RealtyReality Insights for Real Estate and Infrastructure industry leaders

A newsletter under Grant Thornton Insights series | Issue 5

Grant Thornton

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About Grant Thornton Insights Series

Grant Thornton Insights Series brings to you a set of

tri-annual thought-leadership newsletters such as:

• Aspire: Insights for dynamic business owners

• India Ahead: A snapshot of emerging economic and

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This series of publications draws on our industry expertise,

clients‟ experiences and our commercial know-how. It

discusses the underlying issues, challenges, and industry and

market dynamics that impact Indian businesses over medium

to long term.

More about RealtyReality

Published tri-annually by Grant Thornton India, RealtyReality

is a thought-leadership newsletter focused on providing

leading-edge insights on the Real Estate and Infrastructure

industry of India.

Acknowledgement: Neeraj Sharma & Misbah Hussain

Editor: Vikram Jethwani

www.wcgt.in/publications

Preface | Pg 4

Strategic framework for CRE

companies| Pg 14

Preface

The weakness in global economy has created

considerable levels of distressed real estate in a

number of markets around the world. In all but a few

locations, reduced economic activity and growth

prospects have led to falling rental incomes, collapsing

property values and construction projects being put

on hold.

This in turn has turned many previously „performing‟

commercial real estate loans and investments into

„underperforming‟ or „non-performing‟ assets. Banks

and other lenders are increasingly being exposed to

these assets.

This situation is further complicated by the reality that

many lenders are themselves in varying states of

"distress", and are trying to resolve their portfolios of

distressed loans. Faced with significant regulatory

pressure, banks are tightening lending criteria,

reassessing loan to value ratios, and trying to shore up

their RE&C loan portfolios in order to preserve their

own financial independence.

Some banks have become less willing (and possibly

unable) to negotiate better terms from the perspective

of the distressed asset holder.

RealtyReality | 4

In other cases, however, lenders are selectively

ignoring the issue in order to avoid writing down loan

values, which would potentially compromise their

own balance sheets and capital adequacy

requirements. In effect, these institutions are

essentially hoping that the economy will right itself

and their loan portfolios will recover without the need

of significant additional capital injections into the

bank.

"Though many observers believe that the recession officially ended

in the summer of 2009, most industries, including commercial real

estate, continue to feel its effects. CRE industry fundamentals

remain subdued and according to industry estimates, no meaningful

recovery in the West, can be expected soon. This is not surprising

given that the CRE industry usually lags behind the general

economy by 12 to 18 months. The extent and timing of upswing in

CRE will largely depend upon geographic market and asset class."

RealtyReality | 5

Vishesh Chandiok

National Managing Partner

Grant Thornton India

Global landscape

RealtyReality | 6

The US:

• As per industry estimates, over US$1.4 trillion of debt in real estate assets will

become mature by 2014, creating immense pressure on banks for coming up

with solutions to resolve troubled loan issues.

• This scenario can have a delimiting effect on the recovery of the US economy,

owing to the pressure on banks to sell loans at a price lower than their face

value, in order to prevent losses.

• Driven by the assumption that valuations will increase in 2011, Real Estate

Investment Trusts (REITs) will begin to look out for opportunities to acquire

properties, including the distressed properties, at reduced prices.

Brazil and Mexico

attracts most of the FDI

in Latin America's

CRE market

The UK:

• UK's CRE market continues to show signs of weakness with occupier

demand falling in negative territory.

• Lenders will be under pressure to find ways to resolve their troubled loan

portfolios due to the wave of debt maturities.

• Property prices in the country will become stable, owing to the

normalisation of the supply and demand balance.

Global landscape

RealtyReality | 7

Russia:

• It is expected that demand in the commercial real estate sector

will increase marginally, owing to the reduction in vacancy

rates.

• In the overall realty sector, warehouse and retail are expected

to clock the fastest growth.

• The sector is likely to attract sizeable investment; especially in

the the high-quality small to medium size property segment.

Brazil:

• For the next two years, Brazil, being the host of the 2014 FIFA World

Cup and 2016 Olympics, will continue to attract huge investments in

the hospitality sector.

• An export-led boom along with surge in household incomes, entry of

new conglomerates and the increasing trend of opting for better-

placed or more attractive office spaces are the reasons that will drive

the demand for commercial property in the near future.

• Demand for real estate will also be impacted by the recent legislation

reform establishing increased lines of credit to the local mortgage

market as well as consumer finance.

Global landscape

RealtyReality | 8

China:

• Though China, like all other BRIC economies, show resilience, its real

estate market is not completely insulated from the global pressure.

• As the opportunities for investing the bulk of domestic savings remain

bleak in the country, real estate will continue to remain an attractive

avenue for investment.

