A rapid expansion in Sri Lanka’s housing sector, forecast to now happen, means that fewer people will live in urban discomfort or have to brave irritatingly long queues of traffic to get home to suburbia. Near record low mortgage rates, better pay and bonuses and optimism about the future will drive housing sector expansion. But the ongoing building frenzy can become an economic threat than a triumph if it continues its concentrated focus mainly on high-end apartment development. Real estate services firm Jones Lang LaSalle, now calling itself JLL, estimates that upto 80% of real estate sector investments by large firms are concentrated around high-end apartment development but contends the opportunity now lies in retail and office space.

Anuj Puri, Chairman and country head of JLL India says the condition in the Indian market is even more polarized with huge inventory overhand of luxury apartments whereas demand is for more affordable apartment units, office space and retail space. Eighty percent of Indian real-estate investments, so far, have also been focused on high-end residential apartments. In an interview Anuj Puri discussed the challenge for Indian real estate and the undesirable parallel the Sri Lankan property market now shares with the Indian one.

 

What are the factors now influencing the Sri Lankan property market?
One is land and the other is built structures. On the land, a lot of people I met were excited prices had continued to go up, which I can understand if you are an investor. My fear is Sri Lanka will become uneconomical and unviable for new businesses if land prices continue to rise. High land prices will make the built form more expensive, whether it’s residential, retail or offices, because land is the underlying asset. So the final product cost will increase. It will then get to a stage where business is difficult and residential properties unaffordable.

When demand is growing for something that’s in limited supply isn’t a price rise the usual market reaction?
That’s right. But in real estate, supply goes first followed by demand. So you are hoping there will be demand. There is a fair amount of residential real estate being built, and you are hoping that demand will pick up. But that isn’t happening. Today, as all these residential projects are being launched, there is a slow sales momentum.

This has happened in several economies, and India is also facing this today. How has this happened?
Over 5 years, developers continued to build, land prices escalated and project costs rose because construction costs went up. Of course quality improved and the size of the apartments also became bigger. So the overall ticket price for the product became expansive. But buyers said ‘I’m not disputing that your price is wrong, but I don’t have the money to buy this’. That is where the industry got caught out.

This is happening in Sri Lanka as well, as the cost of labour increases and prices of inputs like steel and cement rise. At some stage, people need to realize that there has to be better and more infrastructure in Colombo city to connect it to the large parcels of developable land outside. Otherwise prices will continue to increase. At some stage, you’ll have to put in more roads, railways and connectivity, so that large land parcels can be unlocked within and outside the city. Rajagiriya seems to be an upcoming place but when we speak to the corporate occupier, they say it takes too long to travel there. Is there something that can be done, like a mass rapid transport system or metro to open up those areas?

On the built assets side, I see a huge opportunity for private equity and for foreign institutional players to invest. I’m not very versed with local laws, but I have understood from our team and clients that there isn’t any restriction for a foreign developer to take a 49% stake in a real estate project. I think that is phenomenal. There is also so much demand from office occupiers for good quality buildings. If I was one of the large institutional private equity players at a global level, this is a superb investment opportunity because there is huge demand, the economy is growing and Sri Lankans and foreign companies are expanding operations here.

In retail, there is very little good quality retail mall space in Sri Lanka. I see a wonderful opportunity for foreign developers to come and partner with locals. They should partner because I doubt they’ll be able to do it themselves because this is still a difficult market to get approvals done on their own. I wouldn’t venture in here without a partner. With 49% ownership, it will be possible for you to consolidate the investment in your balance sheet if you are a foreign developer or a pure foreign private equity. I feel rents will rise and we are finding out from our occupier clients there is fair demand coming in, and no supply.

On the residential side, affordability is based on salary. In India, it used to be 20 years of salary to buy an apartment. Today, it’s come down to 8 years, which is still a lot. In more mature markets, it takes three and a half to five years of your salary. That’s the better benchmark. So India is still behind that benchmark. I don’t know what it is here. Prices of some new apartments here lead me to believe that they are more expensive here. So on the core side of the assets, I feel office and retail have immense  pportunities.

What about Real Estate Investment Trusts (REIT) for funding these opportunities? This is something some in Sri Lanka have suggested. What does the Indian experience teach us?
A REIT is a very mature form of investment. I’m not sure if you should get into REITs so early in the lifecycle in Sri Lanka. In the US, Singapore, Hong Kong and London REITs have been successful. I think the US was the first one about 30 years ago, in the late 70s. In Europe, it’s only been 10-12 years since REITs came in. So while it’s very nice to do that, it’s a highly mature form. For that, you need two to three things. First you need a product. From a REIT you buy units, and you get a monthly dividend. So it is investment ideally suited to retired people, pensioners and insurance companies. A REIT cannot have more than 15% of its total investment in projects under development – 85% has to invested in completed and leased out projects.

