April 2008 VOL. 2

India Residential:
Overheated today, opportunities tomorrow

Over the past three years, domestic and foreign investors flooded India's real estate market with capital, pushing up land prices and creating an intensely competitive investment environment, especially for residential development. But, the frantic pace of investment has slowed, and many industry experts are forecasting a price correction of 15 percent to 20 percent for land over the next six to 18 months.

"We saw investors lapping up anything and everything with residential in it, but investors are being a little more circumspect today," says Avnish Singh, country head for India for GE Real Estate.

During the last two years there has been extraordinary inflation in the price of well-located land in the major cities, according to Daniel MacEachron, country head and senior vice president with Hines India Real Estate Private Ltd., which is not currently developing residential projects in India, although it hopes to have that opportunity in the next few years.

"In most major cities such as Bangalore, Chennai, Delhi, Hyderabad and Mumbai, there are many examples of land sales where prices have doubled, tripled or even quadrupled," MacEachron says, adding that most experienced real estate investors increasingly believe that there is a pricing bubble.

MacEachron, along with Singh and others, expects that turmoil in the capital markets will cause demand for Indian real estate to slow, thereby forcing sellers to accept lower prices for their land.

But, the pricing correction has little to do with the India's growth and demand for housing. Instead, investors have come to a greater understanding of market risk and have recognized that investing in India requires patience and a long-term investment horizon, Singh says. In fact, GE Real Estate is currently evaluating joint venture partners and seeking out residential development opportunities. The company hopes to have $200 million to $300 million worth of residential real estate under management over the next three years.

"If you're an investor with a global real estate portfolio, you cannot miss the opportunity that India presents," says Subbu Narayanswamy, a partner in McKinsey & Company's Mumbai office. "There is no other market in the world showing this level of growth, and no other place where there is such a supply and demand gap for housing."

Living large
Without question, India is facing an acute housing shortage today. With a population of 1.1 billion people, experts estimate that the country needs to add 400 million to 450 million square feet of housing just to meet the demand that exists today. Over the next seven to 10 years, a total of 4 to 6 billion square feet of residential space will be needed, according to Singh.

"We've had four to five decades of no supply while demand has continued to grow," Narayanswamy points out, adding that by some estimates it will take 10 to 15 years to fill the pent-up demand.

The majority of India's housing units are at least 10 years old and primarily low-rise buildings constructed by the Indian government, although there are a few gated communities. The most development has primarily been done by Asian developers and is high-rise for-sale product.

India's population is growing a rate of 1.3 percent per year, contributing to the ongoing and expanding demand for housing. While that annual growth rate might seem relatively unimpressive compared to other countries, it's actually quite enormous - every year for the next 20 years or so, India's population will add the equivalent of Canada's entire population, according to McKinsey. And, by 2030, India will overtake China as the most populous country in the world with a population exceeding 1.6 billion.

India's growing population is just one reason why housing demand is so huge. The country also is undergoing mass urbanization, with millions of people fleeing rural areas for the bright lights of the big cities.

Today, India's cities house 318 million people, or nearly 30 percent of the population, but two-thirds of the country's total population increase over the next two decades will occur in urban markets. By 2025, 523 million Indians will live in cities - more than the entire population of the European Union today.

Most of the Indians who are moving to cities are young, and more than 63 percent of India's urban population has an average age of 26 - a prime age for setting up a household. In fact, the average age of a new homeowner has decreased to 32 years from 45 years, says Sunil Suri, principal and managing member of Menlo Capital Group. The San Francisco-based company is currently developing high-rise residential condos targeted toward middle-income Indians.

Bill Poorvu, professor emeritus of Harvard Business School and author of Creating and Growing Real Estate Wealth, compares the population migration in India today to the population migration the U.S. experienced after World War II and into the 1950s.

Moreover, Poorvu points to India's growing middle class as a major demand driver for new housing. "As many Indians achieve middle-class status, the housing that exists today just doesn't meet their new needs," he says. "These middle-class Indians want to live in modern housing."

Just a few years ago, India's middle-class was almost non-existent. But, the emergence of India's information technology (IT) sector has allowed millions of Indians to move up the economic ladder. If India continues on its current economic growth trajectory, incomes levels will almost triple, and the country will climb from its position as the world's 12th largest consumer market to the world's fifth largest by 2025, according to McKinsey.

Today, India's middle class numbers about 50 million; by 2025, it is expected to swell to a whopping 583 million. "Many of the new middle-class aspire for individual homes away from the nuclear family," Suri says. "The Joint Hindu Undivided family has gone the way of the Stone Age."

The Indian government is doing its part to encourage homeownership by making mortgage finance available to a larger group of people, Narayanswamy says. While interest rates in India have been as high as 18 percent, they're now about 11 percent.

Still, homeownership in the country is significant lower than other Asian markets: the mortgage to GDP ratio in India is about 4 percent compared to 25 percent for Malaysia and 70 percent for other developed countries, Singh notes.

Building in IT hubs
The promise of 20 percent returns (or more) for residential development has enticed a number of developers to put shovels in the ground including Unitech, DLF, Shobha, Mahindra Gesco and Emaar MGF. Although most developers are local to India or from the Asia-Pacific region, many Indian-based companies have ties to the U.S. or are funded by U.S. money. For example, Xander Funds, a real estate private equity investment company based in India, was co-founded three years ago by Arthur Segel, a professor of real estate at Harvard University's School of Business.

Xander, along with several local partners, is currently developing roughly 750 acres in five locations across India, Segel says. The projects are modeled as integrated townships, which are self-sustaining communities similar to masterplanned communities in the U.S.

GE Real Estate also is interested in developing large mixed-use projects anchored by residential, Singh says, as well as standalone residential projects in dense urban areas. Because India's housing shortage is most acute in cities that are established as IT hubs or those that are emerging IT destinations, GE Real Estate is looking to invest in residential projects in IT markets like Bangalore, Chennai, Hyderabad, Mumbai and Pune.

GE Real Estate is focusing its efforts on India's middle-income population, and that sector is where McKinsey's Narayanswamy sees the most opportunity. "The big opportunity here is in housing for the masses," he says. "This is a volume game - it's not building one great building but delivering a large number of units."

But, there are significant challenges, even for small projects, says John Vogel, a professor at the Tuck School of Business at Dartmouth College in Hanover, N.H. He points out India, like the U.S., is a system of states, and each state has different regulations and different levels of interest in new development. Obtaining approvals can be difficult. Moreover, title insurance is not available in India, which scares off a lot of investors.

"India is a complicated and extremely difficult place to do business," says MacEachron of Hines. "Many multinational companies have come to India and have given up on trying to do business after a few years. Anyone considering investing or developing in India should do his due diligence carefully and thoroughly and not undertake it lightly."