The Slope of Descent

The slope of descent

A closer look into India’s rental dynamics

� Advance - The slope of descent

Executive Summary• During the real estate boom from �005 to �008, a sentiment-driven upswing generated unparalleled demand, leading to a decided undersupply situation across Indian cities.

• Exaggerated expectations of future growth led to the planning of even more projects with larger floor plates, and the cities’ suburban landscape were soon spiking with the onslaught of tremendously increased construction activity.

• In mid-�008, highly non-amenable global economic conditions reached Indian shores, and their ripples were increasingly felt by the real estate sector. While tenants’ expectations and affordability followed a declining curve, landlords still resisted change and held on to their existing price levels.

• In �H08, the market took a U-turn from being landlord-driven to being tenant-driven. Valuations got better, and rentals fell in search for a right price to evoke interest in tenants.

• Sentiments, supply and affordability are the three forces which affect the rental envelope of a real estate market. The precincts are expected to correct in varying degrees depending on the prevalent push and pull magnitude of these forces.

• As the market shows signs of stability after a couple of quarters, we expect considerable opportunities for firms to cut down their operational costs and restructure their real estate portfolios.

• We expect the market’s recovery to be subtle and steady with the return of positive sentiments, with developers and occupiers gaining experience from the present crisis. While non-affordability and oversupply-led correction will push commercial market in India to favour tenants in the short term, the long term will see it transform gradually into a landlord-driven market once more.

Sentiments, supply and affordability are the three forces which affect the rental envelope of a real estate market. The precincts are expected to correct in varying degrees depending on the prevalent push and pull magnitude of these forces

While non-affordability and oversupply-led correction will push commercial market in India to favour tenants in the short term, the long term will see it transform gradually into a landlord-driven market once more

Advance - The slope of descent �

Reaching the EdgeThe principle of ‘greater fool’ states that during an upswing of sentiments, people tend to buy into the most questionable deals at high prices, as they are confident of selling to a greater fool at even higher prices later on.

During the real estate boom from �005 to �008, a sentiment-driven upswing generated unparalleled demand, leading to a decided undersupply situation across Indian cities. Seeking opportunities for growth in nascent and emerging markets, developers planned and constructed huge projects. These were aided by a slew of fiscal reforms and regulations introduced by the government to help the real estate sector grow. A total of 1�7 million sq ft of Grade A commercial office space became operational during the four-year period from �005 to �008 against the completions of only �� million sq ft in the preceding years in 2001 to 2004 (See figure 1).

India recorded a consistent GDP growth of 9–10% in the same period from �005-�007. This kept demand buoyant and absorption rates higher than 80%, despite phenomenal construction activities. Exaggerated expectations of future growth led to the planning of even more projects with larger floor plates, and the cities’ suburban landscape were soon spiking with the onslaught of tremendously increased construction activity.

While new entrants who did not want to ‘miss the boat’ joined in, established players reaped huge profits in the middle of the ocean. Landlord domination led to high price volatilities, creating asset-price bubbles in the market, which were denied by both developers and occupiers.

They continued leasing out spaces to expand headcounts and portfolios.

Real estate was caught in a ‘plateau of denial’ in �008…… however, in mid-�008, highly non-amenable global economic conditions reached Indian shores. Their ripples were increasingly felt by the real estate sector. While tenants’ expectations and affordability followed a declining curve, landlords still resisted change and held on to their existing price levels. The resulting periods of stagnant rentals had the market witnessing considerably reduced transactions. This ‘plateau of denial’ continued for two to three quarters, accompanied by a wide gap between quoted and ready-to-transact prices. Construction activity also slowed down significantly, with projects in the advanced stage of implementation desperately seeking pre-leasing before becoming operational.

On account of pre-commitments to tenants, some projects commenced operations even at high vacancy levels. The undersupply created due to

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Figure 1. Growth of Commercial Office Space in India

Annual incremental supply

Stock as of year-end

Stock as of year-end

� Advance - The slope of descent

sentiments and high demand in the yesteryears led developers to construct extensively across cities which soon haunted as a huge oversupply factor in some of the precincts.

