Commercial Real Estate's Perfect Storm: What Lies Ahead?

By M H Ahssan

"For the last few years we've enjoyed a perfect storm in commercial real estate," said Brian Lancaster, head of structured products research at Wachovia Securities, the brokerage group within Wachovia, a financial services firm with more than $541 billion in assets. "There has been a simultaneous occurrence of stabilizing rents, improving fundamentals, and really, really cheap money."

The commercial real estate market has been on a tear in the last few years. Banks, insurance companies and institutional investors funneled money into the market because its returns, in an environment of low interest rates, exceeded those of alternative asset classes. This segment of the broader real estate market typically includes office, retail, multifamily and industrial properties.

Lancaster observed that the commercial real estate market remains strong, although "not as great as it has been in the last few years." More than 10% of Wachovia's assets are in commercial real estate.

Lancaster made these comments at a conference last month on Innovation and Risk Management in Real Estate Markets, sponsored by the Wharton Financial Institutions Center and Mercer Oliver Wyman, a financial services strategy and risk management consulting firm. He took part in a panel discussion about the emerging risk profile of commercial real estate lending. The other industry experts were Caroline Blakely, a vice president in multifamily housing and community development at Fannie Mae; Richard Edelstein, a professor at the Haas School of Business at the University of California at Berkeley; and Bradford Case, an economist with the Board of Governors of the Federal Reserve System.

Fannie Mae's Blakely agreed with Lancaster that investments in commercial real estate continue to be strong, adding that in the multi-family sector, "real estate fundamentals are on the mend." U.S. demographic trends and steady job growth bode well for apartment rentals. In line with that, "vacancies are declining and asking rents are climbing," she said. Fannie Mae is slightly less optimistic about rent growth than other institutions in the real estate industry, but nonetheless expects it to be in the 2.5% to 3.5% range over the next year.

The mortgage financing giant also does not see the expanding supply of multi-family rental properties as a threat. "We're not concerned right now about an increase in multi-family construction, although we're certainly watching the condo conversion market and the oversupply in condos," Blakely said. Last year, Fannie Mae helped finance more than $25 billion in multi-family rental apartments in the U.S. The company's portfolio of multi-family commercial real estate assets totals more than $124 billion.

Low Rates
After the 2000 dot-com crash, Wachovia's Lancaster noted, commercial real estate revenues declined, vacancies rose and rents decreased. But since late 2001, revenues have steadily increased, with investors pouring more money into the sector. The key was the Federal Reserve flooding the market with liquidity through low interest rates, enabling commercial real estate investors to enjoy "phenomenal returns in the face of poor fundamentals," he said. One result was extremely low levels of delinquencies and default for Wachovia's and other banks' commercial real estate portfolios.

While Lancaster said he remains bullish on commercial real estate returns because fundamentals have improved in recent years, he also expects to see a "significant slowdown" in price appreciation for real estate. He added that the high prices still being paid in some areas of the apartment sector are "worrisome." However, property transactions overall have already slowed this year and buyers have been holding out for better prices, Lancaster said. In his view, this "cooling" is rational and a sign that some of the effects of higher interest rates are percolating through the system.

Lancaster noted that Wachovia's views on the commercial real estate market are predicated on its positive economic views. The firm expects the 10-year Treasury note to rise to about 5.40% by the end of the summer, with inflation concerns easing later this year. However, he said, "all bets are off in a stagflationary scenario or if job growth tanks, or if we get real significant increases in interest rates."

Fannie Mae's Blakely, while also positive about prospects, sounded a further note of caution. Commercial mortgage debt outstanding as a percentage of GDP crept toward 16% in the fourth quarter of 2005, surpassing the record set in 1988, she said. In addition, 70% of conduit loans (loans that are securitized) are partly or fully interest-only loans, triple the level two years ago. With interest rates continuing to rise and more capital seeking commercial real estate deals, Fannie Mae's worry is that debt underwriting standards could decline. The company is also "a little worried about stress levers" in the interest-only and low debt service coverage markets, added Blakely.

Edelstein, a real estate professor at the University of California at Berkeley's business school, was less sanguine about prospects for the commercial real estate market. He agreed that commercial real estate is currently in a good position, and that the U.S. economy's strength and resilience will benefit the industry generally. But he pointed out that the world we live in now is more global than it was 10 or 20 years ago and that capital can be rapidly pulled out of markets because of events that occur thousands of miles away. That makes commercial real estate's status as a favored child more precarious, he said.

"Capital market integration and securitization is going on and is inevitable," Edelstein observed. Securitization refers to the pooling together of relatively illiquid assets into more diversified financial products, whose securities are then sold to investors. This enables markets to develop by expanding their investor base and providing lower-cost financing. However, investors can now respond to new information more quickly than ever before -- and in Edelstein's view, this has the potential to create more volatility, not less.

"There has been a capital tsunami and that's likely to continue for a while, but there's nothing so mobile as capital," Edelstein said. "The tsunami could flow out very, very quickly." Events in other parts of the world could affect demand for many U.S. assets, including real estate. At the same time, the commercial real estate market's shift in the last year or two into higher-risk and leveraged assets could exacerbate any problems that develop, he added.

What could cause this to happen? China could revalue its currency faster than expected, Edelstein said. That would translate into higher prices in the U.S., which would impact the real estate market. An unanticipated jump in U.S. interest rates could also cause investors to shed real estate very quickly. "All you need is a few performance failures, because a lot of real estate is being bought with the notion that there will be growth in fundamentals," Edelstein noted. "I think we're at a very high risk point in real estate," he said.

Institutional Interest
Despite the rise of interest rates, institutional money from pension funds and other large investors continues to flow into the commercial real estate market. The robust commercial mortgage-backed securities (CMBS) market shows little sign of cooling off. CMBSs are securitizations backed by mortgages on commercial properties. Last year, U.S. CMBS issuance was a record $169 billion, up from the previous record of $93 billion in 2004, according to the Commercial Mortgage Securities Association, an industry trade group. In the first four months of this year, U.S. CMBS issuance was higher than it was during the same period last year.

Another market that has gained steam on Wall Street is the commercial real estate CDO market. A commercial real estate CDO, or collateralized debt obligation, is typically backed by a wide range of real estate debt assets, including riskier and shorter-term debt. Traditional CMBSs are usually backed by long-term fixed-rate mortgage loans. Since 2004, numerous actively managed commercial real estate CDOs have also been issued. These enable new collateral to enter and exit the CDO and have a shorter average life than the other bonds in the pool.

The result is that these CDOs have opened up narrowly financed parts of the commercial real estate market to new investors, said Wachovia's Lancaster. Various forms of debt -- such as mezzanine loans, B-notes and preferred equity -- can now be included in a managed real estate CDO vehicle, which is then sold to investors all over the world. Real estate risk is thus transferred to more players in non-U.S. geographic markets, Lancaster said.

Fannie Mae's Blakely noted that CMBS issuance forecasted for this year totals $182 billion, while commercial real estate CDOs are forecasted to reach $34 billion. She added that the growth of the CMBS market over the past 15 years has clearly benefited the commercial real estate market. Indeed, as it has grown it has also become Fannie Mae's chief competitor for apartment building mortgages, aside from Freddie Mac. Blakely pointed out that the CMBS market views multifamily rentals as one of the stronger real estate classes -- and therefore a class that CMBS issuers seek.

Analyzing Correlations
Bradford Case, an economist with the Board of Governors of the Federal Reserve System, focused his comments on the quality of data in the commercial real estate market. He noted that as the institutional market continues to expand, insufficient data could take a toll on both investments and risk management. In particular, the paucity of key performance data about markets and market segments could make managing the risk associated with a portfolio of commercial real estate assets more difficult.

Unlike the stock and bond markets, which produce a stream of intraday data, the commercial real estate market is often lucky to have monthly performance data, Case said. He noted that national real estate data sources mainly cover the larger markets, while smaller markets may or may not be included in local or regional data sources. Consequently, researchers and real estate portfolio managers tend to "analogize" between a market for which they have data and those they think are similar.

However, this can be risky since the markets may not behave as similarly as expected under all circumstances. Case noted that his comments did not necessarily reflect the views of the Federal Reserve.

"Good information comes from really deeply knowing the market," Case said. He referred to this as "unsystematic local expertise," since it is expertise particular to a local segment of the market. An example may be the apartment rental market in Tallahassee, as opposed to the overall commercial real estate market in Florida, which comprises many market segments that could have different characteristics and performance results. Without this local-level expertise, Case said, lending can be risky and inefficient because of the existence of an "information asymmetry problem" -- a situation in which the person with better local knowledge has a leg up on a lender who is less familiar with the price and performance dynamics in that particular market.

Case also noted that managing a portfolio of commercial real estate assets requires investors and analysts to understand how asset classes within the real estate market move in relation to one another. This could involve knowing how and when asset classes in various areas are affected by factors such as unemployment and population growth -- and when they're not. He suggested that the dearth of detailed and uniform performance data in commercial real estate should also cause investors and others to question how they define a particular real estate market.

For example, the Boston office properties segment of the commercial real estate market may have a similar performance pattern to the office market in other Northeast cities, or it may be similar to the office market for large cities across the country. Alternately, it may have more in common with other real estate market segments in the Boston area than it does with office markets in other geographic areas. Too often, Case said, assumptions about how various market segments are correlated reflect seat-of-the-pants views but lack empirical support.

