to acquire properties, including the distressed properties, at reduced prices. The UK: • UKs CRE market continues to show signs of weakness with occupier demand falling in negative territory. • Lenders will be under pressure to find ways to resolve their troubled loan portfolios due to the wave of debt maturities. Brazil and Mexico • Property prices in the country will become stable, owing to the normalisation of the supply and demand balance. attracts most of the FDI in Latin Americas CRE market RealtyReality | 6
Global landscape Russia: • It is expected that demand in the commercial real estate sector will increase marginally, owing to the reduction in vacancy rates. • In the overall realty sector, warehouse and retail are expected to clock the fastest growth. • The sector is likely to attract sizeable investment; especially in the the high-quality small to medium size property segment. Brazil: • For the next two years, Brazil, being the host of the 2014 FIFA World Cup and 2016 Olympics, will continue to attract huge investments in the hospitality sector. • An export-led boom along with surge in household incomes, entry of new conglomerates and the increasing trend of opting for better- placed or more attractive office spaces are the reasons that will drive the demand for commercial property in the near future. • Demand for real estate will also be impacted by the recent legislation reform establishing increased lines of credit to the local mortgage market as well as consumer finance. RealtyReality | 7
Global landscape China: • Though China, like all other BRIC economies, show resilience, its real estate market is not completely insulated from the global pressure. • As the opportunities for investing the bulk of domestic savings remain bleak in the country, real estate will continue to remain an attractive avenue for investment. • Affordability has decreased marginally due to the bleak financial situation of the local government, which is widely in debt after being handed billions of Yuan in bank loans. India: • Banks have reportedly increased risk weightage on CRE financing. Real estate companies may face cash flow pressure, while they replace low-cost debt by high-cost finance. • Developers would be more receptive to new and more collaborative lease models, in acknowledgement of tenants concerns. • Metropolitans may not witness growth in rentals, however, properties that enjoy strategic locations in Tier 2 and Tier 3 cities are expected to register a relatively higher rate of growth in rentals and capital values, in the next 2-3 quarters. RealtyReality | 8
Commercial real estate: headwinds in India However, the industry is about to face a post-recessionAs per media reports, the Reserve Bank of India has paradigm, which it has never seen before. The recoveryexpressed concerns on escalating real estate prices and following the 2001 recession is not a good benchmark becauseadvised banks to keep a stringent check on loans toCRE companies of late. In order to regulate risks and access to capital may be much more severely constrained. Themake loans expensive, banks have reportedly increased lending market will probably be flooded with demand, whilerisk weightage on loans to developers. higher loan-to-value ratios, tighter credit standards and an uncertain securitisation market may limit refinancingAmidst this scenario, developers who have already opportunities.initiated their projects now have no choice but toborrow from non banking finance companies at interest Interest rates are currently at historic highs, and anyrates ranging from 16-20%, private lenders at 20-35%, further increase in these rates will not only impact theand private equity firms at 25-35%. This is turn has profitability but also the viability of many CRE projects nowstarted putting pressure on developers and the entire teetering on the brink. Those who are unprepared for the shiftmarket at large. in the industry may find themselves battling for scarce capital — even as they struggle against competitors that tookThe various players in the CRE industry are in a stalemate of advantage of the downturn to prepare for the recovery.sorts. Not enough buyers for CRE assets currently exist,especially if one excludes the so called vulture investors. The Therefore, time is of the essence. CRE companies have alending community is delaying foreclosure procedures and sale limited window of opportunity during this industry downturnof real estate-owned properties because of depressed values. to make important changes that will affect their futureThese factors foster an environment of stagnation in the performance and viability. All new initiatives should beglobal CRE industry, due to which companies may be tempted evaluated based on their cost versus long-term valueto limp along and simply survive. contribution. The urgent need today is to take forward- thinking actions that will drive future growth.
Commercial real estate: headwinds in IndiaTop 5 challenges for CRE companies in 2012 Interest rate hikes 43% Inflationary pressure 23% Cost of construction 22% FDI & FII inflows 7% Skilled manpower With a view to figure out the top-5 challenges for CRE companies in 5% 2012, Grant Thornton India conducted a survey covering more than 100 CRE developers and dealers in the National Capital Region RealtyReality | 10 (NCR), Mumbai and Bengaluru. The response from the participants has been collated as above.