By the end of the year, it reached the edge of the plateau… and fellIn 2H08, investment flows dried up, and the severe liquidity crunch hit developers high and dry. In two to three quarters, the market took a U-turn from being landlord-driven to being tenant-driven. In the last quarter of �008, valuations got better, and rentals fell in search for a right price to evoke interest in tenants.

As rentals seek new levels in �009, we discuss the forces behind the rental adjustment process and their implications on commercial office space in India.

The principle of ‘mean reversion’ states that when prices rapidly move away from their mean price, they will revert to that mean in the short term. If prices fall rapidly, they are likely to rally in the short term - and if prices rise rapidly, they are likely to fall in the short term.

Figure �. Indian Real Estate – At the Edge of a Plateau


Transaction Volume

Absorption Rate

Rental Movement

�00�

Recovery Expansion

Landlord market Tenant market

Contraction Slowdown

�005 �006 �007 �008 �009F

65% 77% 80% 86% 67% ��%

11% 17% ��% �1% -�% -��%

Advance - The slope of descent 5

The BFSI (Banking, Financial Services and Insurance) and IT/ITES sectors - the two most prominent office space occupiers in the country, have been adversely affected in the economic downturn

NASSCOM (National Association of Software and Services Companies) has revised the revenue growth rate estimate for software and service exports (IT and BPO sectors) in FY08 from 21–24% to 16–17%. Going forward, the sector is expected to grow at a CAGR of 15% per year until FY 2011

The Push and the Pull ForcesIn a market, rentals are continually pushed and pulled by various forces of demand and supply. We have identified three market indicators that put pressure or ease the rental envelope depending on the direction (push force or pull force). In periods of slowdown and expansion, the extent of correction and appreciation depends on the magnitude of the push and pull forces applied (See figure3).

A Case of Good and Weak SentimentsDemand for commercial real estate space is a function of the economy and the major industries which will be occupying it. The state of the economy is linked to a number of exogenous variables- employment, consumption, construction costs, interest rates and tax rates. A change in these variables has repercussions on market sentiments, with a corresponding effect on demand. In other words, positive sentiments pull the rental envelope while negative sentiments push it. A sentiment-driven change becomes apparent in the market if a sufficient number of these exogenous variables are moving in the same direction.

The Current Indian ScenarioThe BFSI (Banking, Financial Services and Insurance) and IT/ITES sectors - the two most prominent office space occupiers in the country, have been adversely affected in the economic downturn. The BFSI sector suffered globally with the collapse of major US and UK banks resulting in many financial corporates putting their expansion plans on hold. BFSI demand for office space in India’s business districts fell in �008, and it is projected to remain sluggish in the short term.Currently, the BFSI sector accounts for more than �0% of the total exports in the IT and BPO (Business Process Outsourcing) sectors. NASSCOM (National Association of Software and Services Companies) has revised the revenue growth rate estimate for software and service exports (IT and BPO sectors) in FY08 from 21–24% to 16–17%. Going forward, the sector is expected to grow at a CAGR of 15% per year until FY 2011.

The Supply ConundrumThe magnitude of supply in a real estate market is a measure of options for tenants and of competition among landlords. If supply is low, the market tends to favour landlords, and will pull the rental envelope outwards. However, increased supply causes the pendulum to swing in favour of the tenant, pushing the rental envelope inwards. Oversupply occurs when the market sees the arrival of large volumes of a particular category of supply (non-IT or IT). Conversely, a condition of undersupply is typified by a dearth of supply in a particular category. We measure undersupply and oversupply in terms of expected vacancy gaps in the market.