The Federal Reserve economist stressed that without knowing which segments of the larger market move together and which are affected by the same supply and demand shocks, it is hard to estimate correlations among returns within a portfolio, as well as default probabilities and portfolio loss distributions. He added that once various correlations are better understood, it will also be possible to make better predictions for markets that lack data -- or, at least, there will be a stronger basis on which to draw analogies between markets for which information exists and those for which information does not exist.

Case said he has conducted preliminary research into correlations within segments of the U.S. commercial real estate market in more than 50 metropolitan areas. But his research is tentative and he hopes economists within the financial industry will generate better and more thorough data in the near future. As became clear at the conference, this additional knowledge -- whether it confirms or refutes existing assumptions about market segments -- can only help real estate investors risk-manage their portfolios better.

Commercial Real Estate's Perfect Storm: What Lies Ahead?

By M H Ahssan

"For the last few years we've enjoyed a perfect storm in commercial real estate," said Brian Lancaster, head of structured products research at Wachovia Securities, the brokerage group within Wachovia, a financial services firm with more than $541 billion in assets. "There has been a simultaneous occurrence of stabilizing rents, improving fundamentals, and really, really cheap money."

The commercial real estate market has been on a tear in the last few years. Banks, insurance companies and institutional investors funneled money into the market because its returns, in an environment of low interest rates, exceeded those of alternative asset classes. This segment of the broader real estate market typically includes office, retail, multifamily and industrial properties.

Lancaster observed that the commercial real estate market remains strong, although "not as great as it has been in the last few years." More than 10% of Wachovia's assets are in commercial real estate.

Lancaster made these comments at a conference last month on Innovation and Risk Management in Real Estate Markets, sponsored by the Wharton Financial Institutions Center and Mercer Oliver Wyman, a financial services strategy and risk management consulting firm. He took part in a panel discussion about the emerging risk profile of commercial real estate lending. The other industry experts were Caroline Blakely, a vice president in multifamily housing and community development at Fannie Mae; Richard Edelstein, a professor at the Haas School of Business at the University of California at Berkeley; and Bradford Case, an economist with the Board of Governors of the Federal Reserve System.

Fannie Mae's Blakely agreed with Lancaster that investments in commercial real estate continue to be strong, adding that in the multi-family sector, "real estate fundamentals are on the mend." U.S. demographic trends and steady job growth bode well for apartment rentals. In line with that, "vacancies are declining and asking rents are climbing," she said. Fannie Mae is slightly less optimistic about rent growth than other institutions in the real estate industry, but nonetheless expects it to be in the 2.5% to 3.5% range over the next year.

The mortgage financing giant also does not see the expanding supply of multi-family rental properties as a threat. "We're not concerned right now about an increase in multi-family construction, although we're certainly watching the condo conversion market and the oversupply in condos," Blakely said. Last year, Fannie Mae helped finance more than $25 billion in multi-family rental apartments in the U.S. The company's portfolio of multi-family commercial real estate assets totals more than $124 billion.

Low Rates
After the 2000 dot-com crash, Wachovia's Lancaster noted, commercial real estate revenues declined, vacancies rose and rents decreased. But since late 2001, revenues have steadily increased, with investors pouring more money into the sector. The key was the Federal Reserve flooding the market with liquidity through low interest rates, enabling commercial real estate investors to enjoy "phenomenal returns in the face of poor fundamentals," he said. One result was extremely low levels of delinquencies and default for Wachovia's and other banks' commercial real estate portfolios.

While Lancaster said he remains bullish on commercial real estate returns because fundamentals have improved in recent years, he also expects to see a "significant slowdown" in price appreciation for real estate. He added that the high prices still being paid in some areas of the apartment sector are "worrisome." However, property transactions overall have already slowed this year and buyers have been holding out for better prices, Lancaster said. In his view, this "cooling" is rational and a sign that some of the effects of higher interest rates are percolating through the system.

Lancaster noted that Wachovia's views on the commercial real estate market are predicated on its positive economic views. The firm expects the 10-year Treasury note to rise to about 5.40% by the end of the summer, with inflation concerns easing later this year. However, he said, "all bets are off in a stagflationary scenario or if job growth tanks, or if we get real significant increases in interest rates."

Fannie Mae's Blakely, while also positive about prospects, sounded a further note of caution. Commercial mortgage debt outstanding as a percentage of GDP crept toward 16% in the fourth quarter of 2005, surpassing the record set in 1988, she said. In addition, 70% of conduit loans (loans that are securitized) are partly or fully interest-only loans, triple the level two years ago. With interest rates continuing to rise and more capital seeking commercial real estate deals, Fannie Mae's worry is that debt underwriting standards could decline. The company is also "a little worried about stress levers" in the interest-only and low debt service coverage markets, added Blakely.

Edelstein, a real estate professor at the University of California at Berkeley's business school, was less sanguine about prospects for the commercial real estate market. He agreed that commercial real estate is currently in a good position, and that the U.S. economy's strength and resilience will benefit the industry generally. But he pointed out that the world we live in now is more global than it was 10 or 20 years ago and that capital can be rapidly pulled out of markets because of events that occur thousands of miles away. That makes commercial real estate's status as a favored child more precarious, he said.

"Capital market integration and securitization is going on and is inevitable," Edelstein observed. Securitization refers to the pooling together of relatively illiquid assets into more diversified financial products, whose securities are then sold to investors. This enables markets to develop by expanding their investor base and providing lower-cost financing. However, investors can now respond to new information more quickly than ever before -- and in Edelstein's view, this has the potential to create more volatility, not less.

"There has been a capital tsunami and that's likely to continue for a while, but there's nothing so mobile as capital," Edelstein said. "The tsunami could flow out very, very quickly." Events in other parts of the world could affect demand for many U.S. assets, including real estate. At the same time, the commercial real estate market's shift in the last year or two into higher-risk and leveraged assets could exacerbate any problems that develop, he added.

What could cause this to happen? China could revalue its currency faster than expected, Edelstein said. That would translate into higher prices in the U.S., which would impact the real estate market. An unanticipated jump in U.S. interest rates could also cause investors to shed real estate very quickly. "All you need is a few performance failures, because a lot of real estate is being bought with the notion that there will be growth in fundamentals," Edelstein noted. "I think we're at a very high risk point in real estate," he said.

Institutional Interest
Despite the rise of interest rates, institutional money from pension funds and other large investors continues to flow into the commercial real estate market. The robust commercial mortgage-backed securities (CMBS) market shows little sign of cooling off. CMBSs are securitizations backed by mortgages on commercial properties. Last year, U.S. CMBS issuance was a record $169 billion, up from the previous record of $93 billion in 2004, according to the Commercial Mortgage Securities Association, an industry trade group. In the first four months of this year, U.S. CMBS issuance was higher than it was during the same period last year.

Another market that has gained steam on Wall Street is the commercial real estate CDO market. A commercial real estate CDO, or collateralized debt obligation, is typically backed by a wide range of real estate debt assets, including riskier and shorter-term debt. Traditional CMBSs are usually backed by long-term fixed-rate mortgage loans. Since 2004, numerous actively managed commercial real estate CDOs have also been issued. These enable new collateral to enter and exit the CDO and have a shorter average life than the other bonds in the pool.

The result is that these CDOs have opened up narrowly financed parts of the commercial real estate market to new investors, said Wachovia's Lancaster. Various forms of debt -- such as mezzanine loans, B-notes and preferred equity -- can now be included in a managed real estate CDO vehicle, which is then sold to investors all over the world. Real estate risk is thus transferred to more players in non-U.S. geographic markets, Lancaster said.

Fannie Mae's Blakely noted that CMBS issuance forecasted for this year totals $182 billion, while commercial real estate CDOs are forecasted to reach $34 billion. She added that the growth of the CMBS market over the past 15 years has clearly benefited the commercial real estate market. Indeed, as it has grown it has also become Fannie Mae's chief competitor for apartment building mortgages, aside from Freddie Mac. Blakely pointed out that the CMBS market views multifamily rentals as one of the stronger real estate classes -- and therefore a class that CMBS issuers seek.

Analyzing Correlations
Bradford Case, an economist with the Board of Governors of the Federal Reserve System, focused his comments on the quality of data in the commercial real estate market. He noted that as the institutional market continues to expand, insufficient data could take a toll on both investments and risk management. In particular, the paucity of key performance data about markets and market segments could make managing the risk associated with a portfolio of commercial real estate assets more difficult.

Unlike the stock and bond markets, which produce a stream of intraday data, the commercial real estate market is often lucky to have monthly performance data, Case said. He noted that national real estate data sources mainly cover the larger markets, while smaller markets may or may not be included in local or regional data sources. Consequently, researchers and real estate portfolio managers tend to "analogize" between a market for which they have data and those they think are similar.

However, this can be risky since the markets may not behave as similarly as expected under all circumstances. Case noted that his comments did not necessarily reflect the views of the Federal Reserve.

"Good information comes from really deeply knowing the market," Case said. He referred to this as "unsystematic local expertise," since it is expertise particular to a local segment of the market. An example may be the apartment rental market in Tallahassee, as opposed to the overall commercial real estate market in Florida, which comprises many market segments that could have different characteristics and performance results. Without this local-level expertise, Case said, lending can be risky and inefficient because of the existence of an "information asymmetry problem" -- a situation in which the person with better local knowledge has a leg up on a lender who is less familiar with the price and performance dynamics in that particular market.

