Modi's PSU Land Use Formula for Industrialization

While the ordinance on the land acquisition bill has been referred to a Joint Committee, according to the media, the government plans to use the large land reserves (250,000 acres) available with central PSUs (Public Sector Units), mainly financially troubled ones, for industrial and infrastructure projects.

Some of the land with the PSUs is leased from the state governments, not directly owned, while some is encroached on. The location of the surplus land will need to match with the requirement of the projects.
Healthy PSUs giving up land for the private sector could lead to protests from employees and opposition parties.

Apparently, the government is also planning to use this land for plug and play projects (all the clearances in place before the award), which as we pointed out in our budget note (see F16e India Budget: Visible Infra
Focus dated March 1, 2015) could be a game-changer. If the PSUs involved are already financially troubled companies, the impact of taking away unutilized land will be insignificant, reducing the risk of opposition from any stakeholders.

Declining Affordability, RBI Data Alludes Correction in Property Prices

RBI residential property index trends for 3Q15 indicates a marginal increase in all India property prices. While Bangalore witnessed 11% increase in prices YoY, Mumbai, Kolkata, and NCR saw limited price improvement during the period. In addition, home affordability continued to decline over last one year.

However RBI data indicates material time correction in Mumbai, NCR and Kolkata property prices last year. Bangalore and Chennai witnessed consistent increase in property values primarily driven by end user demand. Time correction has a domino effect in regions with high proportion of investor flats, as non-commensurate returns impact asset holding capacity of the investors, resulting in property price correction.

Home affordability has declined over last one year as EMI to income ratio increased from 36% to 40% during the period. As the home affordability declines, we see a gradual shift to smaller apartments especially in Mumbai, Pune and Chennai.

While property price escalation has moderated, it has outpaced rental inflation significantly over last 3-4 years. Lower rental growth and declining affordability has resulted in deferral of purchase decision by end users leading to higher inventory level across regions.

Mortgage lending rates have been reduced by 15-20bps across banks/NBFCs post the RBI policy in Apr-15. While the reduction is directionally positive, the reduction in EMI, in our view, is not material enough to improve demand scenario in the sector.

New Residential Launch, Push Up Sales

All cities except Gurgaon saw an increase in new launches in 1QCY15 leading to a QoQ increase in sales (demand). We question sustenance here as we believe (from historic property cycle experiences) that developers use new launches at attractive prices as one of their strategies to push up sales and cash flows in periods of market weakness. Gurgaon clearly witnessed this play out in CY14 with little success.

Mumbai - 1QCY15 witnessed a pick-up in sales velocity led by launches at attractive pricing by well-known developers timed with local New Year in March. However, we maintain our view that Mumbai housing market remains tough evidenced by CY14 annual absorption rate flat at 24% compared to CY13. We reiterate our belief that projects by developers with good brand-value and execution track record will see better sales velocity. 10 key project launches (mainly in eastern & western suburbs) accounted for 33% of total new sales in 1QCY15.

Bangalore - 1QCY15 was the 2nd consecutive quarter to witness new project launches greater than 13,000 units (14,000 units in 4QCY14). Led by aggressive launches, 1QCY15 clocked new sales (demand) of more than 8,000 units (only the 2nd occurrence in last 7 years). As unsold inventory continues to rise above 70,000 units or above 10 quarters, we believe these are early signs of weakness. Also, mere 4% increase in overall housing price in CY14 supports our hypothesis

Noida - CY14 strategy of controlling new launches (supply) worked well in containing rising unsold inventory. We believe Noida’s unsold inventory has peaked at 100,000 units. However, given recent absorption rate, Noida will require 14 qtrs to exhaust this unsold inventory. 1QCY15 witnessed new sales of ~4,800 units which is the lowest in last six years. Absorption rate at 4.5% is lowest ever as investors who held the market in the past seemed to have deserted the market given poor visibility on timely delivery, price appreciation and exit to end-user.

