India has always been in love with real estate. We are ranked 126th in the world when it comes to median wealth per adult and yet ranked 8th in the world by homeownership rate. Indeed, this disproportionate interest in the property is warranted: real estate has historically enabled families to accumulate wealth safely and predictably. But for the most part, the selection of real estate has largely been an emotional one, with a preference for buying properties in familiar neighborhoods or curation based on hearsay. This has meant that, while property ownership has always been an aspiration, the potential of real estate to enhance one’s investment portfolio has not been fully optimized.
There is a learning curve involved in profiting from real estate, just like there is with stocks. Unlike stocks though, the stakes tend to be higher with real estate, the errors less reversible, and the sources of high-quality information less. With this in mind, we have put together the three most common mistakes that investors make when investing in real estate and our suggestions on how even new investors can profit from this highly lucrative sector.
Mistake 1: Looking for liquidity
Real estate by nature is not the most liquid asset class. While there are now an increased variety of investment types within real estate, some of which offer more liquidity like rent-yielding commercial property REITs, these come with reduced returns. Asset sellers offering high-liquidity options are no longer competing with other real estate players to win your money. Instead, they are up against other fixed-income options like bank deposits and bonds and can afford to reduce the IRRs they need to offer by as much as 50% and remain competitive in the financial markets. On the other hand, your money becomes highly valuable to asset sellers who can rely on this capital for a longer period of time, and as a result, the returns you get from these less liquid assets are much higher.
Mistake 2: Being impatient for outcomes
Advances in the real estate investment world, like SEBI-registered AIFs, and publicly-traded REITs, have made adding real estate assets to one’s investment portfolio as easy as stocks. However, the underlying real estate market – prices, vacancy rates, rents, new developments – move slowly like a supertanker and not like a speedboat. Investors who expect quick outcomes tend to make suboptimal decisions, such as prematurely exiting an investment that is on the right long-term trajectory. When investing in real estate, it is important to understand that this is one of the largest industries in the world and it inherently moves at a slower speed than the financial markets. It is worth keeping in mind that people need homes to live in and offices to work from, so real estate will eventually do well in the long run in growing cities despite temporary downturns in property markets.
Mistake 3: Geographic myopia
Real estate has often been an emotional investment, giving investors the comfort of physically possessing an asset. Additionally, there is a false feeling of expertise in one’s own city or locality. This leads to a locally concentrated real estate portfolio, which is an inefficient dynamic, especially for such a large asset class. Investors are far more agnostic and practical when it comes to stocks, chasing only the best-performing assets in search of the highest returns without needing to physically inspect, control, and own the asset. Given that a small number of disproportionately fast-growing geographies command a large share of potential profits, investors will earn much better returns by letting go of their geographic myopia and selecting the best possible locations for profitability.
Conclusion: Access to high-quality real estate investments is better than ever before. Profiting from property markets is no longer an opaque, specialized, and closed affair. By avoiding these common mistakes, one can substantially increase returns and reduce investor anxiety. When investing in real estate, choose an investment manager that has deep domain expertise in this complex industry to help you eliminate these investing errors and realize the potential of real estate profits.
Absolute Views October 20, 2020
PE investments in Indian real estate have been growing rapidly. As of March 2019, SEBI data shows commitments towards Category II AIFs, which include real estate private equity funds, have touched $30bn. And yet, there is a curious dichotomy for investors: on the whole, the real estate industry is growing rapidly, and yet, many of their individual investments don’t seem to be paying off as well as expected.
What explains the overall growth and returns of the industry and the highly variable outcomes of specific investors? How are certain types of funds able to offer consistently high IRRs on all their projects, while others seem to have a wide variance from asset to an asset? In this article we answer this question with three key insights, showing that it is not in fact the innate unpredictability of real estate, but instead controllable factors that a few firms have mastered while most are unable to.
Legal curation: Every institutional investor in real estate undertakes legal due diligence before investing funds. However, not all legal diligence is of the same quality. While all firms will engage the services of lawyers to vet the title documents and obtain a written title report, some go beyond just the documentation and delve deeper into the legal risks. They will have liaising departments that check with various government agencies about the liaising and regulatory risks that could be specific to that land parcel or the proposed project. They will check with local information sources about any disputes simmering beneath the surface that could be revealed during the development phase. They will use architects to evaluate the development plan to ensure that it complies with building codes and by-laws. We have done exactly that here at SMARTinco, for instance by recently discovering that what seemed like a highly desirable star project had a local issue that would have caused problems with its road access, thus potentially reducing returns through a protracted legal battle or, in the worst case, cancellation of the project.
Financial expertise: All institutional investors have highly trained investment teams with smart MBAs and finance professionals. These experts tend to be very good at crunching the numbers to see if a proposed investment will meet the investment objectives. But a spreadsheet is only as good as the numbers one plugs into it, and most funds are dependent on external sources, very often the proposed investee, for the project’s numbers. The more successful firms, on the other hand, have to finance professionals who are complemented by in-house experts to ensure that key numbers, such as costs, timelines, sale price, and sales velocity, are taken at conservative values based on the specifications of the project and the prevailing conditions in the market.
Real estate expertise: The very biggest developers often do not offer very high IRRs to their funding sources as their brand allows them to wield significant bargaining power. With a large number of institutional sources of capital available, the returns from these projects tend to be average at best. The best IRR opportunities come from underrated regional or local developers who are excellent at a particular set of competencies but perhaps lacking in others. Institutional investors who have deep domain expertise in the various functional areas of real estates, such as architecture, engineering, project management, marketing, and sales, can tap into these smaller developers and yet keep risks low as they can fill any void incompetency that may exist with a particular developer.