“In tandem with the global economic environment, the commercial realestate sector is in a phase of consolidation. Both real estate developersand investors are evaluating their current strategies and futureexpectations.Nevertheless, challenges and opportunities are going hand-in-hand:coping with interest rate hikes and inflation; protecting profits whilecontinuing to invest; leveraging vibrant domestic economy; seizinginternational opportunities; differentiating products and services; retainingand attracting talent; and cultivating stronger relationships with lendersand fund managers.Success in real estate business largely hinges on how you navigate thesecomplexities, while retaining investor and buyer confidence, andmaximising stakeholder returns.” David Jones Partner and Practice Leader – Real Estate Walker, Chandiok & Co. 11
Making ways through panic stationsAmidst the situation of uncertainty in the global economy and Strong financial analysisweak cues in the domestic market, Indian real estate Developing a financial forecast of continuing and future rentaldevelopers need to evaluate their options for renegotiating revenues, complete with cost analysis and identification ofloans. To do so effectively, they need to have a thorough opportunities to reduce costs could help formulateunderstanding of their own financial position as well as strategies to control pressure.that of their lenders. Tenants are typically required only to disclose a minimalIn order to face multi-pronged pressure from the market, financial picture, and property owners are faced with a lack ofdevelopers shall consider the following: visibility into current and future rent/revenue streams. Some RE&C owners display poor record keeping with respect toPortfolio stress-test loan covenants and hence, risk that they are, or will be, inFor Indian real estate developers, it is the need of the hour to breach.assess the severity of financial condition, on the spectrumranging from potential risks to major problems, both current Negotiate terms, consider re-financingand future. Developers shall consider assessing their lender‟s ability to negotiate terms and, if appropriate, consider proactivelyIn particular, these tests should look at risks of major negotiating with the lender, prior to breaching loan covenants.tenants leaving or going bankrupt, any co-tenancyagreements and exposures, and the industry outlook for the Considering options for refinancing also helps in avoidingvarious types of tenants currently occupying the properties. the risk of foreclosure. Some of the options to be considered include extending the term of the loan, restructuring their credit, or improving management of the property to accommodate the needs of tenants who are also facing financial difficulties. RealtyReality | 12
Making ways through panic stations Stress-test In-depth Re-negotiate portfolio financial terms analysis examine exposure to risks Multi-pronged market pressures forecast realistically re-visit loan covenants re-negotiate with lenders consider re-structuring improve management, prevent leakages RealtyReality | 13
Strategic framework for Indian CRE companiesIn the current market scenario, it is advisable that CRE Conformer (low value, high costs)companies map the universe of available actions on a Actions in the upper left quadrant are costly tocost-value matrix that has two dimensions: the long- implement and have minimal long-term impact. Theseterm value added and the short-term costs incurred. actions often relate to problems, which should have beenActions taken by the company will fall into one of the addressed previously, such as weak or dysfunctionalfour quadrants: information and control systems, a lack of discipline in executing agreed upon plans, and inconsistencyMyopic (low value, low costs) of the cash management system with the stakeholderActions in the lower left quadrant are not costly to requirements.implement, but they have low (and in extreme cases,negative) long-term impact. One example of this kind of Highactivity is leasing to risky tenants in order to boost short-term occupancy. Similarly, companies often slash capital Conformer Forwardspending and selling, as well as general and Short-term costs thinkeradministrative costs, without analysing the long-termimpact of their actions.A company should avoid taking actions that decreaselong-term value and should minimise low-impact Myopic Cherryactions that may distract management from pursuing pickerstrategic initiatives. Low Low High Long-term value The four quadrants of action for CRE companies RealtyReality | 14
Strategic framework for Indian CRE companiesCorrecting these problems in a shortened time period Forward thinker (high value, high costs)can be costly in terms of both time and dollars. Actions in the upper right quadrant are costly toCompanies carrying out actions that fall in this quadrant implement but have high impact. Most of these actionsshould attempt to move towards more meaningful, demand the use of resources — capital, time, labour —higher-value initiatives that yield more results at the same without offering short-term returns. Examples includecost. strategic capital investments such as the reconfiguration of leased space, new or redesignedCherry picker (high value, low costs) marketing programs, and strategic acquisitions andActions in the lower right quadrant are not costly to divestitures.implement, yet they have high long-term benefit.Examples include a review of portfolio performance, Unsurprisingly, not all companies are willing — or evendisposition of noncore assets, cash generation able — to make large investments, particularly during ameasures, and a reduction in overhead and period when global signs are weak. But it‟s important todiscretionary capital expenditures. remember that even though these actions do not yield immediate results, they do have the potential to set theBecause these actions are the corporate equivalent of business apart from its competitors.low-hanging fruit, a company must assume that itscompetitors are drawing advantage from its actions. Anycompany that strives to be more competitive mustconsider investing additional resources in initiatives,having the potential to transform it into a marketleader. RealtyReality | 15
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