Natural vacancy rate is the vacancy rate in a market at which there is neither excess demand nor excess supply and rental is at its long-run equilibrium (Rosen and Smith, 1983). A natural vacancy is created due to:

Figure �. Underlying Forces of Rental Adjustment Process: The Push and the Pulls


Sentiments

Corrected rental

envelope

Over

Sup

ply

Push Pull

Unde

r Sup

ply

Unaffordability

AffordabilityCurrent rental envelope

Appreciated rental envelope

6 Advance - The slope of descent

• frictional vacancy from turnovers or churning;• structural vacancy caused by mismatch between space requirements of tenants and space availability offered by landlords; • profitability vacancy due to landlords maintaining minimum rent for profitability.

Vacancy gap is the difference between the expected vacancy rates and the prevalent natural vacancy rate in a micro-market. Vacancy gap = Expected vacancy rate – Natural vacancy rate

If the vacancy gap is positive (vacancy rate > natural vacancy rate), it is a condition of oversupply; if it is negative, this denotes a condition of undersupply. While oversupply pushes the rental envelope inward, undersupply pulls it outward. The forces accelerate with the magnitude of the gap.

The Current Indian ScenarioIn the process of suburbanisation, most peripheral districts in Indian cities are witnessing a large amount of supply. About 198 million sq ft of Grade A commercial office space is expected to see completion by end-�011 in the top seven cities of India. Most of this supply is expected to come for the IT/ITES sector, implying a definite imbalance in the planning of projects. This non-diversified supply in a land as diversified as India is expected to create a positive vacancy gap in the short term, exerting a push force on rentals to varying degrees.

Mystics of Price VolatilitiesHistorical price appreciation is an indicator of future price appreciation potential. Rapid and continued increases in the rate of rental appreciation lead to increases in risk for future rental declines. Rapid increases in the past implied high volatility in the market, which outstripped the pace of demand growth and made rentals unaffordable. By principle of mean reversion, rentals return to their mean affordable levels if they are characterised by rapid movements. Hence,

About 198 million sq ft of Grade A commercial office space is expected to see completion by end-�011 in the top seven cities of India. Most of this supply is expected to come for the IT/ITES sector, implying a definite imbalance in the planning of projects

Micro-markets with rapidly rising rentals are at a greater potential risk of falling than those that were relatively stable

the high rental appreciation in the past is likely to make rentals unaffordable for the market and push the rental envelope inwards.

The Current Indian ScenarioThe unprecedented growth of the industry and services sector (especially IT and BPO) in India during �005–�007 led to tremendous demand for office space across cities. This demand led to high absorption rates and rentals spiralled upwards in several micro-markets. However, the degree of surge depended on the expectations of future growth in that precinct. Micro-markets with rapidly rising rentals are at a greater potential risk of falling than those that were relatively stable.

To analyse the varying depths of correction in various precincts, we plotted the two indicators of supply and rental appreciation—expected vacancy gap in �009 and increase in rental values (since end-2004 to the peak in 2008).

The cluster of micro-markets that was obtained have been analysed against the expected correction in rentals. In the ‘concrete jungle’ of the Indian real estate, survival and growth strategies differ for wise and steady tortoises, lean and fast deer, aggressive cheetahs and the sheep who follow the path beaten by the predators.


CBD Connaught Place and surrounding roads CBD Begumpet, SP Road, Punjagutta, Raj Bhavan Road, Somajiguda

SBD Nehru Place, Jasola SBD Banjara Hills, Jubilee Hills, Ameerpet.Gurgaon NH-8, MG Road, Golf Course Road, Sohna Road Hitec City Madhapur, Kondapur, Hitec CityNoida Noida City, Noida – Gr Noida Expressway Gachibowli Gachibowli, Nanakramguda, Raidurg, Gopanpally, KokapetCBD Nariman Point, Cuff Parade, Fort, Ballard Estate CBD Park Street and surrounding roadsSBD Central Worli, Parel, Prabhadevi, Lower Parel, Dadar SBD EM Bypass near Ruby till Abhishar, Tangra, Topsia, Park