Case also noted that managing a portfolio of commercial real estate assets requires investors and analysts to understand how asset classes within the real estate market move in relation to one another. This could involve knowing how and when asset classes in various areas are affected by factors such as unemployment and population growth -- and when they're not. He suggested that the dearth of detailed and uniform performance data in commercial real estate should also cause investors and others to question how they define a particular real estate market.

For example, the Boston office properties segment of the commercial real estate market may have a similar performance pattern to the office market in other Northeast cities, or it may be similar to the office market for large cities across the country. Alternately, it may have more in common with other real estate market segments in the Boston area than it does with office markets in other geographic areas. Too often, Case said, assumptions about how various market segments are correlated reflect seat-of-the-pants views but lack empirical support.

The Federal Reserve economist stressed that without knowing which segments of the larger market move together and which are affected by the same supply and demand shocks, it is hard to estimate correlations among returns within a portfolio, as well as default probabilities and portfolio loss distributions. He added that once various correlations are better understood, it will also be possible to make better predictions for markets that lack data -- or, at least, there will be a stronger basis on which to draw analogies between markets for which information exists and those for which information does not exist.

Case said he has conducted preliminary research into correlations within segments of the U.S. commercial real estate market in more than 50 metropolitan areas. But his research is tentative and he hopes economists within the financial industry will generate better and more thorough data in the near future. As became clear at the conference, this additional knowledge -- whether it confirms or refutes existing assumptions about market segments -- can only help real estate investors risk-manage their portfolios better.

Do You Have A Real Estate Strategy?

By Sarah Williams

The importance of a strategic real estate plan to a successful business plan is no Mickey Mouse affair. Walt Disney needed to learn that lesson only once when he set out to create what have since become the world's most successful theme parks. Just before World War II, Disney envisioned an eight-acre amusement park. When his plans were delayed by the war, he used the time to expand his dream, ultimately purchasing a 160-acre tract of orange groves in Anaheim, Calif. There, he built Disneyland.

By any standard, the park has been a success. At the time, Disney's decision to acquire a larger tract of land than he thought he would need was seen as extravagant. And yet even that seeming extravagance proved inadequate. Shortly after the park's opening day, Disney predicted, "We're gonna kick ourselves for not buying everything within a radius of 10 miles around here."

Decades later, while planning for Disney World in Orlando, he was determined not to make the mistake he'd made in California. In Florida, he developed a long-term master plan for future growth, acquiring a land holding that rivals many midsize cities. The result has been decades of continual expansion of Disney World - driven by a sound, strategic real estate plan with flexibility that is still in sync with the company's overall business vision.

Few of us will ever be challenged to develop a master plan of this scale. But all businesses rely on some form of real estate to execute their business plans, whether it's a one-person consultancy in a shared office space, a multimillion-dollar manufacturer, or behemoths like Wal-Mart or McDonald's. As Disney learned in Anaheim, the lack of a fully developed strategic real estate plan can limit a company's ability to respond to future opportunities and challenges.

Today, executives who have the responsibility of aligning their corporate real estate strategies with overall business plans see the need for more real estate assets on the balance sheet. Yet, current business trends often dictate that real estate assets consume less of the company's capital.

However, some firms do plan larger real estate investments. Today, 30 percent or more of the value of American corporate holdings currently is allocated to real estate. A new study by Ernst & Young LLP shows that 42 percent of the businesses surveyed plan to increase the amount of real estate they occupy in the next 12 months. Further, 65 percent plan to increase their investment in real estate. Whether a firm is planning to increase or decrease its real estate investment, all firms share the same fundamental mandate: real estate investments must be tied strategically to the business plan.

Who Will Take the Lead?
Though it may represent a substantial part of the balance sheet - and often one third of a corporation's assets - real estate planning receives a disproportionately lower amount of staffing, budgeting, and other resources when compared with other corporate functions. Most manufacturing companies, for example, have in-house expertise in engineering, financial management, communications, and human resources. Some larger companies have substantial in-house real estate planning and management expertise. But it's rare for small to midsize companies to have any in-house real estate capability.

Perhaps this state of affairs occurs at many firms because real estate is not a discipline through which decisions are passed routinely. Because of that, real estate planning frequently has no in-house champion, making it all the more difficult to assemble the necessary resources when real estate decision-making is critical. With a global market and ever-more sophisticated and complex business environments, it's apparent to most that the days have passed when key corporate real estate decisions could be made on an ad-hoc basis by people who are skilled in other areas but unprepared to develop strategic approaches to real estate.

The low priority that strategic real estate planning too often receives is especially troublesome given some recent events. For example, prior to September 11, major corporations generally considered it sound practice to concentrate corporate offices in a central location. After all, this tends to maximize efficiency. In the wake of that day's devastation, however, prevailing wisdom has challenged this monolithic, all-in-one-place approach.

Dispersal to multiple locations that are linked by technology dominates the current debate on how best to locate corporate operations. To illustrate the point, in the week following September 11, AT&T reported a 20-percent increase in its teleconferencing business. Similarly, a Prudential videoconferencing facility that rents to the public doubled business that week.

Manufacturers once distributed their inventories to small warehouse facilities in many locations. Now, so-called super-regional distribution centers and just-in-time through-docking facilities - which take products in the front door and push them almost immediately out the back - are best serving changing business needs. Add to that the weaker economy and it is clear that companies need more flexibility than ever to shrink or grow their real estate assets in lock-step with the demands of the marketplace.

Implementation
At this point, some readers of Area Development might think, "Tell me something I don't know!" Every corporate real estate executive, CFO, or CEO at least gives lip service to the idea that strategic real estate planning is critical to business success. In much the same way, every football coach knows that a team must run and block well, that quarterbacks need good arms, and that receivers need good hands. Just about everyone knows what it takes to be successful. Yet some teams win consistently and some almost never do. The winners are able to move from knowledge to execution.

Typically, thinking about real estate is limited to factors such as how a facility contributes to creating a product, how it affects the supply chain, whether or not it contributes to client intimacy, and how it contributes to employee morale and satisfaction. But real estate can affect many more factors that directly impact the bottom line. Good or bad real estate choices invariably have an impact on recruitment, training, client relations, corporate image, efficiency of workflow, the ability to deploy new technologies, and the return on public or private equity investments in a company.

Because real estate decisions can affect so many things, truly strategic real estate planning is linked closely to the business plan in realistic and practical ways. Assembling a complex real estate plan is precisely that - a complex undertaking with many parts that must be integrated seamlessly to form a coherent picture. Yet far too many real estate plans fail to account for all of the pieces of the puzzle.

For example, if your company were to consider buying the "perfect" building today, how perfect will it be when the size of your business doubles in accordance with your business plan? Would it be smarter to lease space in a corporate-center environment where the landlord has ample motivation to accommodate your expansion requirements? Would a stand-alone building be the only way to project the high-end image that's also demanded by your business plan? Or would a stand-alone facility belie your market position as the value provider of your product or service?

The following questions deserve consideration in any such analysis:

- Should you be deploying any capital to bricks and mortar when your business plan calls for capital investments in other areas of your company?

- Would that capital provide a higher return if it were used to support the purchase of new capital equipment, increase marketing, or fund other capital requirements?

- Are your facilities geographically aligned with your targeted growth markets?

- Are you considering the locations, technologies, and amenities that are required to attract and keep the kind of workers you need?

- Conversely, how will your real estate plan accommodate an unexpected downturn in sales?

Real Life Real Estate
These and other questions were among the challenges considered recently by executives at Philips Communication, Security & Imaging, Inc., which is now pending acquisition by German-based Bosch GmbH. The Communications, Security & Imaging unit - currently a division of Philips North America Corp. - designs, manufactures, and supports communications and security products and systems, including closed-circuit video surveillance, paging, and public-address systems. The company's U.S. headquarters were housed in an antiquated facility that was inherited when the current parent company purchased the firm. The executive team agreed that the facility did not support the business strategy in many ways.

The building had been retrofitted so many times that materials no longer flowed through the facility efficiently and departments that needed to relate physically could not do so. The building was not attractive, a factor that had real consequences for a firm known in its industry as a technology leader. Also, the building didn't offer a pleasant working environment, which had a profound effect on employee morale and productivity. Further, the facility was leased from a landlord who didn't share the firm's desire to make the infrastructure improvements that were sorely needed, such as sophisticated telecommunications systems, high-speed Internet access, and HVAC improvements. This was a straightforward case of a company's real estate being out of sync with its business planning.

Philips executives reached a number of conclusions. First, they did not have the in-house expertise to assemble their complex real estate puzzle, and, second, they did not want to take on the overhead of a full-time, in-house real estate planning and development team.

So Philips hired the expertise it needed. The company's requirements included locating the new facility within close proximity to the existing facility and avoiding any disruption to the commuting patterns of the current work force - which would reduce the need for a large recruitment and training effort. Philips wanted its manufacturing and distribution facilities to be connected to its office facilities, yet also saw the advantage of having some separation between them. Company executives also wanted a large amount of office space outfitted with the high-end look and sensibility they needed to support their position in the marketplace. Finally, despite the highly customized requirements they had, they did not want to invest their assets in owning a facility.

The firm that Philips chose was a full-service real estate company that was able to locate and purchase the real estate; design, specify, and handle permits; build the facility; and create a lease structure that was attractive both to Philips and to the real estate company, which would also serve as Philips' lessor. And, because the real estate firm specialized in development projects within the same geographic areas in which it operated, it also helped Philips take advantage of special state-level funding programs that provided incentives for companies to expand or retain jobs in the state.