• Affordability has decreased marginally due to the bleak financial

situation of the local government, which is widely in debt after being

handed billions of Yuan in bank loans.

India:

• Banks have reportedly increased risk weightage on CRE financing. Real

estate companies may face cash flow pressure, while they replace low-cost

debt by high-cost finance.

• Developers would be more receptive to new and more collaborative lease

models, in acknowledgement of tenants' concerns.

• Metropolitans may not witness growth in rentals, however, properties that

enjoy strategic locations in Tier 2 and Tier 3 cities are expected to register a

relatively higher rate of growth in rentals and capital values, in the next 2-3

quarters.

However, the industry is about to face a post-recession

paradigm, which it has never seen before. The recovery

following the 2001 recession is not a good benchmark because

access to capital may be much more severely constrained. The

lending market will probably be flooded with demand, while

higher loan-to-value ratios, tighter credit standards and an

uncertain securitisation market may limit refinancing

opportunities.

Interest rates are currently at historic highs, and any

further increase in these rates will not only impact the

profitability but also the viability of many CRE projects now

teetering on the brink. Those who are unprepared for the shift

in the industry may find themselves battling for scarce capital

— even as they struggle against competitors that took

advantage of the downturn to prepare for the recovery.

Therefore, time is of the essence. CRE companies have a

limited window of opportunity during this industry downturn

to make important changes that will affect their future

performance and viability. All new initiatives should be

evaluated based on their cost versus long-term value

contribution. The urgent need today is to take forward-

thinking actions that will drive future growth.

Commercial real estate: headwinds in India

The various players in the CRE industry are in a stalemate of

sorts. Not enough buyers for CRE assets currently exist,

especially if one excludes the so called vulture investors. The

lending community is delaying foreclosure procedures and sale

of real estate-owned properties because of depressed values.

These factors foster an environment of stagnation in the

global CRE industry, due to which companies may be tempted

to limp along and simply survive.

As per media reports, the Reserve Bank of India has

expressed concerns on escalating real estate prices and

advised banks to keep a stringent check on loans to

CRE companies of late. In order to regulate risks and

make loans expensive, banks have reportedly increased

risk weightage on loans to developers.

Amidst this scenario, developers who have already

initiated their projects now have no choice but to

borrow from non banking finance companies at interest

rates ranging from 16-20%, private lenders at 20-35%,

and private equity firms at 25-35%. This is turn has

started putting pressure on developers and the entire

market at large.

Commercial real estate: headwinds in India Top 5 challenges for CRE companies in 2012

RealtyReality | 10

Interest rate hikes

Inflationary pressure

Cost of construction

FDI & FII inflows

Skilled manpower

43%

23%

22%

7%

5% With a view to figure out the top-5 challenges for CRE companies in

2012, Grant Thornton India conducted a survey covering more than

100 CRE developers and dealers in the National Capital Region

(NCR), Mumbai and Bengaluru. The response from the participants

has been collated as above.

“In tandem with the global economic environment, the commercial real

estate sector is in a phase of consolidation. Both real estate developers

and investors are evaluating their current strategies and future

expectations.

Nevertheless, challenges and opportunities are going hand-in-hand:

coping with interest rate hikes and inflation; protecting profits while

continuing to invest; leveraging vibrant domestic economy; seizing

international opportunities; differentiating products and services; retaining

and attracting talent; and cultivating stronger relationships with lenders

and fund managers.

Success in real estate business largely hinges on how you navigate these

complexities, while retaining investor and buyer confidence, and

maximising stakeholder returns.”

11

David Jones

Partner and Practice Leader – Real Estate

Walker, Chandiok & Co.

Strong financial analysis

Developing a financial forecast of continuing and future rental

revenues, complete with cost analysis and identification of

opportunities to reduce costs could help formulate

strategies to control pressure.

Tenants are typically required only to disclose a minimal

financial picture, and property owners are faced with a lack of

visibility into current and future rent/revenue streams. Some

RE&C owners display poor record keeping with respect to

loan covenants and hence, risk that they are, or will be, in

breach.

Negotiate terms, consider re-financing

Developers shall consider assessing their lender‟s ability to

negotiate terms and, if appropriate, consider proactively

negotiating with the lender, prior to breaching loan covenants.

Considering options for refinancing also helps in avoiding

the risk of foreclosure. Some of the options to be considered

include extending the term of the loan, restructuring their

credit, or improving management of the property to

accommodate the needs of tenants who are also facing

financial difficulties.

Making ways through panic stations

RealtyReality | 12

Amidst the situation of uncertainty in the global economy and

weak cues in the domestic market, Indian real estate

developers need to evaluate their options for renegotiating

loans. To do so effectively, they need to have a thorough

understanding of their own financial position as well as

that of their lenders.