Circus ConnectorSBD BKC Bandra Kurla Complex, Kurla, Kalina Salt Lake Sector 5 Salt LakeSBD North Juhu, Andheri, Santa Cruz, Jogeshwari Rajarhat RajarhatW Suburbs Malad, Goregaon CBD Pune Cantt, Bund Garden Road, Shivaji Nagar, Deccan,

Koregaon Park, Senapathi Bapat RoadE Suburbs Ghatkopar, Vikhroli, Kanjurmarg, Powai SBD Karve Road, Baner, Kalyani Nagar, Airport Road, Nagar

Road, Hadapsar, Aundh, KharadiT and NM Subs

Navi Mumbai and Thane Suburbs Hinjewadi, Pimpri, Chichwad, Balewadi, Wakad, Pashan, Fursungi, NIBM

CBD Radius of about � km from the MG and Brigade roads junction CBD radius of 3.5 km from the Gemini flyover

SBD CV Raman Nagar, Bannerghatta Road, Inner Ring Road, Koramangala, Airport Road, Banashankari, Audgodi

SBD Anna Nagar, SP Road, Mount Poonamallee Road, Guindy, Velachery, Adyar, MRC Nagar, Ambattur

Whitefield 5�0 acres in East Bangalore Suburbs Old Mahabalipuram Road (OMR), GST RoadElectronic City ��0 acres in South Bangalore

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NHY

DERA

BAD-

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A-KL

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ALOR

E-BG

Decoding the Rental Rubik

SBD DL

Gurgaon

Noida

SBD Central MB

SBD BKC MB

W Suburbs MB

E Suburbs MB

T & NM Subs MB

CBD BG

SBD BG

CBD CN

CBD KL

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CBD PN

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UnaffordabilityAffordability

Over

supp

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w Su

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Resistant 10-�0%

Followers �0-�5% Aggressors �0-�0%

Fast Movers �0-�5%

Electronic City

Figure �. Expected Correction in Commercial Micro-Markets

Note: Indicated expected corrections in boxes are from the peak in �008 to the trough in �009


Despite low supply and lower historical rental appreciation, a sentiment-led correction in these micro-markets is expected.

The suburban micro-markets of Bangalore – Whitefield and Electronic City – are among the most economical real estate destinations in Tiers I and II Indian cities. They have negligible historical rental appreciation and a controlled supply pipeline. The SBD of Bangalore also had relatively stable rentals and is not expected to witness a significant rise in vacancies resulting from excellent pre-leasing levels. Around 70–75% of the projects expected to be operational in the SBD of Bangalore in �009 are already pre-leased. These markets of Bangalore primarily cater to IT/ITES occupiers that have put their expansion plans on hold during these uncertain times as their major clientele (the US BFSI sector) is in trouble. Hence, we expect a 10–�0% correction in these micro-markets.In the past, rentals in the CBDs of Bangalore and Hyderabad have appreciated more than the precincts of Bangalore. However, they are expected to correct in the same range as other precincts in the quadrant, since they are witnessing very thin supply in the short term. The CBD of Chennai, although not appreciating as much, has about � million sq ft of space under construction. Hence, it is expected to correct by around �0%.

Resistant – The Tortoise

RecoveryThese micro-markets are expected to lead a revival, although marginally, when economic sentiments recover in the medium term. A strong bounce is not expected due to low price volatilities.

10-�0% Expected Correction

Sentiment-Led Correction

Although micro-markets in this category are not looking at a huge supply pipeline, their rentals have reached unaffordable levels due to high historical appreciation. High price volatilities and negative sentiments are expected to push the rental envelope inwards. The CBDs of Mumbai, Delhi and Kolkata, along with the SBD-BKC (Bandra Kurla Complex) in Mumbai, are characterised by low supply and very high rental appreciation. Rental values rose more than �.5 times in these precincts, reaching unaffordable levels. Hence, they are expected to correct by �0–�5% in the short term. Maharashtra’s urban ministry has increased the floor space index (FSI) for commercial developments (both existing and future) in the SBD of BKC from � to �. With additional FSI available at a considerably reduced premium of approximately INR 9,500 per sq ft, developers have the option of building more on the same plot. If they plan more construction, vacancies will move northwards, transforming BKC from being a fast mover into an aggressor.