Honest Evaluation
It's useful to look behind the scenes at decisions that were made in the Philips deal. The facility that Philips needed was unique. For the real estate company, it would not have been economically sound to build so much office space in a manufacturing facility - if the tenant were to leave, finding a replacement company with similar requirements would be nearly impossible.

In order to serve Philips' needs and also make it economically feasible for the developer and facility owner, two buildings were designed - one for offices and one for manufacturing and distribution. The two were connected by an umbilical structure that could be removed if later required. This met Philips' needs and protected the investment of the real estate company.

How can you develop a sound real estate strategy for your business? The truth is, you probably can't do it alone. The first step is to honestly, rigorously, and objectively evaluate whether you have the in-house expertise required to tackle such a mission-critical task. If the answer is no, your first step must be to determine how to fill that need, either by building the capability in-house or engaging the necessary outside help.

Just as lawyers, accountants, and other consultants help in crafting a business's strategy, qualified real estate professionals who contribute their knowledge and guidance can yield huge dividends for an organization.

Developing any important strategy that will influence the future of your business is tough and complicated work. Sometimes, it can seem overwhelmingly complex. But as Disney was fond of saying, "It's kind of fun to do the impossible."

Point Of Concern: Why Real Estate Ponzi Schemes Continues Despite New Real Estate Bill In India?

The major question is why the real estate ponzi schemes are making waves in investors despite the new regulatory bill introduced. Why government is not making any efforts to curb these schemes?

On 7 April 2015, the Union cabinet cleared the Real Estate (Regulation and Development) Bill. The Bill essentially mandates that every state needs to set up a Real Estate Regulatory Authority (RERA), to protect consumer interests.

Is Commercial Property Still a Good Investment?

By M H Ahssan

These are blissful times for commercial real estate investors. Having fallen into a deep slump with the ending of the Internet boom, the market has come surging back. In 2004 alone, prices rose 26% for apartment complexes, 21% for industrial properties, 14% for retail properties and 6% for office buildings, according to Real Capital Analytics, a New York real estate research firm.

And the market gives no sign of slackening. "We're not seeing any slowdown at all," says Steven Dunn, chief economist for CB Richard Ellis, a big commercial real estate services company based in Los Angeles. "The numbers are great, not just for sales but for leasing, too."

But not everyone is so confident. Over the past few months, a number of major institutional and private investors have been selling off large chunks of their portfolios of prime commercial real estate. These investors, which include Calpers, the $186 billion pension fund, have been taking advantage of what they see as a frothy market. They are putting the sale proceeds into less expensive real estate or into other assets entirely.

The Rubenstein Company, a Philadelphia-based real estate firm, is one investor that has pulled its money out of real estate with the expectation that prices will come back down. Last year, the company sold nearly all of its office buildings for about $1 billion. "We thought the markets weren't going to get much better and had a chance to get considerably worse," says CEO David Rubenstein.

To be sure, for every seller there is a buyer, and other investors have rushed forward to buy these properties, often at record prices. But as the consensus builds that the housing market has become seriously overvalued, some are asking whether the same might be true of commercial property. The answer matters not just to the individual and institutional investors who are committing ever-greater sums to real estate, but also to the growing number of companies who are using their valuable property to obtain cheap financing.

A Flood of Capital
Several forces are driving commercial real estate's revival. Most obviously, the economy is improving and businesses are growing once more. As they expand their operations and hire new employees they need additional space. But real estate pricing has recovered faster than the economy itself. Indeed, while prices have rebounded nicely, rents have been sluggish: The average rent today is $15.42 a foot, down from $28.92 in 2000. A more important reason for real estate's rise has been a flood of new investment capital. Some of this comes from individuals seeking better returns than they can achieve in the debt or equity markets. These investors have channeled great sums to investment vehicles such as REITs and TICs (tenants-in-common).

The big money has come from institutions. Spooked by their losses after the dotcom bust and drawn to the reliable cash flows offered by property, these investors are now paying closer attention to commercial real estate. One is TIAA-CREF, a national financial services company with over $340 billion in assets under management. "We see this asset class as a great addition to our portfolio," says Tom Garbutt, the company's managing director and head of real estate. "It's a nice diversifier, has a current income stream and a potential for appreciation." The company now owns $14 billion of real estate properties.

The resulting upswing in prices for the best properties has been a boon for the owners. In fact, a growing number of corporations are taking the opportunity to use their real estate as a financing tool. Through sale-leasebacks, companies can sell their property to an investor who will agree to lease it back to the company for a specified period. Many find this as attractive as issuing debt, since property values are high but rents remain affordable. Some of these deals have been gargantuan. Last year, Bank of America did a $770 million leaseback for most of its bank branches. McDonald's (which has historically been an owner of property) also did one, valued at $340 million. Companies are using the money for different purposes, ranging from balance sheet improvement to acquisitions.

Few Signs of Trouble
How sustainable are today's high prices? Not very, argue some. "We feel that properties are overvalued," says David Harris, a research analyst who covers REITs for Lehman Brothers. Harris notes that the "euphoria" of bidding on certain commercial properties should give investors pause, especially since rising interest rates may soon make real estate a less attractive investment.

Another potential concern is that yields on property ownership are falling. Also known as capitalization rates ("cap rates" for short), yields have dropped over the past three years to near-historic lows. While this is the natural outcome of higher prices -- cap rates are the ratio of a property's yearly income to purchase price -- it can also indicate that operating income hasn't kept pace with the higher prices. This can make real estate less attractive to investors primarily interested in the cash stream.

But there are good reasons to believe that the market is actually quite strong. One is that the fundamentals are improving. Metropolitan office vacancies, for example, have fallen from 16.8% during the first quarter of 2004 to 15.4% today. Dunn points to San Francisco as an example of an area where the improvement has been substantial: In eight quarters, vacancies in that market have fallen from 23% to just 15%.

And improving occupancy levels mean higher income. "People often forget that income goes up faster than occupancy," says Peter Linneman, a professor of real estate at Wharton. "That's because as occupancy picks up you can boost your rents a little and you pick up more ancillary income from things such as parking and health clubs. I think this year will be good in terms of income for commercial properties, and next year will be great."

Furthermore, the market does not suffer from excess construction. "There was huge overbuilding in the late 1980s which really hurt the market when we had a recession," says Joseph Gyourko, also a professor of real estate at Wharton. "But for the most part real estate did not get overbuilt before the last downturn." Nor do developers' plans seem excessive. One reason is that banks have become more conservative in their lending, requiring developers to show that their buildings will be fully leased. Another is that the soaring price for concrete and steel (a product of China's massive construction boom) has made new construction costly. The result, of course, is limited supply at a time of growing demand, which suggests that prices have further to rise.

Ultimately, say many experts, investors should be asking how commercial real estate compares with other investments. And next to stocks and bonds, it remains attractive. "If you do CAPM or other risk pricing models, you find that real estate remains 15 to 35% underpriced based on its cash stream and its risk profile relative to other alternatives," says Linneman. In other words, not only does real estate give investors a better current income than debt or equity, but it's safer.

The reason is simple: commercial real estate is a lease claim on the same companies that make up the S&P 500. If a company runs out of cash, it will always pay its rent before it pays a dividend and will usually pay rent before it makes debt payments. "Real estate has a risk profile closer to bonds, but it's trading as if it's equity," says Linneman.

Largely because of this comparatively attractive income stream, the institutional investors are unlikely to abandon the market. This may be true even if cap rates fall farther. Because institutional investors often pay with cash, they can accept lower cap rates: Without interest payments, their effective yields are higher that those of more leveraged buyers. Garbutt says that TIAA-CREF has no plans to reduce its exposure to real estate. "We don't play the short game. For us, the question is, 'What makes sense for our participants?' And the answer is to stay well diversified and active in all markets."

What about interest rates? While higher rates can dampen the real estate market by raising borrowing costs, rates remain at historic lows. The Federal Reserve has signaled its intention to increase rates gradually, about a quarter point per quarter, but this may not be enough to ward off buyers. "If we saw a 200 basis point uplift in the 10-year treasury over a year, that would have some effect on real estate pricing," comments Garbutt. "But remember that an abrupt jump in interest rates and the 10-year would affect other asset classes, too."

Buyer Beware
None of this is to say that some real estate isn't perilously overpriced. In particular, speculation appears to be driving the prices of many apartment buildings and condominiums to unsustainable levels. "There some people who are being wildly aggressive when it comes to pricing cash streams for apartment buildings," says Linneman. "They are looking at a building with 45% vacancy and saying 'I'm going to buy it as if it's 90% occupied.'" Similarly, condominiums -- which offer virtually no income stream since they are owned, not leased -- are looking shaky. Between 50% and 60% are now being presold to investors who don't plan to live in them. Once buyers stop showing up to the presales, the prices will tumble.

David Rubenstein also sees weakness in certain office markets, especially in the suburbs of Washington, D.C., and in southern California. In those markets leasing costs are rising, net operating income is falling (due to leases that tenants signed five years ago but are now up for renewal, at lower rents), and investors are taking on what he considers excessive leverage. That should produce lower prices for some properties.

And there's always the risk of some broader meltdown that would bring down the real estate market along with stocks and bonds. Linneman argues that in this case, an investor would be wise to be in the asset that's the least overvalued to begin with: commercial real estate.

