India's urbanisation drives valuation boom

July 2008 - Cash-rich international pension funds are queuing up to invest in India’s booming real estate market. And who can blame them? With an estimated population of 1.2bn, India is the world’s second most populous country and the largest democracy. Its population is expected to surpass China’s within the next 25 years and it will move to third position after the US and China in terms of total GDP.

But perhaps the biggest thing the country has going for it is the huge trend towards urbanisation. While almost 70% of Indians live in rural areas, migration to larger cities in recent decades has dramatically increased the country’s urban population. Urbanisation will add more than 150m people to India’s metropolitan population over the next 10 to 15 years, according to Indy Singh, managing director of Fiducian Portfolio Services.

Those moving up the ladder to become consumers would see their per capita income rise from €3,100 to €16,600, he adds.

This heightened prosperity is fuelling consumption and putting pressure on the country’s infrastructure, particularly in such populous cities as Mumbai and Delhi. “[The people moving to the cities] all require housing, office space and retail malls so we are undersupplied in every segment of real estate,” says Anshuman Magazine, chairman and managing director of CBRE South Asia.

As the supply imbalance pushes retail and office rents skywards, institutional investors are rightly chasing a piece of India’s real estate pie. The government opened up the market for foreign direct investment (FDI) in real estate in 2005 and since then there has been a flurry of activity from private equity, hedge fund and pension fund investors.

Mercer has responded to growing interest in investment opportunities in India by opening an office this year in Mumbai. Rashmi Mehrota, business leader for investment consulting, India, says Australian superannuation funds are eyeing the Indian property market as part of their unlisted exposure to assets such as real estate and infrastructure. “They’re looking at India as part of their unlisted allocations rather than their Asia-Pacific allocations, so it doesn’t matter where the underlying investment might be,” she says.

“I know that some of the Indian real estate funds have started pitching to Europe as well as Australia.”

Most fund managers offer vehicles that allow institutional investors to invest in ‘green field’ or development projects. With the exception of hotels, foreign investors cannot buy existing assets in India so are forced to invest indirectly via funds and fund of funds, or establish a joint venture with a local partner on the ground where they can leverage each others’ capabilities.

“The local player’s expertise comes in aggregating land, getting all the approvals and then doing the construction and development, while the capital is provided by the foreign investor,” Magazine explains. This is the route that ABP, the €208.9bn Dutch pension fund, is likely to adopt when it makes its imminent foray into the Indian real estate market.

Patrick Kanters, managing director real estate, Europe and Asia Pacific, at ABP, says joint ventures allow the fund to invest larger amounts of capital and align its interests with local players that have not yet set up a fund. “It allows us to set up more focused strategies rather than broad strategies, so perhaps a focused single-country sector fund or niche categories that might not be interesting for a broader market fund,” he says.

“As a large-scale investor we are interested in certain niche categories like senior living and healthcare, where those categories are still at a very early stage.” Hospitality and healthcare are two areas where foreign investors are not required to be compliant with FDI regulations.

The regulations, along with a lack of core, investment-grade real estate, mean institutions are forced to take development or opportunistic positions.

But despite its limitations, the opportunities in the property market are abundant and the underlying fundamentals point to continued positive returns. The high savings rate should underpin strong growth in GDP over coming years, while favourable demographics mean around 50% of the population are under 25 years of age.

“We have a proper legal system, which few developing countries can boast, and we have established regulatory bodies,” Magazine says.

“Bureaucracy - which can be a hurdle at the same time - is well entrenched, so there’s a rule of law and it’s an English-speaking country. Of course, we also have one billion people, 300m of whom are middle class, so the biggest plus is that, in the next few years, we will have another 100m people coming into the consumption stream and, with the exception of China, no other country has that sort of long-term consumption demand.”

The market capitalisation of the Indian real estate sector currently stands at more than US$6bn.

Kang Puay-Ju, deputy fund manager for AIPP Asia and AIPP Asia Select at Aberdeen in Singapore, says, while India is still by and large a development game, the fund management market - though not necessarily the underlying real estate market - has deepened considerably.

“There has been a flurry of fund offerings, initially by the usual suspects and then by more and more local players and boutique firms,” she says.

Mehrota at Mercer believes India best lends itself to high-risk, high-return investments, which is the area most pension funds are targeting. “Mumbai is considered one of the most expensive markets in the world for office space. There is a huge demand/supply imbalance so what people really want to do is take advantage of that and go in on the supply side, which means new developments,” she explains.

However, Stephen Hayes, portfolio manager at Perennial Real Estate in Sydney, is not yet sold on the India story. Perennial’s A$794m (€487m) Global Property Securities Trust invests through domiciled exchanges in Singapore, Hong Kong and Japan, but has not delved into India.