Fast Movers – The Deer

�0-�5% Expected Correction

Unaffordability & Sentiment-Led Correction

Recovery Vacancies in these precincts would not rise appreciably. As rental levels correct and become affordable, space will be rapidly absorbed. In the next bull cycle, the fast movers are expected to revive with the resistant micro-markets, but at a faster pace.

�011

�01�

Recovery

Rental Appreciation

�009

Expansion

Future Supply

�010 �01�

�011

�01�

Recovery

Rental Appreciation

�009

Expansion

Future Supply

�010 �01�


The followers are expected to witness a correction due to the huge supply that is under construction in these micro-markets. These are mostly the suburban micro-markets that were boosted by the development of infrastructure and support from the government. As land was relatively cheap, huge projects were planned following the real estate boom of the more-established CBDs and SBDs of the cities.

The suburbs of Kolkata, Hyderabad, Chennai and Pune, along with Thane and Navi Mumbai and Noida - fall in this category. The SBD of Pune, which is relatively young on the commercial real estate scene, saw its stock more than quadruple in the last three years. Another 8.8 million sq ft of office space is under construction in the precinct, which is expected to create a tremendous oversupply that will bring down rentals by �0–�5%.

Followers – The Sheep


Oversupply & Sentiment-Led Correction

Recovery A continuous supply pipeline in these micro-markets will continue to put pressure on rentals in the medium term, and they will recover later. They will also compete with the already-established aggressors, who are also witnessing a large amount of supply.

The aggressors are characterised by high supply as well as significant historical appreciation in rentals. Good infrastructure and proximity to the city led developers and occupiers to believe in the growth potential of these areas. Therefore, while rentals surged, a lot of projects were put under construction in these markets. They are expected to correct the most, bringing rentals down to affordable levels, which will evoke interest from tenants.

Gurgaon, SBD Central Mumbai, SBD Delhi and the Western and Eastern suburbs of Mumbai are expected to witness high vacancy levels in the short term with a corresponding pressure on rentals. They will correct in the range of �0–�0% since the peak in �008. Although rentals in the CBD of Pune have not appreciated significantly, they will fall appreciably as the area is the most expensive central district among India’s Tier II cities, making it decidedly unaffordable.

Aggresors – The Cheetah


Oversupply, Unaffordability & Sentiment-Led Correction

Recovery There will be sufficient vacant space available to be absorbed over a longer time horizon and recovery will happen after that of resistant and fast movers. When sentiments recover and demand comes back in the market, the aggressors will bounce back strongly and faster than the followers.

�01�

Recovery

Rental Appreciation

�009

Expansion

Future Supply

�011

�010 �01�

�01�

Recovery

Rental Appreciation

Expansion

Future Supply

�011

�010 �01�

�009

Start of Recovery Start of Expansion

Over Supply/Unaffordability Low Supply/Affordability


Figure 5. REIS Commercial Office Property Clock

Figure 6. Major Commercial Office Space Demand Drivers in India


The RecoveryThe office sector in India has entered into the ‘rents falling’ quadrant, and the downturn phase is expected to last 8-10 quarters (See figure 5). Various micro-markets will stay in the quadrant for varying time periods depending on the nature of rental-adjustment forces acting on them. As the market shows signs of stability after a couple of quarters, we expect considerable opportunities for firms to cut down their operational costs and restructure their real estate portfolios.In a recently revised estimate, NASSCOM has projected the growth rate of India’s IT and BPO sectors at a CAGR of 15% until FY11. This growth should help absorb a portion of the available supply at affordable rentals. The growth story is still strong for several micro-markets that have a diversified supply and improving infrastructure. Demand from various industries—healthcare & pharmaceuticals, biotechnology, semiconductor, telecommunications, logistics & warehousing and automotive—is expected to increase in the future as India establishes itself on the manufacturing landscape of South-East Asia (See figure 6). With the abundance of available intellectual capital, the knowledge process outsourcing (KPO) sector—which constitutes data management and analytics, contract research and biotechnology, animation and gaming, scientific and medical publishing,

