The problem with space

Can the real estate boom survive this lethal combination of slow delivery of projects and inflated prices?

The Indian real estate sector has shot into global prominence. Largely unorganised, it is championed by two large conglomerates, DLF and Unitech, followed by smaller players 8212; Indiabulls, Parsvnath and Ansal Properties. DLF8217;s chief promoter, Kushal Pal Singh, was recently inducted to the club of rupee trillionaires. The emergence of the sector was endorsed by the Bombay Stock Exchange, when it launched the BSE Realty Index on July 9. Today, the total market capitalisation of the sector is about 50 billion.

In the past two years, global funds have raised 20 billion to invest in the sector. In addition, 3 billion was raised through domestic IPOs, 1 billion by domestic funds, and 1 billion through the Alternative Investment Market AIM on the London Stock Exchange. Also, real estate development companies have highly leveraged balance sheets and continue to tap the debt markets. Based on these numbers, we will see an influx of at least 30 billion in the next 6-7 years. Real estate companies and global funds are aggressively raising money, luring investors with the prospect of rampant growth.

Is the Indian real estate story a farce? The World Population Report 2007 states that India8217;s population in urban areas will expand from 30 per cent at present to 40 per cent by 2030. The effect is compounded by rising disposable incomes, access to capital, trend towards nuclear families and a young population. Consequently, the demand for residential, commercial and retail space is set to rise. There is a compelling and indisputable case in favour of the sector. Yet, the surge in the stock prices and valuations these companies trade at seems unrealistic. Are analysts and investors pricing in the risk to the sector adequately? Are we being swept away by the heightened sense of euphoria displayed by the developers?

The execution capability of the developers and price instability caused by excess supply undermine the enriched valuations of companies. Having amassed large land banks, developers now confront the challenge of converting their acreage into square footage. Developers are suggesting a ramp up of between 10-15 times from their existing execution levels. This will not be easy, and requires clear titles, a slew of licenses, a ratcheting up of the labour force. It is crucial to determine if the developers can deliver on their assurances. DLF has executed 29 million square feet since its inception and says it will deliver 600 million square feet by 2015, implying 75 million square feet every year for the next 8 years. Similarly, Unitech has executed 7 million square feet since its start and now promises to deliver 500 million square feet by 2015, implying 40 million square feet every year for the next 8 years. These numbers seem highly over ambitious!

Let us assume that the developers do manage to execute their projects on time. We then need to evaluate if there is an existing market to absorb this quantum of supply. An industry study revealed that the top 10 organised players will develop about 1.5 billion square feet over the next 10 years. Assuming 50 per cent of the market is unorganised, a total of 3 billion square feet will be developed. This implies a supply of 300 million square feet annually. Bear in mind that additional developers are entering the market and will add to the supply bucket in the future. This flow of development could lead to a sharp correction in property prices that have run up sharply in the past two years.

The current rental rate for the office space at Nariman Point is Rs 400/square foot 8212; an astonishing 400 per cent rise since August 2005! Admittedly, this is prime commercial space but the price rise is disconcerting nonetheless. Are these rates sustainable or is this a case of asset inflation caused by bull markets? A recent report by Knight Frank suggests that 8216;residential values across the country will remain under pressure and going forward some market may witness a correction to the tune of 15-20 per cent over the medium term8217;. Retail companies complain of high lease rentals and slow execution of projects implying muted growth and elevated costs. This lethal combination of slow delivery of projects and inflated prices is affecting the entire spectrum of residential, commercial and retail space.

The writer is director of Indusino Advisors, an FII consultancy