Realty check

According to a recent survey by a property advisory, office space in India is entering an oversupply zone.

Consider these snapshots from the latest survey by international property advisors DTZ India: The estimated supply of commercial office space in 2007 in Delhi is 15.9 million sq ft while the corresponding absorption is estimated at 13.2 million sq ft (20 per cent excess supply).

In Bangalore, this estimated excess supply stands at 38 per cent, in Kolkata at 66 per cent, Hyderabad is at 33 per cent while Chennai and Pune are both expected to have an oversupply exceeding 200 per cent.

The DTZ survey reveals that "the A-grade leasehold office space sector across our universe of cities is seeing the beginning of an oversupply situation that will continue in the short to medium term. Our city-level demand supply analysis, seen in conjunction with the macro-economic fundamentals, clearly indicates that office space rentals are likely to hit a plateau in the next 6-12 months. Barring a few exceptions (primarily the CBDs), the oversupply situation will lead to a correction in office space rental values."

A study conducted by DTZ across seven cities finds that the continuing healthy demand, attractiveness due to rising capital and rental values and easy availability of capital resulted in a large number of projects being started at major locations. While demand continues to be strong, the supply of quality commercial real estate is likely to outstrip demand in the short to medium term.

The second crest
Ankur Srivastava, MD, DTZ India, explains that the Indian real estate markets are entering their next phase or a wave of evolution. "The markets saw their last crest in 1995-96 and there was a correction in 1997 in the major markets (then) like Delhi, Mumbai and Bangalore. The change then was due to large foreign occupiers, corporates and IT firms rejecting low quality office space built by many Indian developers at the time," he says.

The impact, then, was a complete redefinition of what constituted A-grade office space in India. This second crest in 2006-07 is being driven by sophisticated foreign capital that is being pumped into the Indian real estate market. DTZ firmly believes that this phase will again bring about significant changes and that industry participants will go through fast and somewhat painful structural changes.

Better quality
Foreign investors coming in now will not build low quality office space. They are here for a longer term. "Unlike most Indian investors who tend to build-lend-sell in a very short period of time, mostly due to weak balance sheets and mostly building on debt, foreign investors will want to mature these assets by holding them from anything between 5-8 years and then selling to core category investors," says Srivastava. In the bargain, these international investors and developers will build high quality properties and domestic developers will have to follow suit.

As of today though, core category investors don't exist in India. Srivastava does agree that they (pension funds, insurance firms, capital protection funds et al) are starting to look at investing in India. "These investors usually look at investing in low-risk, low-return long-term assets," he says.

The issue in India, at the moment, is that these core category investors cannot buy finished office space. But as people have started to figure out ways to structure these deals, more such investors will come running.

To connect this aspect to the current situation "" there is a distinct possibility that some of the new supply being created (which is also part of the oversupply) will find no takers since the better quality product is likely to get leased.

This would mean longer absorption timeframes and longer gestation periods for projects (longer break-even period). As a result of this, there are chances that profitability for investors might shrink "" not so much for larger investors and developers. The smaller developers might even lose their shirt.

On the other hand, for foreign developers and investors wanting to make an entry with a partnership or a JV, these are very interesting times. The tables are certainly turning. As cost of debt as well as equity goes up in the Indian market, valuations for Indian companies come down, which means in an equity situation, an international investor can do with putting lesser money. So from a purely sellers market, it will become a more balanced market and therefore new deals will pick up.

A good time to buy
"In such a scenario, developers are better off divesting their stakes in their projects sooner rather than later as valuations are expected to reduce further due to increased cost of capital and higher expected returns," says Srivastava.

A direct result of this, of course, will be that while bigger developers with better quality products will manage to hold fort (even though breakeven period for them gets stretched), smaller developers will be the worst hit, as is already happening in some micro markets due to these reasons.

A case in point, explains Srivastava, is the old Mahabalipuram road where along with some considerably larger developers, a number of small developers have invested in office space, most of which is unfinished at the moment. These smaller developers, as the market comes down, are feeling the heat and are now ready to sell their properties cheaper.

Looking at the discounted prices, this might be a good time for some foreign or large domestic developers to buy out 30-40 per cent complete structures at a lower price, put in some more money and get a higher quality finished product. A semi-finished structure at least offers some leeway to the developer to improve the property, the quality of which could be circumspect.

Only pockets of oversupply at present
At the moment there are only pockets of oversupply in these seven cities across India. Some of the more prominent ones are Whitefield in Bangalore, Noida in the NCR, the old Mahabalipuram road and Ambattur in Chennai, and some parts of Pune and Hyderabad. The other part of the oversupply stock will hit the markets in the next 10-12 months.

Impact on rental values
The oversupply situation will surely have an impact on the rental values across these cities as well as on other segments of real estate. As the government does not distinguish between commercial and retail space, if there are measures from the government to tighten the noose, it might impact the retail segment as well.

As far as rental values go, Srivastava explains that it is difficult to generalise the correction level across the board. Rentals in most central business districts will stay strong over the next 12-18 months as this is a very small segment with almost nothing new being added to the supply. The peripheral areas will see most of the action, both in terms of new supply coming in and rentals taking a real beating (in some cases). Let's look at each of these markets in brief.

Market by market account
According to the study, the NCR is expected set to see an oversupply of 20 per cent, most of which Srivastava attributes to the oversupply in Noida. Rentals in Noida are already low and with more supply, they will be impacted marginally.

The real impact, though, will be felt in Gurgaon, says Srivastava, as most new expansions for occupiers might head towards lower-cost Noida. Noida will offer a decent product at half the price. Over the next 10-12 months, rentals in Gurgaon will come down to Rs 50-55 sq ft for large IT occupiers from today's level of Rs 80 and above. Noida will settle anywhere between Rs 35-38 per sq ft. At the moment though, there is an undersupply situation in Gurgaon.

Bangalore, which is expected to have a 38 per cent oversupply, will see rentals in the outer ring road area stagnate or maybe even get corrected marginally (10-15 per cent). Whitefield is already down while surprisingly, north Bangalore could see slight appreciation at the moment. Within the next 12-24 months though, there will be an oversupply situation. North Bangalore is the area around the new airport which will start operations sometime early next year. A lot of new supply being planned here will also hit the market around the same time.

Kolkata is maturing as a market. Salt Lake City and Rajarhat are the two main commercial areas of the city and these won't see much correction, just stabilisation of rentals over the next 10-12 months. Because of the longer development timelines in Kolkata due to various factors in the short term, there might be a supply crunch. In the medium term, there will be decent amounts of supply and in 6-12 months, rentals might come under some pressure. The study predicts 66 per cent oversupply in the city.

Chennai and Pune clock the highest percentage figures in oversupply "" 200 and 208 per cent respectively. Chennai's oversupply situation is mostly because of huge supply on its old Mahabalipuram road and Ambatur. B-grade products here will suffer quite significantly and might see a correction. The problem is that their rentals are already very low and there's a slight possibility of them plummeting any further.

Mumbai is the only market which has an undersupply. It's going as strong as ever, with growth in the financial services business in the city driving this demand. Over the next three years though, there might be some significant sized developments that will come up in new places such as Navi Mumbai and Vashi.

The overall oversupply situation may not be so pronounced as to be threatening, but it seems the next 12-15 months will tell how the market handles the new supply that is expected to come. And as the real estate market heads towards its second crest, this time led by foreign investors, we will see improved quality of commercial space hitting the market. What's so scary and negative about improved quality?