Barring a calamity, investors should expect solid, if not spectacular, returns, says Gyourko. He predicts that while the real estate market will continue to do well, the days of double-digit appreciation are over. "Relative to historic pricing, real estate is pretty expensive, and that's something that should make everyone think hard," he says. "Does it mean that prices are going to fall? No it doesn't. But it almost certainly means that the returns will be lower going forward. The million dollar question is this: Will you be disappointed relative to other things you could have done with your money?"

Is Commercial Property Still a Good Investment?

By M H Ahssan

These are blissful times for commercial real estate investors. Having fallen into a deep slump with the ending of the Internet boom, the market has come surging back. In 2004 alone, prices rose 26% for apartment complexes, 21% for industrial properties, 14% for retail properties and 6% for office buildings, according to Real Capital Analytics, a New York real estate research firm.

And the market gives no sign of slackening. "We're not seeing any slowdown at all," says Steven Dunn, chief economist for CB Richard Ellis, a big commercial real estate services company based in Los Angeles. "The numbers are great, not just for sales but for leasing, too."

But not everyone is so confident. Over the past few months, a number of major institutional and private investors have been selling off large chunks of their portfolios of prime commercial real estate. These investors, which include Calpers, the $186 billion pension fund, have been taking advantage of what they see as a frothy market. They are putting the sale proceeds into less expensive real estate or into other assets entirely.

The Rubenstein Company, a Philadelphia-based real estate firm, is one investor that has pulled its money out of real estate with the expectation that prices will come back down. Last year, the company sold nearly all of its office buildings for about $1 billion. "We thought the markets weren't going to get much better and had a chance to get considerably worse," says CEO David Rubenstein.

To be sure, for every seller there is a buyer, and other investors have rushed forward to buy these properties, often at record prices. But as the consensus builds that the housing market has become seriously overvalued, some are asking whether the same might be true of commercial property. The answer matters not just to the individual and institutional investors who are committing ever-greater sums to real estate, but also to the growing number of companies who are using their valuable property to obtain cheap financing.

A Flood of Capital
Several forces are driving commercial real estate's revival. Most obviously, the economy is improving and businesses are growing once more. As they expand their operations and hire new employees they need additional space. But real estate pricing has recovered faster than the economy itself. Indeed, while prices have rebounded nicely, rents have been sluggish: The average rent today is $15.42 a foot, down from $28.92 in 2000. A more important reason for real estate's rise has been a flood of new investment capital. Some of this comes from individuals seeking better returns than they can achieve in the debt or equity markets. These investors have channeled great sums to investment vehicles such as REITs and TICs (tenants-in-common).

The big money has come from institutions. Spooked by their losses after the dotcom bust and drawn to the reliable cash flows offered by property, these investors are now paying closer attention to commercial real estate. One is TIAA-CREF, a national financial services company with over $340 billion in assets under management. "We see this asset class as a great addition to our portfolio," says Tom Garbutt, the company's managing director and head of real estate. "It's a nice diversifier, has a current income stream and a potential for appreciation." The company now owns $14 billion of real estate properties.

The resulting upswing in prices for the best properties has been a boon for the owners. In fact, a growing number of corporations are taking the opportunity to use their real estate as a financing tool. Through sale-leasebacks, companies can sell their property to an investor who will agree to lease it back to the company for a specified period. Many find this as attractive as issuing debt, since property values are high but rents remain affordable. Some of these deals have been gargantuan. Last year, Bank of America did a $770 million leaseback for most of its bank branches. McDonald's (which has historically been an owner of property) also did one, valued at $340 million. Companies are using the money for different purposes, ranging from balance sheet improvement to acquisitions.

Few Signs of Trouble
How sustainable are today's high prices? Not very, argue some. "We feel that properties are overvalued," says David Harris, a research analyst who covers REITs for Lehman Brothers. Harris notes that the "euphoria" of bidding on certain commercial properties should give investors pause, especially since rising interest rates may soon make real estate a less attractive investment.

Another potential concern is that yields on property ownership are falling. Also known as capitalization rates ("cap rates" for short), yields have dropped over the past three years to near-historic lows. While this is the natural outcome of higher prices -- cap rates are the ratio of a property's yearly income to purchase price -- it can also indicate that operating income hasn't kept pace with the higher prices. This can make real estate less attractive to investors primarily interested in the cash stream.

But there are good reasons to believe that the market is actually quite strong. One is that the fundamentals are improving. Metropolitan office vacancies, for example, have fallen from 16.8% during the first quarter of 2004 to 15.4% today. Dunn points to San Francisco as an example of an area where the improvement has been substantial: In eight quarters, vacancies in that market have fallen from 23% to just 15%.

And improving occupancy levels mean higher income. "People often forget that income goes up faster than occupancy," says Peter Linneman, a professor of real estate at Wharton. "That's because as occupancy picks up you can boost your rents a little and you pick up more ancillary income from things such as parking and health clubs. I think this year will be good in terms of income for commercial properties, and next year will be great."

Furthermore, the market does not suffer from excess construction. "There was huge overbuilding in the late 1980s which really hurt the market when we had a recession," says Joseph Gyourko, also a professor of real estate at Wharton. "But for the most part real estate did not get overbuilt before the last downturn." Nor do developers' plans seem excessive. One reason is that banks have become more conservative in their lending, requiring developers to show that their buildings will be fully leased. Another is that the soaring price for concrete and steel (a product of China's massive construction boom) has made new construction costly. The result, of course, is limited supply at a time of growing demand, which suggests that prices have further to rise.

Ultimately, say many experts, investors should be asking how commercial real estate compares with other investments. And next to stocks and bonds, it remains attractive. "If you do CAPM or other risk pricing models, you find that real estate remains 15 to 35% underpriced based on its cash stream and its risk profile relative to other alternatives," says Linneman. In other words, not only does real estate give investors a better current income than debt or equity, but it's safer.

The reason is simple: commercial real estate is a lease claim on the same companies that make up the S&P 500. If a company runs out of cash, it will always pay its rent before it pays a dividend and will usually pay rent before it makes debt payments. "Real estate has a risk profile closer to bonds, but it's trading as if it's equity," says Linneman.

Largely because of this comparatively attractive income stream, the institutional investors are unlikely to abandon the market. This may be true even if cap rates fall farther. Because institutional investors often pay with cash, they can accept lower cap rates: Without interest payments, their effective yields are higher that those of more leveraged buyers. Garbutt says that TIAA-CREF has no plans to reduce its exposure to real estate. "We don't play the short game. For us, the question is, 'What makes sense for our participants?' And the answer is to stay well diversified and active in all markets."

What about interest rates? While higher rates can dampen the real estate market by raising borrowing costs, rates remain at historic lows. The Federal Reserve has signaled its intention to increase rates gradually, about a quarter point per quarter, but this may not be enough to ward off buyers. "If we saw a 200 basis point uplift in the 10-year treasury over a year, that would have some effect on real estate pricing," comments Garbutt. "But remember that an abrupt jump in interest rates and the 10-year would affect other asset classes, too."

Buyer Beware
None of this is to say that some real estate isn't perilously overpriced. In particular, speculation appears to be driving the prices of many apartment buildings and condominiums to unsustainable levels. "There some people who are being wildly aggressive when it comes to pricing cash streams for apartment buildings," says Linneman. "They are looking at a building with 45% vacancy and saying 'I'm going to buy it as if it's 90% occupied.'" Similarly, condominiums -- which offer virtually no income stream since they are owned, not leased -- are looking shaky. Between 50% and 60% are now being presold to investors who don't plan to live in them. Once buyers stop showing up to the presales, the prices will tumble.

David Rubenstein also sees weakness in certain office markets, especially in the suburbs of Washington, D.C., and in southern California. In those markets leasing costs are rising, net operating income is falling (due to leases that tenants signed five years ago but are now up for renewal, at lower rents), and investors are taking on what he considers excessive leverage. That should produce lower prices for some properties.

And there's always the risk of some broader meltdown that would bring down the real estate market along with stocks and bonds. Linneman argues that in this case, an investor would be wise to be in the asset that's the least overvalued to begin with: commercial real estate.

Barring a calamity, investors should expect solid, if not spectacular, returns, says Gyourko. He predicts that while the real estate market will continue to do well, the days of double-digit appreciation are over. "Relative to historic pricing, real estate is pretty expensive, and that's something that should make everyone think hard," he says. "Does it mean that prices are going to fall? No it doesn't. But it almost certainly means that the returns will be lower going forward. The million dollar question is this: Will you be disappointed relative to other things you could have done with your money?"

Indian Real Estate: Investors Are Shopping, but Are They Buying Hype?

By M H Ahssan

Drive through any of India's major cities and it will be impossible to go a mile without running into brightly colored cranes, construction rubble and men in yellow helmets scurrying up and down skyscrapers. Commercial high rises, residential townships, industrial parks and shopping malls are exploding into existence, encouraged by both long-term and speculative investors. Oversized private equity commitments by a growing number of foreign investors and home-grown financial institutions are helping to feed the frenzy.

But several astute industry watchers have begun poking big holes in that picture. For one, they say that many foreign investors have actually brought in only a small portion of their promised investments. Second, soaring land prices and price resistance from buyers are narrowing investors' margins significantly. Finally, they note that concerns continue to run high about the regulatory opaqueness for real estate ventures, bureaucratic red tape and the absence of title insurance, in addition to a host of other issues. India Knowledge@Wharton spoke with prominent private investors, property developers and brokerage firms to understand how these factors are tempering investors' appetites for Indian real estate.