In Sri Lanka, you don’t have many projects to do REITs, so the market has to grow. Once there is an optimal size, then you can start to think about it. But first, I think private equity has to come in here and accumulate. Once they have a critical mass, they will REIT it out. I don’t think there are many buildings in Sri Lanka that are wholly owned by developers of commercial or retail that are of a meaningful size that you will be able to do a REIT. And a REIT is not one building.  It has to have a larger portfolio – 8-10 million square feet portfolio. In India it’s now possible to do a REIT (since 2014), but no one is doing it. They are still amassing assets and looking at how to do it. Private equity came to Indian real estate in 2006, and in 2015 we are still looking for the first REIT. Today Indian private equity investors have significant real estate portfolios; 8-10 million square feet, Blackstone has 21 million square feet, so now they are thinking of a REIT to monetize the assets.

There are a lot of expectations surrounding India’s political will to drive growth. Surely this is not easy. How is the Modi government doing in your opinion?
We ourselves are contemplating whether it is disappointing, has he delivered what he has said, or is it somewhere in the middle? I think it is somewhere in the middle. It is certainly not what we had thought at the time that he came – that he’ll be able to sort out everything , and that India will regain its glory quickly and there is going to be a boom. From that perspective, there has been a bit of a disappointment. What the public at large thought that he’ll be able to do, the next phase of reforms, and India’s emergence on to the global economic growth map hasn’t really happened. It has been a slow comeback. I think Modi has been very fortunate that commodity prices have fallen, and that has benefited the economy. So GDP is growing, the budget deficit has started to narrow and inflation has started to decline. But I think this has less to do with his policies, and more to do with luck. So there is disappointment that the expectation wasn’t delivered in the first year. Having said that, he’s been very clear. He said he didn’t realize the ‘well was so deep’, and that it would take time for the economy ‘to be pulled out’. After the first 100 days, he said they first mistook it for a ‘shallow well’, adding they’ve now realized economic troubles are much deeper than they had thought.

How would you relate that to Indian real estate and the capital markets related to it?
Real estate is having a troubled time in India. India has about 235billion dollars of ongoing real estate construction of which 80% is residential. That’s where developers have got caught out because either they have priced apartments too high, or they have built large apartments. Developers are going back to buyers and saying ‘tell us where we are making money, we are not making much money’. The buyer is saying ‘I’m not disputing that you are not making money, or demanding you bring down the price because you are making too much money. I am only saying that my job doesn’t pay me that much money to buy this apartment’.

I’ve never seen this much disconnect between the seller and the buyer in the top eight Indian cities in my 20 years of working in real estate. Many of these real estate firms are listed companies so it’s easy to see they aren’t making much money.

The second disadvantage for Indian real estate has been high interest rates, just like in Sri Lanka. Your mortgage rates have been very high and that becomes a killer. For developers also borrowing is expensive. So if you hold inventory for 2-3 years, that’s at a 14-15% per annum interest.

That would be a 50% cost escalation. In India if sellers had the ability to reduce prices to the extent that it would’ve met buyers’ expectations, they would’ve done so by now. In many of the Indian markets, we have a huge inventory overhang, upto 36 months (3 years) built up. There is demand. Indian data shows there is a 18 million dwelling unit shortfall. But the trouble is that the product is at one level and demand is at another. The only way they are doing it is by reconfiguring the apartment size. So apartments that were at 4,000 square feet are being brought down to 2,000 square feet and the pricing cut in half.

The balance 20% of the market has been very exciting in India. With the growth in the US economy, IT back office outsourcing has increased. Since 2005, every year, US corporates take more space on lease in India than do Indian firms. So we are more aligned to US economic growth and it has nothing to do with the Indian economy. Then there is some growth from Indian corporations as well. Pharma companies, media companies, investment banks and Indian banks have all started to expand. It’s similar to the Sri Lankan situation.

I see a huge market opportunity in the 20% bit of the market in Sri Lanka, which is commercial and retail. If I could, I would relocate to Sri Lanka to just work on that – office and retail –because there is so much latent demand. Look at India, you have 400 retail malls, you don’t have a mall here, you have retail centres which are beautiful and of superior quality, but that’s not a mall. It’s not a mall that’s got a large food court, multiplexes, hypermarkets, departmental stores and a lot of entertainment and shopping.

Do you think faster economic growth in India will help accelerate the absorption of the inventory, or is this a long-term problem?
Office and retail do not have an overhang. On the residential, I think it will be a factor of four things that have to happen and it’s got complicated. One is that mortgage rates have to come down significantly – at 11%, it’s very expensive. India was used to 6.75%, so we’ve gone up and its high compared to what people are used to. That’s the first thing that needs to happen. Second is the reconfiguration of the apartments. Those who have the flexibility will be able to sell it, those who don’t will have some trouble. Third is the hope the economic recovery will continue and salaries and bonuses of buyers will rise, so their propensity to buy will increase.

