BY TAPONEEL MUKHERJEE
Trends, both global and Indian, across the financial markets often reaffirm and, more importantly, remind us of the basic principles of business and investments. The word "basic" here implies the fundamental underpinning of business, rather than a casual reference to simplicity. Both current issues and opportunities that confront India must be analysed in terms of how capital has flowed into different sectors with varying capacities to generate income and the "risk perception" that investors have about the income.
A quick review of investment styles promoted by the acolytes of value investing, summarised in the essay titled 'Buffett's Analytical Framework' by 'The Private Investment Brief' (a specialist investment newsletter) is useful. Viewing an asset through the spectrum of the capital required to acquire the asset, and the consequent income the asset can generate as the yield, provide the necessary framework required. Additionally, the potential growth rate of the income streams from the asset must be factored in, to get a basic structure that can be utilised to compare asset returns.
As the Indian economy gradually works towards resolving issues in the real estate space, both on the physical inventory side as well as financial instruments space, it is worthwhile viewing real estate investments through the simple framework mentioned above. Analysing income streams is especially true for the residential segment. While solutions are being worked upon, the crucial aspect that merits attention is for the capital allocated to distressed real estate segments, what income or cash-flows can be generated and how is this income expected to grow in the years to come.
The framework mentioned above, while simple, throws light upon precisely why the residential real estate segment is still struggling to generate the requisite investment. Fundamentally, an asset that is yielding two to three per cent of income, not adjusting for any other risks, at best is unable to compete for capital with different segments in the Indian economy, and for that matter globally. Lowering home-loan rates is a welcome step. However, such moves do not address the core issue at hand that current asset prices might still need further adjustment to truly get demand going unless one can foresee an unlikely scenario of residential rental yields doubling soon.
Additionally, an even more troubling question for the real estate sector and the policymakers to bear in mind is, why such a situation arose in the first place. Markets overshooting valuations in the face of exuberance is part and parcel of the game, but the degree of such overshooting must be reduced through cleverly designed policies to reduce the kind of over-drag the residential real estate segment has lately seen in India. Land prices, valuations at which land is available for residential real estate development, and the policies that drive the decisions need an urgent relook.
A quick comparison between the fate of the commercial office real estate segment in India versus the residential real estate segment provides a valuable insight into how vital the income component is to assets trying to attract investments. The commercial office real estate segment has seen robust investor interest over the last five years as the annual yields the assets generate (capitalisation rates) have gradually come down from the low teens to around eight to nine per cent. While the actual return varies with asset type, the key takeaway is that commercial office real estate segment in India has seen investor interest because the returns generated adjusted for the risk undertaken are competitive versus other investment avenues.
More importantly, the back of the envelope framework stated above is the one that lenders need to be mindful of. Of all those involved in financing projects lenders are the ones who are most dependent on project cash-flows to generate returns as opposed to dependency on speculative capital gains. The "attractiveness" of an asset from an income generation perspective needs to be kept in mind because it allows both the generation of a sensible rate of return and the creation of assets that are competitive across a multi-asset spectrum.
As the Indian economy looks to provide the next phase of investment-driven growth and tide over a real estate led developer and NBFC crisis, an eye on the cash-generative capacities will be essential to ensure a sustainable and value-generative investment environment. Going forward, investors must assess the income-generating ability, and so must the lenders, while the policymakers must look at framing policies that help improve the attractiveness.
(The views expressed in this article are personal and that of the author. The author heads Development
Tracks, an infrastructure advisory firm. You can contact him at taponeel.mukherjee@development-
tracks.com or @Taponeel on Twitter)