legal research and intellectual property among other fields—is also slated to expand in the cities of Pune, Hyderabad and Kolkata.We expect the market’s recovery to be subtle and steady with the return of positive sentiments, with developers and occupiers gaining experience from the present crisis. While non-affordability and oversupply-led correction will push commercial market in India to favour tenants in the short term, the long term will see it transform gradually into a landlord-driven market once more.

Source: Jones Lang LaSalle Meghraj Research

Core Demand Drivers

Core Demand Drivers

Growth rate of 15-27% (2003-2008)Automotive Mission Plan �006To reach 10% of GDP and additional employment of �5 mn people by �016

Source: IBEF

CAGR 51% (2001-07)

By �010-11, Projected share in global KPO industry 65-70%

Source: IBEF

Growth rate �0-�0% per yearTo add 1�5 mn sq ft by �010Indian Govt to spend USD �� bn in the next 8 yrs on supply chain infrastructure

Source: Colliers International, RREEF

Telecom density 20% (2008)Projected 51% (2012)Projected CAGR �1% (FY 2007-2010)

Source: IBEF, BMI, Gartner Inc.

Projected CAGR 19.�%(FY 2008-2012)By �01�, India will account for 5% (currently 3%) of the Asia-Pacific revenues

Source: India Semiconductor Assn

USD �5 bn by revenueProj USD 75 bn (2012)1.1 mn beds (2008)Needs � mn more by �01�

Source: IBEF, Technopak, CII

TELE

COMM

UNIC

ATIO

NSSE

MICO

NDUC

TORS

HEAL

THCA

RE

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MOTI

VEKP

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Authors

Himadri Mayank, Senior Analyst, Research & [email protected]+91 �� 61�1651�

Himadri Mayank joined Jones Lang LaSalle Meghraj Research team in July 2008 and is responsible for tracking and monitoring market activity and trends in office, retail and residential property sectors for Indian cities. Based out of Mumbai, he also contributes towards regional and local research publications covering economy, sector analyses, market forecasts and investment strategies.

He holds a degree of B.Arch. from Indian Institute of Technology Kharagpur and has two years of experience in the field of construction and architecture. Abhishek Kiran Gupta, Associate Director, Research & [email protected]+91 �� 61�1651� Abhishek Kiran Gupta leads the Jones Lang LaSalle Meghraj India Research team and is based in Mumbai. He manages research operations on a Pan-India level and is responsible for the team’s outputs, including research reports such as topical white papers, property market digests and bespoke research projects based on specific client requirements. Prior to joining Jones Lang LaSalle, he had seven years of experience in market research, business analysis and market strategy consulting, servicing diversified industries including pharmaceutical, software publishing and insurance.

AcknowledgementsWe would like to acknowledge the contribution of the entire Research India team whose efforts have resulted in the underlying data for this report.

COPYRIGHT © JONES LANG LASALLE MEGHRAJ 2009 All rights reserved. No part of this publication may be published without prior written permission from Jones Lang LaSalle Meghraj. The information in this publication should be regarded solely as a general guide. Whilst care has been taken in its preparation no representation is made or responsibility accepted for the accuracy of the whole or any part. We stress that forecasting is a problematical exercise which at best should be regarded as an indicative assessment of possibilities rather than absolute certainties. The process of making forward projections involves assumptions regarding numerous variables which are acutely sensitive to changing conditions, variations in any one of which may significantly affect the outcome, and we draw your attention to this factor.

Jones Lang LaSalle Meghraj offices

www.jllm.co.in

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The Slope of Descent