Gurgaon - We believe the key reasons for drop in absorption rate are – 1) poor affordability as housing prices rose amidst slowing income growth, 2) pace of development of physical and social infrastructure much slower than housing development and 3) stock dump by investors in projects nearing completion (launched in 2009-10). We foresee following events to occur before any meaningful resurrection in sales and cash flows – 1) notable rise in new launches with freebies and discount schemes and 2) reduction in investor inventory in secondary market.

Real Estate Regulator India - Closer to Reality with Modi's Land Bill

The Union cabinet headed by Narendra Modi has approved amendments to Real Estate (Regulation and Development Bill), 2013. Key changes / inclusion introduced in the amendments are a) Residential and commercial projects under ambit of the new Real Estate Regulator that will come into force, hopefully and not like Jan Lokpal.

We believe Real Estate (Regulation and Development Bill), 2013 is a step in the right direction to address the end user concerns. The key feature of the bill is appointment of Appellate Authority which will adjudicate disputes between the industry participants with predefined timelines. In addition the transparency introduced at the time of registration with Authority (documents like commencement certificate, layout plan, agreement copy etc.) will help end user in taking an informed decision.

Ambit of regulation has been increased by bringing 1) Commercial projects and 2) projects which have not received completion certificate under the its jurisdiction. Previously projects which had received commencement certificate before the implementation of act were exempted from registration.

In original draft bill developer was required to compulsorily deposit 70% of amount realised from allottees in a separate account. The deposit amount has been reduced to 50% thus improving working capital flexibility as compared to draft bill. Another key amendment is the requirement of consent from 2/3rd allottees if the developer intends to alter plan or make structural changes.

REIT to Fuel A new bull market in Investment Property

Over a 3 day tour over Mumbai / Delhi / Bangalore we explored the fundamentals of investment property assets (Office /Malls/ Hotels) along with longer term prospects of REITs in India. In summary we think Investment Property assets are entering a new bull market driven by positive rental reversions / peaking of new supply growth / market share consolidation and likely lower interest rates one year out. Cap rates then in our view will likely trend 100-150bps below current 9%-9.5% levels as market starts discounting positive rent reversions over the next 3 years

Office /Retail Real Estate markets are getting more consolidated, with the top 2-3 developers in each market increasingly controlling a higher share of new supply. This is because smaller developers are increasingly shying away from a capital intensive model and tenants too are now increasingly discerning across landlords.

Across our meetings with companies/ consultants/ funds in 3 cities, the clear trend that emerged was that office /retail real estate now is entering a new bull market. Rental revisions post lock in are rising 50-70% across portfolios for many companies. This is essentially driven by rentals catching up to market pricing and reflective of likely tight demand supply fundamentals in the space over next 3-4 years

Hotels are one of the worst affected asset class of the current slowdown but now seems poised to come back as peak supply is now starting to get over. Hotels in areas such as Gurgaon / Bangalore suburbs are witnessing near sell out levels as new industry is now moving towards city suburbs rather than conventional city centers. We think as peak supply gets over in the market, RevPAR reflation in the market will revert to double digit growth levels over the next 2-3 years

Modi Dislikes Investment in Gold / Real Estate

India has a higher savings rate than its peers. For instance, data from the World Bank suggests that a typical emerging market has a savings rate of 24% when its per capita income is US$1,600. India, on the other hand, had a savings rate of 30% when its per capita income was at US$1,500 in CY13.

Despite this, India is characterised by a high cost of debt capital and poor accessibility to capital, as more than two-thirds of India’s household savings are held in physical form, which includes real estate and gold.

Physical savings instruments are preferred to financial savings instruments in India because of the following two reasons: (1) Whilst the purchase of physical assets can be funded using black money, the purchase of financial assets cannot be funded using black money, and (2) Physical assets are perceived to be superior inflation hedge as against financial assets. The outright preference for physical assets in India is evident from the fact that an overwhelming 65% of households in a middle-income country like India own the houses they live in whilst only 59% of households have access to banking services.

Furthermore, the preference for gold over bank deposits has become even more pronounced in the last few years, as the size of India’s black economy has burgeoned (owing to the rise in corruption) and as inflation rates have soared. Besides explicitly targeting the black economy, PM Modi also aims to expand the white economy. He plans to exponentially increase the number of households with access to banking services.