With yields between 30% and 40% during the past two years, India's real estate industry has been the toast of global investment funds. But expectations for future returns have been sharply reduced to between 12% and 20% over the next few years. For many foreign investors, this means having to weigh Indian real estate opportunities against deals that offer comparable returns in other emerging markets like Eastern Europe or Latin America.

Fears of a real estate bubble and an overheated economy have led India's central bank to require a lender cutback on real estate loans. That move has pushed up interest rates, lowering consumers' appetites for home financing and simultaneously raising rents for apartments and offices. Most Indian real estate companies are privately held and their financial information is not readily available. The absence of comprehensive market data across product types like office, retail, industrial and residential properties further hurts the ability of investors to read the right signals, and the occasional rumor of a large deal going bust or a property developer resorting to a distress sale can damage investment sentiments far more than warranted.

More Hype than Actual Investments
Clearly, local investors understand the terrain far better than foreign investors. Much of the foreign capital committed to Indian real estate ventures has yet to be invested, says Aashish Kalra, co-founder and managing director of Trikona Capital, a private equity firm with offices in New York City, London and Mumbai. "Last year, less than $1 billion [was actually invested in] Indian real estate. That's less than the value of half a building in Times Square," he says. That compares with market estimates of between $15 billion and $20 billion in foreign capital headed for Indian real estate.

Kalra cited these figures during a panel discussion on real estate investing at a recent New York City event organized by The Indus Entrepreneurs (TiE), a network of entrepreneurs founded 15 years ago in Silicon Valley. "A negligible amount of foreign capital will get invested in Indian real estate in the next 24 months," he told the panel.

Sameer Nayar, managing director and head of real estate finance-Asia Pacific at Credit Suisse, offers a similar assessment. "There is a lot of hype about capital going into Indian real estate ... [but] not a lot of money is actually going in," he says. Extracting good returns from those investments calls for significant local market expertise in dealing with regulatory and other obstacles. "You make money because you can deal with the problems, and that's why your returns could be 50%," he adds. "If it were an easy market to work in, you would make only 15%."

Short-term Disenchantment
In April 2006, Trikona Capital group firm Trinity Capital raised 250 million pounds ($500 million) for Indian real estate investment in a public offering through London's Alternative Investment Market (AIM). Kalra says his company has deployed about $400 million in Indian real estate projects over the past year.

Including Trinity, about a dozen real estate funds targeting India have raised a combined $2 billion in the past year through listings on the AIM. Most of them are currently trading at levels significantly below their offer prices, revealing investor disenchantment. Trinity's share made its debut in April 2006 at one pound; it now trades at about 86 pence. Hirco, an Isle of Man-domiciled company promoted by the Mumbai-based Hiranandani Constructions group, raised about 382 million pounds ($755 million) from its IPO last December; since then, its shares have lost considerable sheen, down from 5 pounds to about 390 pence in the second week of May. Exceptions include Unitech Corporate Parks, which listed on the AIM last December at 93 pence and now trades at 96.25 pence.

"We see the opportunity [in Indian real estate], but we also see the risks and challenges involved," says Chanakya Chakravarti, managing director of real estate at Actis, a London-based private equity fund that manages assets of about $3.4 billion. Actis plans to set up a $300 million India real estate fund. It already has two other existing funds with an estimated equity of $475 million that have invested in Indian real estate, auto ancillaries and other industries. "Each fund has a unique risk-return profile, and we work with these. For us, India is a long-term story," he adds.

Chakravarti lists three main risks or challenges that real estate investors in India will be up against in the short term. The first, he says, is an oversupply of office space in the major and second-tier cities. A hazy regulatory framework fostering indecision and delayed investments is another concern. Finally, he notes, opaque deal-making processes that narrow the exit routes will deter serious investors.

"The property market today is rife with uncertainties. Prices as well as interest rates have been rising," says Anuj Puri, managing director of real estate services firm Trammell Crow Meghraj, the Indian joint venture of Dallas, Tex.-based real estate services firm Trammell Crow and the Meghraj Group, a financial services firm in London. "It is not advisable to expect any short-term gains; but of course, for long-term investors, India's strong fundamentals are still intact. A long-term investor can expect average returns of 15% to 20% per year."

Vikas Oberoi, managing director of Oberoi Constructions in Mumbai, says the risk-return profile for real estate investments is far brighter for those who have accumulated land inventory at prices much lower than prevailing levels. "The average net margin in today's market is 20% to 25%; we can easily do 15% better than the market," he says. Oberoi claims his company can achieve those higher returns because, among other reasons, "most of the land has been bought earlier."

Oberoi Constructions has an inventory of 15 million square feet of mostly prime land in Mumbai. At today's prices, Oberoi expects it to generate gross revenues of $2.2 billion. The company is focused mostly on for-sale residential apartments, although it dabbles in shopping malls, hotels and other commercial property lines. Oberoi expects his company to post $200 million in revenue this year, rising to $300 million in 2008.

This past January, Morgan Stanley's Special Situations Fund invested $152 million for a 10.75% stake in Oberoi Constructions, effectively valuing the company at about $1.4 billion. Oberoi says the untapped upside in his company's land bank was a major attraction for the institutional suitors it attracted. For instance, five years ago it bought a land lot with 8 million square feet in Mumbai's northwestern suburb of Goregaon for Rs. 100 crore ($24 million). Oberoi says the property would be worth 20 times more today.

"Where is the supply? There is only demand," says Oberoi. "In fact, I want the market to stabilize or [prices to] come down because then we would get land at cheaper prices. It is absolutely a seller's market."

Second-tier Migration
The most visible changes in the Indian real estate sector include the emergence of well defined product categories, the division of the market into tiered cities and a widening of financing options.

In the past, real estate was sold either as residential or as commercial property. With the maturing of the market and globalization of the investor base, the categories have been sharpened and new ones established. "Investors in the residential market are very different from the office and retail space investor," says Sanjeev Dasgupta, CFO and head of investments at Kshitij Investment Advisory Services, part of the Future Group, a large Mumbai-based owner of shopping malls across the country. In the residential sector, investors are in for high returns and are willing to take high risks, he says. This also allows for easy exit, although the risk of a mismatch between potential and real returns is high, he adds.

According to Poonam Mahtani, a national director of retail services firm Colliers International in India, "The investment risk is lower in the metros, but prices there are much higher than those in tier II cities." Several equity funds have consciously focused on tier II cities, because they believe that this offers the most potential. "Land prices are skyrocketing. Buying to sell is a very risky strategy. Land prices are way beyond levels that will generate a decent return. It doesn't make sense to invest any more unless you go to second- or third-tier markets."

Kalra, too, sees the markets outside of India's major cities as the most attractive, simply because they are not the low-hanging fruit sought by the early crop of investors with relatively lower risk appetites. "There are lots of opportunities outside the main metros. India has 30 cities with a population of a million people each," he says. Adds Dasgupta, "The returns are huge in tier II cities, where there is a large untapped potential." He believes that this sector will see a rental yield of 12% to 14% in the next few years.

In office space, experts see a migration towards second-tier cities. A recent report by Deutsche Bank on real estate trends notes, "As the demand for modern space has continually increased, new office locations have had to be developed in the south and east of the urban area (Mumbai and Delhi)." In Mumbai, secondary business districts have emerged in recent years, including the Bandra-Kurla complex in the central suburbs, 25 miles from the old commercial hubs in the southern end of the city.

Much-needed Transparency
For foreign investors, one troubling fact is a pan-India phenomenon: inadequate transparency in land valuations they use to price their investments. In an interview last month, M. Damodaran, chairman of the Securities and Exchange Board of India, discussed the lack of clarity in real estate companies' disclosures, especially with respect to their land banks. "We sought clarity ... on matters like, 'What does your land bank comprise, [and] what are the valuation aspects you have indicated?'" he told the India news wire service. "Where there is only an agreement to develop land, there must be complete disclosure. All such agreements are to be made available for inspection," he said, adding that he preferred land valuations to be made at current prices and not on the basis of future projections.

Trammell Crow Meghraj's Puri agrees. "There is a marked lack of transparency, corporate governance and accountability among India's real estate developers. There also continues to be a serious lack of quality infrastructure. In addition, India scores low in terms of congenial political environment in terms of the real estate sector. This means that there is a lack of clarity in pertinent policies."

But Puri also believes those issues will soon fade away as India's real estate markets mature. "Although real estate is a regional and highly location-specific industry, India will replicate the events that occurred in emerging markets like Mexico and Central Eastern Europe [including Russia, Bulgaria and Poland]," he says. "In these countries, too, foreign investments were the primary drivers for transparency, accountability and higher capital appreciation in the real estate sector."

Indian Real Estate: Investors Are Shopping, but Are They Buying Hype?

By M H Ahssan

Drive through any of India's major cities and it will be impossible to go a mile without running into brightly colored cranes, construction rubble and men in yellow helmets scurrying up and down skyscrapers. Commercial high rises, residential townships, industrial parks and shopping malls are exploding into existence, encouraged by both long-term and speculative investors. Oversized private equity commitments by a growing number of foreign investors and home-grown financial institutions are helping to feed the frenzy.