In order to face multi-pronged pressure from the market,

developers shall consider the following:

Portfolio stress-test

For Indian real estate developers, it is the need of the hour to

assess the severity of financial condition, on the spectrum

ranging from potential risks to major problems, both current

and future.

In particular, these tests should look at risks of major

tenants leaving or going bankrupt, any co-tenancy

agreements and exposures, and the industry outlook for the

various types of tenants currently occupying the properties.

Making ways through panic stations

RealtyReality | 13

In-depth

financial

analysis

Re-negotiate

terms

Stress-test

portfolio

Mu

lti-

pro

ng

ed

ma

rke

t p

res

su

res

examine exposure to risks

forecast realistically

re-visit loan covenants

re-negotiate with lenders

consider re-structuring

improve management, prevent leakages

Strategic framework for Indian CRE companies

In the current market scenario, it is advisable that CRE

companies map the universe of available actions on a

cost-value matrix that has two dimensions: the long-

term value added and the short-term costs incurred.

Actions taken by the company will fall into one of the

four quadrants:

Myopic (low value, low costs)

Actions in the lower left quadrant are not costly to

implement, but they have low (and in extreme cases,

negative) long-term impact. One example of this kind of

activity is leasing to risky tenants in order to boost short-

term occupancy. Similarly, companies often slash capital

spending and selling, as well as general and

administrative costs, without analysing the long-term

impact of their actions.

A company should avoid taking actions that decrease

long-term value and should minimise low-impact

actions that may distract management from pursuing

strategic initiatives.

Conformer (low value, high costs)

Actions in the upper left quadrant are costly to

implement and have minimal long-term impact. These

actions often relate to problems, which should have been

addressed previously, such as weak or dysfunctional

information and control systems, a lack of discipline

in executing agreed upon plans, and inconsistency

of the cash management system with the stakeholder

requirements.

RealtyReality | 14

Conformer Forward

thinker

Myopic Cherry

picker

High

Low

Low High

Long-term value

Sh

ort

-term

co

sts

The four quadrants of action for CRE companies

Strategic framework for Indian CRE companies

Correcting these problems in a shortened time period

can be costly in terms of both time and dollars.

Companies carrying out actions that fall in this quadrant

should attempt to move towards more meaningful,

higher-value initiatives that yield more results at the same

cost.

Cherry picker (high value, low costs)

Actions in the lower right quadrant are not costly to

implement, yet they have high long-term benefit.

Examples include a review of portfolio performance,

disposition of noncore assets, cash generation

measures, and a reduction in overhead and

discretionary capital expenditures.

Because these actions are the corporate equivalent of

low-hanging fruit, a company must assume that its

competitors are drawing advantage from its actions. Any

company that strives to be more competitive must

consider investing additional resources in initiatives,

having the potential to transform it into a market

leader.

Forward thinker (high value, high costs)

Actions in the upper right quadrant are costly to

implement but have high impact. Most of these actions

demand the use of resources — capital, time, labour —

without offering short-term returns. Examples include

strategic capital investments such as the

reconfiguration of leased space, new or redesigned

marketing programs, and strategic acquisitions and

divestitures.

Unsurprisingly, not all companies are willing — or even

able — to make large investments, particularly during a

period when global signs are weak. But it‟s important to

remember that even though these actions do not yield

immediate results, they do have the potential to set the

business apart from its competitors.

RealtyReality | 15

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About Grant Thornton

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Our real estate practice

Real estate is a complex business. Owing to its capital intensive nature,

any turbulence in the economic and business environment can affect a

real estate business in a number of ways. With its depth of knowledge

and global experience, Grant Thornton India can assist you in mitigating

these inherent risks. At the same time, we can help you identify and

leverage potential opportunities as well. Assurance, tax and advisory

services are just the beginning of our suite of services.

Please contact Nidhi Maheshwari at nidhi.maheshwari@in.gt.com

or +91 77380 57904 to know more about our solutions for real estate

companies.

Financing your business

• analysing funding requirements

• preparing submissions to financiers

• benchmarking terms and pricing

• considering alternative sources

Working capital management

• managing your cash

• forecasting and re-forecasting

• optimising tax cash flow savings

• improving management information

Protecting profits

• product portfolio analysis

• optimising pricing strategy

• enhancing terms of trade

• identifying overhead savings

Operations and cost reduction

• establishing cost reduction

programmes

• improving supply chain

• enhancing operational efficiency

• outsourcing back office functions

Communication and compliance

• advising on financial reporting requirements

• clarifying directors‟ responsibilities

• mitigating fraud risk

• evaluating and designing controls

Human capital management

• optimising pension and benefit schemes

• retaining the right staff

• devising tax efficient packages

• enhancing reward packages

Strategic direction

• benchmarking against competitors

• entering new markets

• identifying acquisition opportunities

• reviewing business plans

Solutions for real estate companies

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