The financial year just ended for Indian corporations, which we hope will lead to good bonuses, which brings in enthusiasm to go out and buy. The fourth is that we hope new supply would not come in and that people would have understood there is no point in doing more residential, and would invest in offices and retail instead. Hence, over a period of time, the excess supply will start to get absorbed. Having said that, I feel some developers will not be able to sell their inventory and will become non-performing assets for bankers.

What is real estate looking like as an investment play in the rest of Asia?
It’s very exciting. On the office side, it remains exciting because the west continues to outsource work to the Philippines and India, and to China on manufacturing. Those economies continue to do well. If you take the four big economies of Asia-Pacific -Australia, China, Japan and Singapore, Australia is going strong; the trouble in the horizon is with China slowing down and commodity prices declining and how it impacts the Australian economy. It’s also among the most mature real estate markets. In the transparency index that we do, Australia is number one globally. Because transparency is so strong, it attracts the maximum investment from mature markets like the UK and US, and even China and India.

The second is Japan where Abenomics is back in power. The economy is definitely much slower, but their capital values continue to go up. Again, it’s because there are large insurance companies in Japan, and it’s a very liquid real estate market. Insurance companies continue to pump money into buying property. Borrowing is at 1% there and real estate yields are at 3-4%. So there is a huge positive arbitrage, so whatever equity you spend on a building, you are able to make a 6-7% return in a mature market like Japan.

In China, the verdict is still not declared – hard or soft landing, and the impact on the rest of the world if China stops buying what it has been buying. I think, from that perspective, China is a wait and watch. The local economy there has been badly hurt by corruption in the past. But the new premier has just made corruption an executionable offense. So ifyou are found to be corrupt, you will be executed. So foreign retailers like Prada and Gucci have seen a huge impact on sales because people who earlier purchased these luxuries as presents to government officials don’t do so anymore. What they have done exceptionally well as an economy and where they can differentiate from India is that they continue to do huge residential. So does India, but India is in oversupply. China continues to do residential, but its tier three and four towns continue to prosper – and people living there are still making money because they manufacture and export. India was never a manufacturing centre, we were only services, which meant that we cannot go beyond the top eight cities because in tier three cities the population wouldn’t be able to speak English. As a result of this, India’s story is an only eight city story, whereas China’s is a 50 city story.

Then you got Singapore and all Southeast Asian countries. Some, like Indonesia, are doing well. Singapore slowed down and it’s back again. They have slowed down purposely because asset prices have started to go up and the government put a foreign tax to limit foreigners speculating in on the residential real estate market. So they slapped on a 10% additional tax if you were a foreigner and were buying property not to live in but to rent out. The Philippines does well because a lot of the outsourcing that India is losing on voice is going to the Philippines because their dialect and accent is far more Americanized than India’s.

How do you see that Sri Lanka has moved on from 2013?
When I came in 2013, there was going to be foreign developers and investments coming in, and they were scouting for sites. That was two and a half years ago. When I went out yesterday, I saw a huge amount of development undertaken by foreign developers. Chinese, Singaporean and Indian – none of which was visible during my previous visit. There were also cranes all over the place, meaning there was activity. One of the developers we met said that he was going to put three to four slabs each month on the structure. So it’s a big change.
The second thing is that the business community is more positive this time. I also felt there is better understanding of foreign policies and respect of foreign investors coming to Sri Lanka. The biggest difference I saw was the hospitality, the number of hotels being built and the focus on the hospitality side of the business. What I haven’t seen as much is on the capital markets side. I’ve not been able to crack why private equity has still not come in here. Maybe they want to see the proof of some of these developments. So I feel it’s either not been marketed well, or these guys have come in and said they’ll come back in two to three years. To my mind, that’s a big opportunity and a little bit disappointing because people should have discovered this opportunity by now. By law there is a limiting of foreign ownership to 49%, that’s all. But that’s ok. Many countries have that restriction and the solution is to go with a local partner.

The port city that a Chinese firm is planning to build will release 200 hectares for investment. Might that create a bubble? Are we ready for the scale of what we are about to get into?
I think it will be done over a period of time; it’s a five to ten year horizon. CCCC (the Chinese investor) will have done their homework and figured what the absorption degree here is, and depending on that and the additional supply outside the port city – at what stages and phases do they need to launch and deliver those projects. Invariably, there is some pain. When Dubai happened there was pain because of the additional supply that hits the market.
But in hindsight, you can say it’s been a successful project and the developers made money, and it’s done well for the city, the economy and businesses. And the capital appreciation of the buyers of those projects have only gone up because it’s a talked about project not only within the country but in a lot of other places. So for the Palms in Dubai, much of the investment came from Russia, India and other countries in the UAE.