“Most of the Indian property companies have a huge development side to their business and within that there is varying quality of balance sheet and expertise, but in saying that we just can’t get the values to stack up,” he says. “They all look really expensive on a relative basis.”

Mehrota admits almost all of the real estate in the country is overvalued but she does not see this as a barrier to investment. “Valuations don’t tend to be in bubble territory forever and they don’t tend to be overvalued forever, so if you start studying the market now you might have a chance to invest when the time is right,” she says.

One area where she does believe concern is warranted is the risk of oversupply in the retail sector. India’s business daily newspaper Mint recently reported predictions from marketing experts that half of the country’s shopping malls will have shut down in a few years’ time.

Mehrota says it’s a brave call, but while she has not seen an oversupply of apartments, she agrees there are a lot of malls under construction. “From personal experience when you walk around the malls a lot of shoppers are there more for the air conditioning than they are to buy,” she says.

“Just because India has 1.2bn people it doesn’t mean you can sell them anything, but the fact that rents are so high and prices are so high means there is more demand than there is supply right now.”

Oversupply is not the only risk pension funds must take heed of when investing in India.

While currency, which has been weak in the past, is now showing resilience as it gains prominence among the major players in global economic affairs, Singh says currency fluctuations can be a risk, along with the risk of controls that may be imposed unexpectedly on currency repatriation.

“As with most emerging markets, there can be bouts of volatility caused by despair, exuberance and the mood of foreign investors who own over 30% of the entire market,” he says. “[But] the biggest risk is the risk of inadequate knowledge of the Indian market, its unique behavioural characteristics; the impact of political interference and direction of economic policy.”

Kanters says the immaturity of the market means transparency is also an issue. Progress has been made on this front, but the market is still opaque when compared with its developed counterparts.

In late 2006, Mumbai-based real estate rating and research agency Liases Foras launched India’s first real estate sensitivity index - Ressex. The index measures price, availability and supply of real estate versus demand, to calculate the ‘efficiency quotient’ of pricing. It provides a numeric representation of potential and variation in the property industry.

As at December 2007, Ressex measured price at 307, demand at 132 and supply at 105, giving an efficiency rating of 60.

“These markets are still in their infancy, they are immature and it means they are not transparent so it’s even more important to have a strong alignment with established partners who have connections with the governmental bodies and that have been active in those markets for many years,” Kanters says.

Tie-ups with local players can also help pension funds understand development risks that are unique to the Indian market, according to Magazine. “The obvious risks are currency risk and country risk, but besides that there is project risk - India is an emerging market so investors need to understand the market, how to operate in the market, to find the right partner and then to really assess the project and the opportunities,” he says.

In this environment, selecting the right investments is potentially more vital than short-term adjustments in monetary policy.

The topic of whether the Reserve Bank of India will raise or ease interest rates has been hotly debated recently, but Puay-Ju says the bigger problem comes in identifying high-quality products and counterparties.

Chris Lepherd, co-portfolio manager, Global Property Securities Fund at Principal Global Investors, says pension funds should select managers that show consistent yearly outperformance rather than those that have an exceptional single year that makes the long-term numbers look good.

They should also keep a close watch on the geographic and asset type exposures of the fund in which they are invested, he adds. “Pension funds need to be aware of market cycles in each of the countries in Asia-Pacific and to monitor the fund’s exposure to those market cycles.”

“I see parts of the Asia-Pacific region as providing compelling value at the moment. We’ve seen security prices fall by between 20% and 30% and, although there is some ongoing earnings risk, this is largely factored into current pricing.”

But this does not mean investors should ignore the impact that a US recession could have on the Indian economy. Opinions vary over the extent to which the country has decoupled from America, with some fund managers believing that the lack of sub-prime exposure among local financial institutions means the markets are largely insulated.

Those that espouse this theory also claim that there is enough capital liquidity and demand in the real estate market to prevent contagion from bringing the nascent economy to a halt.

However there are also managers who believe any slowdown in the US economy will have a major impact on India’s real economy and real estate market. If investor sentiment is damaged, this may well be the case, but the most widely held notion is that the blow would be less severe than it would be in other countries across the globe.

“If the US goes into recession, a lot of the Asian economies will see slower growth as well and that will feed through to demand for real estate so we may go through a period of softer total returns,” Puay-Ju says.

“But the fundamentals of the Asian economies as well as the real estate markets remain healthy, so there is no reason to think that we’re going to enter into negative return territory. There is still upside, it’s just that it’s going to be much more subdued than we’ve seen over the last few years and that’s not necessarily a bad thing, it could just calm the markets down slightly.”