But several astute industry watchers have begun poking big holes in that picture. For one, they say that many foreign investors have actually brought in only a small portion of their promised investments. Second, soaring land prices and price resistance from buyers are narrowing investors' margins significantly. Finally, they note that concerns continue to run high about the regulatory opaqueness for real estate ventures, bureaucratic red tape and the absence of title insurance, in addition to a host of other issues. India Knowledge@Wharton spoke with prominent private investors, property developers and brokerage firms to understand how these factors are tempering investors' appetites for Indian real estate.

With yields between 30% and 40% during the past two years, India's real estate industry has been the toast of global investment funds. But expectations for future returns have been sharply reduced to between 12% and 20% over the next few years. For many foreign investors, this means having to weigh Indian real estate opportunities against deals that offer comparable returns in other emerging markets like Eastern Europe or Latin America.

Fears of a real estate bubble and an overheated economy have led India's central bank to require a lender cutback on real estate loans. That move has pushed up interest rates, lowering consumers' appetites for home financing and simultaneously raising rents for apartments and offices. Most Indian real estate companies are privately held and their financial information is not readily available. The absence of comprehensive market data across product types like office, retail, industrial and residential properties further hurts the ability of investors to read the right signals, and the occasional rumor of a large deal going bust or a property developer resorting to a distress sale can damage investment sentiments far more than warranted.

More Hype than Actual Investments
Clearly, local investors understand the terrain far better than foreign investors. Much of the foreign capital committed to Indian real estate ventures has yet to be invested, says Aashish Kalra, co-founder and managing director of Trikona Capital, a private equity firm with offices in New York City, London and Mumbai. "Last year, less than $1 billion [was actually invested in] Indian real estate. That's less than the value of half a building in Times Square," he says. That compares with market estimates of between $15 billion and $20 billion in foreign capital headed for Indian real estate.

Kalra cited these figures during a panel discussion on real estate investing at a recent New York City event organized by The Indus Entrepreneurs (TiE), a network of entrepreneurs founded 15 years ago in Silicon Valley. "A negligible amount of foreign capital will get invested in Indian real estate in the next 24 months," he told the panel.

Sameer Nayar, managing director and head of real estate finance-Asia Pacific at Credit Suisse, offers a similar assessment. "There is a lot of hype about capital going into Indian real estate ... [but] not a lot of money is actually going in," he says. Extracting good returns from those investments calls for significant local market expertise in dealing with regulatory and other obstacles. "You make money because you can deal with the problems, and that's why your returns could be 50%," he adds. "If it were an easy market to work in, you would make only 15%."

Short-term Disenchantment
In April 2006, Trikona Capital group firm Trinity Capital raised 250 million pounds ($500 million) for Indian real estate investment in a public offering through London's Alternative Investment Market (AIM). Kalra says his company has deployed about $400 million in Indian real estate projects over the past year.

Including Trinity, about a dozen real estate funds targeting India have raised a combined $2 billion in the past year through listings on the AIM. Most of them are currently trading at levels significantly below their offer prices, revealing investor disenchantment. Trinity's share made its debut in April 2006 at one pound; it now trades at about 86 pence. Hirco, an Isle of Man-domiciled company promoted by the Mumbai-based Hiranandani Constructions group, raised about 382 million pounds ($755 million) from its IPO last December; since then, its shares have lost considerable sheen, down from 5 pounds to about 390 pence in the second week of May. Exceptions include Unitech Corporate Parks, which listed on the AIM last December at 93 pence and now trades at 96.25 pence.

"We see the opportunity [in Indian real estate], but we also see the risks and challenges involved," says Chanakya Chakravarti, managing director of real estate at Actis, a London-based private equity fund that manages assets of about $3.4 billion. Actis plans to set up a $300 million India real estate fund. It already has two other existing funds with an estimated equity of $475 million that have invested in Indian real estate, auto ancillaries and other industries. "Each fund has a unique risk-return profile, and we work with these. For us, India is a long-term story," he adds.

Chakravarti lists three main risks or challenges that real estate investors in India will be up against in the short term. The first, he says, is an oversupply of office space in the major and second-tier cities. A hazy regulatory framework fostering indecision and delayed investments is another concern. Finally, he notes, opaque deal-making processes that narrow the exit routes will deter serious investors.

"The property market today is rife with uncertainties. Prices as well as interest rates have been rising," says Anuj Puri, managing director of real estate services firm Trammell Crow Meghraj, the Indian joint venture of Dallas, Tex.-based real estate services firm Trammell Crow and the Meghraj Group, a financial services firm in London. "It is not advisable to expect any short-term gains; but of course, for long-term investors, India's strong fundamentals are still intact. A long-term investor can expect average returns of 15% to 20% per year."

Vikas Oberoi, managing director of Oberoi Constructions in Mumbai, says the risk-return profile for real estate investments is far brighter for those who have accumulated land inventory at prices much lower than prevailing levels. "The average net margin in today's market is 20% to 25%; we can easily do 15% better than the market," he says. Oberoi claims his company can achieve those higher returns because, among other reasons, "most of the land has been bought earlier."

Oberoi Constructions has an inventory of 15 million square feet of mostly prime land in Mumbai. At today's prices, Oberoi expects it to generate gross revenues of $2.2 billion. The company is focused mostly on for-sale residential apartments, although it dabbles in shopping malls, hotels and other commercial property lines. Oberoi expects his company to post $200 million in revenue this year, rising to $300 million in 2008.

This past January, Morgan Stanley's Special Situations Fund invested $152 million for a 10.75% stake in Oberoi Constructions, effectively valuing the company at about $1.4 billion. Oberoi says the untapped upside in his company's land bank was a major attraction for the institutional suitors it attracted. For instance, five years ago it bought a land lot with 8 million square feet in Mumbai's northwestern suburb of Goregaon for Rs. 100 crore ($24 million). Oberoi says the property would be worth 20 times more today.

"Where is the supply? There is only demand," says Oberoi. "In fact, I want the market to stabilize or [prices to] come down because then we would get land at cheaper prices. It is absolutely a seller's market."

Second-tier Migration
The most visible changes in the Indian real estate sector include the emergence of well defined product categories, the division of the market into tiered cities and a widening of financing options.

In the past, real estate was sold either as residential or as commercial property. With the maturing of the market and globalization of the investor base, the categories have been sharpened and new ones established. "Investors in the residential market are very different from the office and retail space investor," says Sanjeev Dasgupta, CFO and head of investments at Kshitij Investment Advisory Services, part of the Future Group, a large Mumbai-based owner of shopping malls across the country. In the residential sector, investors are in for high returns and are willing to take high risks, he says. This also allows for easy exit, although the risk of a mismatch between potential and real returns is high, he adds.

According to Poonam Mahtani, a national director of retail services firm Colliers International in India, "The investment risk is lower in the metros, but prices there are much higher than those in tier II cities." Several equity funds have consciously focused on tier II cities, because they believe that this offers the most potential. "Land prices are skyrocketing. Buying to sell is a very risky strategy. Land prices are way beyond levels that will generate a decent return. It doesn't make sense to invest any more unless you go to second- or third-tier markets."

Kalra, too, sees the markets outside of India's major cities as the most attractive, simply because they are not the low-hanging fruit sought by the early crop of investors with relatively lower risk appetites. "There are lots of opportunities outside the main metros. India has 30 cities with a population of a million people each," he says. Adds Dasgupta, "The returns are huge in tier II cities, where there is a large untapped potential." He believes that this sector will see a rental yield of 12% to 14% in the next few years.

In office space, experts see a migration towards second-tier cities. A recent report by Deutsche Bank on real estate trends notes, "As the demand for modern space has continually increased, new office locations have had to be developed in the south and east of the urban area (Mumbai and Delhi)." In Mumbai, secondary business districts have emerged in recent years, including the Bandra-Kurla complex in the central suburbs, 25 miles from the old commercial hubs in the southern end of the city.

Much-needed Transparency
For foreign investors, one troubling fact is a pan-India phenomenon: inadequate transparency in land valuations they use to price their investments. In an interview last month, M. Damodaran, chairman of the Securities and Exchange Board of India, discussed the lack of clarity in real estate companies' disclosures, especially with respect to their land banks. "We sought clarity ... on matters like, 'What does your land bank comprise, [and] what are the valuation aspects you have indicated?'" he told the India news wire service. "Where there is only an agreement to develop land, there must be complete disclosure. All such agreements are to be made available for inspection," he said, adding that he preferred land valuations to be made at current prices and not on the basis of future projections.

Trammell Crow Meghraj's Puri agrees. "There is a marked lack of transparency, corporate governance and accountability among India's real estate developers. There also continues to be a serious lack of quality infrastructure. In addition, India scores low in terms of congenial political environment in terms of the real estate sector. This means that there is a lack of clarity in pertinent policies."

But Puri also believes those issues will soon fade away as India's real estate markets mature. "Although real estate is a regional and highly location-specific industry, India will replicate the events that occurred in emerging markets like Mexico and Central Eastern Europe [including Russia, Bulgaria and Poland]," he says. "In these countries, too, foreign investments were the primary drivers for transparency, accountability and higher capital appreciation in the real estate sector."

Indian Real Estate: Investors Are Shopping, but Are They Buying Hype?