Bangalore Residential Sales SlowDown

The primary residential sales dropped in Bangalore in CY2014. Slowing sales have resulted in a 30% drop in launches too in CY2014. As the pace of sales growth didn’t match the pace of launches in Bangalore, pricing power always remained with the buyer. This also resulted in building up of inventory (unsold under-construction area) in Bangalore. What surprised us, not matching our expectation of only super-luxury sales slowing down, is that units selling below Rs 5 mn each also slowed down while those selling above Rs 7 mn each showed volume growth.

Prestige's sales strategy and sales stand out as it entered various markets within Bangalore and launched projects starting below Rs 7 mn/unit, attractively pricing its projects, which have resulted in growth. While Sobha’s strategy of launching only luxury and super-luxury projects resulted in their sales volumes remaining flat (although an increase in value terms), Puravankara has managed to maintain marginal growth on volumes from its new launches. But unlike Prestige and Sobha, Puravankara has sizeable unsold ready units to be sold.

Sobha has soft-launched its ‘Aspirational Homes’ product in 4QFY15, with unit prices starting as low as Rs 3.5 mn/unit. We believe this project will see good response and Sobha needs to replicate such projects at multiple locations for growth from current levels. Prestige, too, acquired 15 projects in 3QFY15. Entry into new markets, we believe, will be the key to Prestige’s volume growth in its residential business.

CY2014 saw some large lease deals in Bangalore. Outer Ring Road (ORR) remains the most attractive location with the largest developments and the largest leases being discussed in the market. In the past five years, absorption contribution in Bangalore has increased from around 40% to around 65%, followed by Whitefield. All major office developers, Embassy Developers, RMZ, Prestige Estates, Salarpuria Group among others, are present in the market. Whitefield is the next desired location among occupiers.

Govt Exempts Capital Gains on REIT Sponsors

The government exempted the capital-gains tax on sponsors (which was only deferred earlier) to as and when the sponsor decides to monetize its holdings in an REIT (all other conditions remaining the same and provided the sponsor pays STT). This puts a sponsor on a level-playing field with most promoters’ equity offerings. For any asset/SPV created before FY2014, the sponsors can monetize their shareholding after FY2016

The government clarified the direct holdings of an asset in an REIT. The income will be a pass-through for the REIT. For the resident investor, there will be withholding tax of 10% while for a non-resident investor it will be as per the tax laws of the respective country. On the face of it, this remains a lucrative structure for institutional investors with a minimum tax leakage (provided the REIT takes a stamp-duty hit in stage 1). But one still needs to understand the taxation for FIIs as this falls under income from house property

While the above measures are progressive steps, they still do not address the issues of (1) upfront MAT payments while transferring shares in the SPV to the REIT and (2) direct transfer of an asset to the REIT. In both cases there is upfront cash outflow for the sponsors, without necessarily getting cash. In (2), there is a large stamp-duty consideration, which is governed by local states rather than the cent

We believe direct holding of an asset in a REIT is the most efficient structure in the long term—as the income in the REIT is a pass-through and with little leakage on distribution, we believe this will augment yields

MAT remains the biggest issue

MAT is still applicable during the initial transfer of shares from the SPV to the REIT. In case of asset transfer, the sponsor will have to pay capital gains. However, since in most cases assets are in SPVs, setting off of MAT credit could be difficult.

Stamp duty is another issue in case of an asset transfer. Stamp duty varies 6-9% as per state regulations. In such a transfer, this will also have to be taken into consideration and will affect yields. As in Exhibit 1, considering all other variable are similar, SPV transfer is better.

Sponsors are also seeking dividend distribution tax (DDT) exemptions in case of SPV holding assets and REITs investing in form of equity of debt. We continue to believe this will be hard to change, as the government is not giving exemption to other sectors on this parameter. Further, direct holding and investment through debt bypass the DDT. All said, we believe that one cannot set up a perpetual vehicle (REIT) based on financial engineering.