Commercial trumps residential segment as investors eye annuity assets

Indiabulls' stock jumped 40% after its demerger of commercial assets into a separate entity

Real estate stocks clocked sharp gains on expectations that investor interest in commercial real estate, lower commercial inventory, especially in Bengaluru, Pune, and Hyderabad, and stable rents in key markets would help developers with sizeable commercial projects to reap benefits. An analyst at a domestic brokerage says global institutional investors are taking a long-term view of prospects in the commercial real estate and are getting annuity projects at attractive valuations.

On Monday, Indiabulls Real Estate announced it will demerge its commercial assets into a separate entity to bring greater focus to its current operations. Earlier in the month, the Canada Pension Plan Investment Board committed an investment of Rs 1,600 crore for a 49 per cent stake in Island Star Mall Developers, a subsidiary of Phoenix Mills. Over 80 per cent of Phoenix Mills' assets are in the commercial segment. Cushman and Wakefield had indicated that private equity investment in Indian commercial assets will hit $3.5 billion in 2017 led by stable commercial property and opportunity of listing assets under real estate investment trust (Reit).

Emkay Global's Adhidev Chattopadhyay believes that low vacancy (five to six per cent in Grade A office space) in cities such as Bengaluru and Hyderabad, large leasing deals by multi-national information technology (IT) industry and other sectors, and limited number of developers with quality assets have led to a surge in investments in commercial assets over 2014-2016 period. This is expected to continue in 2017 as well. On the rentals front, although some experts believe that commercial real estate rents pay see some pressure in certain pockets, most believe it will remain stable or inch up in 2017.

Given the backdrop, it is not surprising that realty stocks have been big gainers in 2017, with many stocks rising 50-100 per cent.

Emkay believes that developers with a ready portfolio of office/retail assets (especially in Bengaluru) and presence in mid-income housing are in a sweet spot. Its preferred picks are Prestige Estates Projects, Brigade Enterprises, and Phoenix Mills. Though the office space leased out in March quarter was eight per cent higher over the year ago quarter at eight million square feet, IT is the largest segment accounting for 37 per cent of the leased space. While so far the trends are positive, any slowdown could dent the leasing offtake and therefore rents. Mumbai, National Capital Region, and Bengaluru accounted for 56 per cent of the leasing in the quarter and thus hold key for growth in this segment.

On the other hand, the residential segment is expected to take about two years to come out of the slowdown. The story of the players in the residential space is different, given the high inventory, weak pre-sales, and significant debt. In the near term, how the players in residential and commercial segments fare will be clear in the March quarter results, which are expected to be muted. Analysts at HDFC Securities believe that given the 30 per cent gain in BSE realty index over the last three months, it is prudent to remain cautious given multiple headwinds such as higher increase in customer litigation due to Real Estate Regulatory Act, lower liquidity, weakening of buyer sentiment, and margin hit for developers as they complete under-construction properties and offer discounts.

Given the high debt and spending needs, net profit of realty companies is expected to fall 25 per cent year over year as well as sequentially (latter due to note ban). However, the impact for companies focused on commercial realty will be much lower, with profit decline seen in single digit.