Drive through any of India's major cities and it will be impossible to go a mile without running into brightly colored cranes, construction rubble and men in yellow helmets scurrying up and down skyscrapers. Commercial high rises, residential townships, industrial parks and shopping malls are exploding into existence, encouraged by both long-term and speculative investors. Oversized private equity commitments by a growing number of foreign investors and home-grown financial institutions are helping to feed the frenzy.

But several astute industry watchers have begun poking big holes in that picture. For one, they say that many foreign investors have actually brought in only a small portion of their promised investments. Second, soaring land prices and price resistance from buyers are narrowing investors' margins significantly. Finally, they note that concerns continue to run high about the regulatory opaqueness for real estate ventures, bureaucratic red tape and the absence of title insurance, in addition to a host of other issues. India Knowledge@Wharton spoke with prominent private investors, property developers and brokerage firms to understand how these factors are tempering investors' appetites for Indian real estate.

With yields between 30% and 40% during the past two years, India's real estate industry has been the toast of global investment funds. But expectations for future returns have been sharply reduced to between 12% and 20% over the next few years. For many foreign investors, this means having to weigh Indian real estate opportunities against deals that offer comparable returns in other emerging markets like Eastern Europe or Latin America.

Fears of a real estate bubble and an overheated economy have led India's central bank to require a lender cutback on real estate loans. That move has pushed up interest rates, lowering consumers' appetites for home financing and simultaneously raising rents for apartments and offices. Most Indian real estate companies are privately held and their financial information is not readily available. The absence of comprehensive market data across product types like office, retail, industrial and residential properties further hurts the ability of investors to read the right signals, and the occasional rumor of a large deal going bust or a property developer resorting to a distress sale can damage investment sentiments far more than warranted.

More Hype than Actual Investments

Clearly, local investors understand the terrain far better than foreign investors. Much of the foreign capital committed to Indian real estate ventures has yet to be invested, says Aashish Kalra, co-founder and managing director of Trikona Capital, a private equity firm with offices in New York City, London and Mumbai. "Last year, less than $1 billion [was actually invested in] Indian real estate. That's less than the value of half a building in Times Square," he says. That compares with market estimates of between $15 billion and $20 billion in foreign capital headed for Indian real estate.

Kalra cited these figures during a panel discussion on real estate investing at a recent New York City event organized by The Indus Entrepreneurs (TiE), a network of entrepreneurs founded 15 years ago in Silicon Valley. "A negligible amount of foreign capital will get invested in Indian real estate in the next 24 months," he told the panel.

Sameer Nayar, managing director and head of real estate finance-Asia Pacific at Credit Suisse, offers a similar assessment. "There is a lot of hype about capital going into Indian real estate ... [but] not a lot of money is actually going in," he says. Extracting good returns from those investments calls for significant local market expertise in dealing with regulatory and other obstacles. "You make money because you can deal with the problems, and that's why your returns could be 50%," he adds. "If it were an easy market to work in, you would make only 15%."

Short-term Disenchantment

In April 2006, Trikona Capital group firm Trinity Capital raised 250 million pounds ($500 million) for Indian real estate investment in a public offering through London's Alternative Investment Market (AIM). Kalra says his company has deployed about $400 million in Indian real estate projects over the past year.

Including Trinity, about a dozen real estate funds targeting India have raised a combined $2 billion in the past year through listings on the AIM. Most of them are currently trading at levels significantly below their offer prices, revealing investor disenchantment. Trinity's share made its debut in April 2006 at one pound; it now trades at about 86 pence. Hirco, an Isle of Man-domiciled company promoted by the Mumbai-based Hiranandani Constructions group, raised about 382 million pounds ($755 million) from its IPO last December; since then, its shares have lost considerable sheen, down from 5 pounds to about 390 pence in the second week of May. Exceptions include Unitech Corporate Parks, which listed on the AIM last December at 93 pence and now trades at 96.25 pence.

"We see the opportunity [in Indian real estate], but we also see the risks and challenges involved," says Chanakya Chakravarti, managing director of real estate at Actis, a London-based private equity fund that manages assets of about $3.4 billion. Actis plans to set up a $300 million India real estate fund. It already has two other existing funds with an estimated equity of $475 million that have invested in Indian real estate, auto ancillaries and other industries. "Each fund has a unique risk-return profile, and we work with these. For us, India is a long-term story," he adds.

Chakravarti lists three main risks or challenges that real estate investors in India will be up against in the short term. The first, he says, is an oversupply of office space in the major and second-tier cities. A hazy regulatory framework fostering indecision and delayed investments is another concern. Finally, he notes, opaque deal-making processes that narrow the exit routes will deter serious investors.

"The property market today is rife with uncertainties. Prices as well as interest rates have been rising," says Anuj Puri, managing director of real estate services firm Trammell Crow Meghraj, the Indian joint venture of Dallas, Tex.-based real estate services firm Trammell Crow and the Meghraj Group, a financial services firm in London. "It is not advisable to expect any short-term gains; but of course, for long-term investors, India's strong fundamentals are still intact. A long-term investor can expect average returns of 15% to 20% per year."

Vikas Oberoi, managing director of Oberoi Constructions in Mumbai, says the risk-return profile for real estate investments is far brighter for those who have accumulated land inventory at prices much lower than prevailing levels. "The average net margin in today's market is 20% to 25%; we can easily do 15% better than the market," he says. Oberoi claims his company can achieve those higher returns because, among other reasons, "most of the land has been bought earlier."

Oberoi Constructions has an inventory of 15 million square feet of mostly prime land in Mumbai. At today's prices, Oberoi expects it to generate gross revenues of $2.2 billion. The company is focused mostly on for-sale residential apartments, although it dabbles in shopping malls, hotels and other commercial property lines. Oberoi expects his company to post $200 million in revenue this year, rising to $300 million in 2008.

This past January, Morgan Stanley's Special Situations Fund invested $152 million for a 10.75% stake in Oberoi Constructions, effectively valuing the company at about $1.4 billion. Oberoi says the untapped upside in his company's land bank was a major attraction for the institutional suitors it attracted. For instance, five years ago it bought a land lot with 8 million square feet in Mumbai's northwestern suburb of Goregaon for Rs. 100 crore ($24 million). Oberoi says the property would be worth 20 times more today.

"Where is the supply? There is only demand," says Oberoi. "In fact, I want the market to stabilize or [prices to] come down because then we would get land at cheaper prices. It is absolutely a seller's market."

Second-tier Migration

The most visible changes in the Indian real estate sector include the emergence of well defined product categories, the division of the market into tiered cities and a widening of financing options.

In the past, real estate was sold either as residential or as commercial property. With the maturing of the market and globalization of the investor base, the categories have been sharpened and new ones established. "Investors in the residential market are very different from the office and retail space investor," says Sanjeev Dasgupta, CFO and head of investments at Kshitij Investment Advisory Services, part of the Future Group, a large Mumbai-based owner of shopping malls across the country. In the residential sector, investors are in for high returns and are willing to take high risks, he says. This also allows for easy exit, although the risk of a mismatch between potential and real returns is high, he adds.

According to Poonam Mahtani, a national director of retail services firm Colliers International in India, "The investment risk is lower in the metros, but prices there are much higher than those in tier II cities." Several equity funds have consciously focused on tier II cities, because they believe that this offers the most potential. "Land prices are skyrocketing. Buying to sell is a very risky strategy. Land prices are way beyond levels that will generate a decent return. It doesn't make sense to invest any more unless you go to second- or third-tier markets."

Kalra, too, sees the markets outside of India's major cities as the most attractive, simply because they are not the low-hanging fruit sought by the early crop of investors with relatively lower risk appetites. "There are lots of opportunities outside the main metros. India has 30 cities with a population of a million people each," he says. Adds Dasgupta, "The returns are huge in tier II cities, where there is a large untapped potential." He believes that this sector will see a rental yield of 12% to 14% in the next few years.

In office space, experts see a migration towards second-tier cities. A recent report by Deutsche Bank on real estate trends notes, "As the demand for modern space has continually increased, new office locations have had to be developed in the south and east of the urban area (Mumbai and Delhi)." In Mumbai, secondary business districts have emerged in recent years, including the Bandra-Kurla complex in the central suburbs, 25 miles from the old commercial hubs in the southern end of the city.

Much-needed Transparency

For foreign investors, one troubling fact is a pan-India phenomenon: inadequate transparency in land valuations they use to price their investments. In an interview last month, M. Damodaran, chairman of the Securities and Exchange Board of India, discussed the lack of clarity in real estate companies' disclosures, especially with respect to their land banks. "We sought clarity ... on matters like, 'What does your land bank comprise, [and] what are the valuation aspects you have indicated?'" he told the India news wire service. "Where there is only an agreement to develop land, there must be complete disclosure. All such agreements are to be made available for inspection," he said, adding that he preferred land valuations to be made at current prices and not on the basis of future projections.

Trammell Crow Meghraj's Puri agrees. "There is a marked lack of transparency, corporate governance and accountability among India's real estate developers. There also continues to be a serious lack of quality infrastructure. In addition, India scores low in terms of congenial political environment in terms of the real estate sector. This means that there is a lack of clarity in pertinent policies."

But Puri also believes those issues will soon fade away as India's real estate markets mature. "Although real estate is a regional and highly location-specific industry, India will replicate the events that occurred in emerging markets like Mexico and Central Eastern Europe [including Russia, Bulgaria and Poland]," he says. "In these countries, too, foreign investments were the primary drivers for transparency, accountability and higher capital appreciation in the real estate sector."