These additional services complement the skills of the developer and allow the project to be more successful and thereby offer higher returns. For instance, at SMARTinco, we offer consulting services for architectural design, land-sourcing, project management, and other critical tasks with our team of in-house experts, thus extracting higher IRRs for our clients.
Conclusion: There has never been a better time to invest in real estate. Strong macroeconomic indicators and local trends both point to a period of sustained growth over the next few years. Regulatory changes are making the industry more transparent, reducing project-risk, and improving the range of instruments available to best accelerate growth in the sector. As the returns from real estate outpace potential gains from other sectors, and demand continues to outstrip supply, the market is experiencing an increase in both the number of investable assets on offer as well as the number of investment firms like PE funds that are expanding into real estate. Unfortunately, the profits from real estate are not going to be democratic even as they continue to rise. Firms that are experts, with strong competence in the various aspects of the real estate industry, will be able to select the best deals, execute with the highest quality, and offer the most lucrative IRRs for clients.
Absolute Views October 24, 2020
Backed by strong growth in India’s services sector, commercial real estate is experiencing an unprecedented boom. With annual office space leasing expected to be over 35 million square feet over the next few years, the largest cities of India are set to enjoy commercial property demand higher even than the United States, and behind only China.
With the advent of digital marketplaces, REITs, and AIFs, these assets are no longer the exclusive domain of institutional investors. A large number of retail investors have begun to participate in this sector with a variety of investment goals. As always with a novel asset type, investors have a few misconceptions about commercial property investments and how to evaluate them.
Having helped hundreds of clients build portfolios of commercial assets that have yielded best-in-class IRRs, we have collected here the top 5 points of misconceptions we see among investors about commercial real estate and explain what you need to know to invest wisely in this sector.
Misconception 1: The total return from owning an office has three parts: rental yield + rent escalations + asset price appreciation.
Understanding the components of your returns is critical because there is a possibility that some aspects of returns might be counted twice incorrectly, like in this case. Commercial properties are sold based on a “cap rate”, which is simply the capitalized value of current net operating income (rents minus expenses). When rents go up, their capitalized value, which is the property price, also goes up. In other words, the return that we count as rent escalation is actually the same return that is resulting in asset values going up, so we cannot count both.
Take the example given below, where a property has an annual rent of Rs.120 and was purchased today for a cap rate of 10, which means it was purchased at Rs.1200. To make the calculations easy to follow, let us assume that the property has annual rent escalations of 5%. So, after one year, this property will have annual rents of Rs. 126 and, if we were to sell it, we would get a price of Rs.1260 at the same cap rate of 10, which is an appreciation of 5% in its price. Let’s now look at the IRR of this investment over a period of 5 years. As you can see in the illustration below, the capital gains and increase in rent together contribute to the 5% extra IRR, and the total IRR of this opportunity is actually 15% (10 plus 5). Even though the pure capital gains achieved over 5 years is 23%, this should not be added to the total IRR.
Misconception 2: Rent escalations of 15% every 3 years is equal to 5% per year.
15% over 3 years actually translates to around 3.5% per year. It is important to remember that when the rent goes up by 15% every 3 years, you get no escalations for 3 years, so you lose out on annual rent increases compared to an annual rent escalation clause in the lease. This is a permanent loss of potential income, which makes a 15% rent increase every 3 years equivalent to less than inflation rates.
Misconception 3: If the property price is 100, and my rent is 8, then my cash yield is 8%, which is a rather healthy number that I can be happy with.
The calculation of the cap rate is another point of confusion we see commonly. Cap rate is not simply annual rent divided by property price. It is the annual net operating income divided by property cost. Net operating income takes annual rent and subtracts operating and other expenses, such as insurance and property tax. While these can be significant, the biggest potential cost is vacancy cost as commercial property tends to take a long time to be leased should a vacancy arise. In a country like India, another important cost is the registration cost of the property. Once we take all these costs into account, the actual cash flow yield of a rental property tends to be significantly less than the headline rental yield number.
Misconception 4: The property is leased, so I do not have to consider vacancy costs.
Commercial properties take much longer to lease out than residential properties even in good locations. The nature of these assets is such that tenants are making an important decision, and the number of prospective tenants is far less than for residential properties. Therefore, it is not uncommon for properties to lie vacant for months or sometimes even years. A general rule of thumb when calculating the potential returns from commercial properties is to assume a vacancy period of about one month per year over the long run, even if the property is currently tenanted, as your tenant will likely vacate at some point or the other.
Misconception 5: REITs are a good way to earn high returns.
REITs have revolutionized rental property investing and made commercial properties accessible to ordinary investors. But it is important to understand how they fit in one’s portfolio as these investments are not for everyone. Commercial properties can be best thought of as a safe place to park your money where you get steady cash flows and a natural hedge against inflation. In that way, they are an attractive alternative to fixed-income investments that do not have an inflation hedge, such as bank deposits and bonds. However, everything comes at a cost and the price you pay for the cash flows from a REIT is that your total returns are likely to not be very high. They are thus a good option for the cash flow part of your portfolio but they are not a good option if your goal is to maximize total return. For long-term investors who wish to maximize returns, a better option may be an AIF that funds commercial property development, as opposed to investing in completed and rent-yielding commercial properties. While these investments tend to be less liquid, their returns tend to be much higher, making them a better option for growing wealth.
Conclusion: Commercial real estate is growing rapidly as an asset class and offers investors multiple ways to profit from it. It is important to understand the economics of this asset so that one can make good investment choices. REITs and AIFs offer two interesting and contrasting ways to allocate one’s portfolio to commercial properties, and done judiciously, they can help you obtain both cash flow and high returns.