Monthly markets podcast India June 2021

Narayan Sharoff (NS): Hello & welcome everyone to our monthly podcast for Barclays Private Clients India. I am Narayan Shroff, part of the India Investments team and I will be your host for this podcast.

In the next few minutes, I will share with you our broad economic and market outlook and our investment strategy, followed by a short interview with our guest, Kaushik Desai, Executive Director at Walton Street India on the prospects of residential real estate in the country, an important emerging investment theme in the country.

It appears that, the impact of the second wave of coronavirus on India and the prolonged restrictive measures taken by various state authorities may delay the country’s economic recovery.

However, the focus on vaccinating the population increases our hope that this may mark the beginning of the end. We believe the second half of the year is likely to see a sharp pick up in business activity and financial market sentiment.

Such transition periods are usually difficult to navigate. That said, they often can be rewarding for investors willing to take advantage of the available, fear-led risk premiums.

As fears of vaccine availability and efficacy, elongated regional lockdowns, a potential third-wave, smaller business stresses, credit concerns and delays in a sustainable revival in demand linger, opportunities remain in play.

Policy support (both monetary and fiscal), including the recent positive surprise on dividends from the Reserve Bank of India (RBI), as well as systemic liquidity should remain conducive in this period.

With global and local liquidity remaining high, and inflation inching up, getting positive real returns may require increasing risk exposures. Reinvestment risk also remains high with structurally low cash and short-term rates in the country.

We believe that the Inflation worries may be overplayed for now.

Fuel prices have moderated somewhat recently, but should remain sticky. Food prices are still low and with good monsoons, as forecast, may remain range-bound. The rupee has also held up well during this period and cushioned the effect of imported inflation.

However, rising global commodity prices may pose challenges. As recent purchasing managers’ index prints also indicated, surging input costs and wholesale price inflation remains a worry.

However, the weak employment and demand conditions through the second wave of COVID-19, and an economy operating below full capacity, should reduce the pass through of input price inflation to retail prices.

Inflation may not be as much of an evil as it is thought, at least in the near term. The Indian central bank, like most others, is likely to look through the coming prints as “transitory” at best. The effects may rather be addressed through counterbalancing factors in the short term and supply-side catch-ups in the medium term. For Indian companies too, reflation has helped top-line growth without much impact on margins, at least for ones with more pricing power.

We suggest investors to keep investing during the transition period. A good mix of investment strategies and ideas that benefit from low rates, and the fiscal and monetary support on one hand and inflation risk on the other, should perform well in the current transition period.

In Indian equities, a selection of quality companies with resilience and pricing power and cyclicals seems to make sense. Similarly, in Indian debt, it may be worth considering a mix of high quality corporate bonds of up to 5-year maturity and select high-yield credits, especially credits collateralised by real assets that generally hold well during high-inflation periods.

Active management seems key, especially during this transition period, with sharp sector rotations a regular occurrence. Bottom-up stock selection remains the key driver of alpha amid rich equity valuations. Exploring the less researched stocks in the small and mid-cap space can be another path to generating alpha.

Similarly, credit selection and monitoring is likely to be critical during this transition period. As the economy recovers, potential ratings and/or perception upgrades are likely.

The different growth profile of the largest economies in the recovery, especially in recent quarters, again highlights the importance of global equity exposure (both across public and private markets) for Indian investors.

Besides the opportunity to participate in external markets, like China or US equities, one can also take advantage of opportunities benefitting from the new normal across the entire technology spectrum. Although not our base case in the short term, such exposures would profit from any rupee depreciation, perhaps caused by worsening inflationary risks.

We believe that Indian real estate is approaching “goldilocks” situation and to discuss more on that, we have our guest Kaushik Desai with us.

Kaushik is the Executive Director at Walton Street India. Across his 24 years of career in real estate and corporate finance, he has been involved in advising a couple of funds in the real estate financing and direct investments of more than 300 million Dollars.

Hi Kaushik. Thanks for joining us today.

Residential real estate seems to be approaching a “goldilocks” situation. Where do you think we are in this cycle?

Kaushik Desai (KD): The residential market is driven by a few key factors – the demand/supply dynamics, affordability, and availability of credit in the sector.

These fundamentals are turning favourable over the last few years:

• Post demonetization, new residential project launches fell and absorption has exceeded supply in each of the year since 2017
• Inventory overhang peaked in 2016 at 690,000 units (34 months) and has been on a downtrend ever since. As of Mar 21, overhang has almost halved at ~18 months across top-7 cities, thanks to subdued launches and a boost in sales in FY21
• Prices have remained largely flat, however, on an inflation adjusted basis, prices had already corrected by ~18% (since 2012-13) prior to Covid-19
• Affordability is at an all-time best – currently at 3.2 years (measured as property price divided by annual income). This was 5.1 years in 2002
• Home loan rates are at a historic low.

However, fence sitters were piling up through this time, waiting for prices to drop.

When the pandemic hit, it forced stressed developers to focus on liquidating inventory by cutting prices – causing an effective discount of 10-30% in certain cases considering the prior time correction. This has motivated fence sitters to transact resulting in a strong pick up in sales in 2H20 & 1Q21.

This momentum in the sector is turning the buyer sentiment positive.

So overall, reducing overhang coupled with subdued supply additions, all-time best affordability, low interest rates and return of positive sentiment all point towards the fact that the bottom is possibly behind us and a new phase of growth is expected going forward.

NS: That is heartening to hear, especially as this sector is a critical employment generator in the country. Kaushik, how has the 2nd wave impacted residential developers? How different has it been vis-à-vis the first wave? What does the pent-up activities in between the two waves tell us about the path to recovery? And finally, where does the investment opportunity lie?

KD: During the first wave, there was a lack of clarity amongst all about how to tackle the situation. There was also anxiety about how the market would react. Developers took time to adjust to the norms, including WFH. Within a couple of months, protocols were put in place and things returned to normalcy. However, 2-3 months were lost adjusting to the new normal. A few smart developers continued their effort towards digital marketing and what took everyone by surprise was the sales momentum post the 1st wave because of the efforts made on digital marketing during the lockdown.

Prior to the 2nd wave, developers were already well prepared. They had processes in place in advance. Learnings from the first wave ensured that sufficient labour, material is maintained at site to minimize disruptions. So the transition to WFH & lockdown restrictions was much smoother during the 2nd wave and there was basically no disruption in construction this time. We expect the recovery to normalcy to also occur very quickly this time.

Developers are currently facing a couple of challenges – inability to attract investors (Private market) at an early stage and void of capital from NBFCs (which were very active in this space from 2014-2019) and banks not lending freely to speed up construction. Due to this capital void, Funds such as ours are able to partner with developers to help them finish projects sooner.

We are also seeing developers come to us for funding against complete/near complete projects so that they can meet their funding/cash flow requirements elsewhere in their portfolio.

We are also seeing opportunities in partnering with Grade-A developers to acquire assets at distressed valuations as small time developers seek to exit the sector.

However, it is crucial to select the right partner and right project while also maintaining a tight grip through active monitoring post investment and keeping focus on the financial closure of the project.

NS: Which residential micro-markets and product types are expected to perform well going forward?

KD: This is important since each market is distinct and looking at residential on an overall pan-India basis may show an inaccurate picture:

• Nearly 50% of the unsold inventory today is located in Mumbai & National Capital Region
• When you look at other end-user driven markets such as Bangalore, Chennai, Hyderabad or Pune, the unsold inventory levels are reasonable – all have 1.5-2 years of inventory, which is healthy 
• However, mid-income products (60-80 lacs per home) in the end user driven markets of Pune, Bangalore, Hyderabad and Chennai – where average prices are in the 4,000-8,000 rupees per square feet range have remained resilient and will continue to perform well
• These ticket sizes are very attractive for the typical IT and other sector employees, due to which, these markets have seen a constant but stable demand for housing. Some markets such as Hyderabad have in fact outperformed with price growth of nearly 40% over the past couple of years.

As a result, our strategy has been to focus on mid-income housing in these key end-user driven markets, where sales are stable & predictable.

Real estate debt offers a few key benefits – diversification, attractive & predictable returns with downside protection, security improves with inflation, complete cash flow control through escrow, exit visibility, ongoing current payouts, stronger security, etc. In an environment where prices are constantly going up, Direct investments may generate higher returns but may not provide any downside protection.

NS: With this, we come to an end of our podcast. Thank You for joining us today. Stay safe and healthy.