Real Estate in times of COVID-19: Opportunity to ask tough questions

Developers are a patient lot. Custodians of one of the most important growth drivers of every economy, these are people with deep pockets and large hearts. Not-deterred by long completion cycles, managing their way through the bureaucratic hurdles, and walking the tight rope of managing contractors and buyers' expectations, they make us believe that businesses can be built on tenacity and zeal as value drivers. The sector has weathered rising Non Performing Assets (NPAs) in construction finance, tight liquidity, high leverage and resulting economic stress in recent times.

However, these are different times. Unperturbed in most trying circumstances, developers are sporting grim faces and frown lines due to the pandemic which has left the entire human community clueless.

Corona virus outbreak has posed serious economic as well as social challenges. While the observation of social isolation, and complete lock-down has been helpful in controlling the spread, the consequential halt in the economy is likely to result in serious medium to long term consequences. Businesses across sectors and geographies are struggling to discern and design an effective response strategy to address these challenges,a task that is made difficult by the uncertainty and information asymmetry around likelihood of discovery of a cure, and the final burden of the disease.

Real Estate sector, a major growth driver for a developing economy during the normal circumstances, is one of the hardest hit in times of pandemic. All the subsectors, residential, commercial and hospitality are going to be impacted in terms of launches, sales and prices.

In the short term, the shock is creating three pronged concerns:

1.    How do I address the labor issues

Abrupt imposition of lock down has caused the sector to face a standstill, and the construction labor force, largely migrants, are either stuck at the sites or have gone back to their hometowns facing difficulty. Both ways, there are challenges.

(a)   For the laborers staying at sites, with no work progressing, keeping them occupied and providing them shelter and food has been an extra cost. Large developers such as Sunteck Reality, Anant Raj Ltd. etc. have reported to incur expenses to ensure supplies of essentials to those laborers staying back at sites. 

(b)  Sites from where majority labor has moved back, will see the return only after railway and other transportation services are resumed and state borders are opened. With state level policies differing and identification of red/yellow and green zones with varying degrees of mobility allowed possibly even after the lock down is lifted, there is a lot of uncertainty around the resumption of work.

2.    What are my working capital needs? How do I ensure enough liquidity?

Completion delays and cost overruns are looming. Occupiers' capacity to make lease rental payments is going to be affected. Order execution is going to be slow and receivable collection will be difficult. Therefore, the operators are required to adapt to case to case basis decision making, rather than a standard centralized way of decision making, to ensure better liquidity flow in the short term.

Daily cash flow monitoring, implementing a cash centric culture at the property level, and optimizing internal cash transfers are some strategies to address the constraints. To manage receivables, raising invoices as early as possible, monitoring daily collections, identifying root causes of delays and addressing them directly and avoiding conflicts can help boost collections. Identifying new committed facilities and potential source of collateral will help in arranging liquidity in case of crunch.

3.    How is the lockdown followed by slowdown of demand going to impact my price, new launches and sales?

Residential sector stood at 2.61 lakh units, will range between 1.7 and 1.96 lakh units, indicating almost a 30-40% reduction in demand. Hospitality sector will see more out-flows and less inflows, causing stress to developers who has large share of their portfolio assets in this sector. It is estimated that residential property prices can fall by as much as 20%.

Commercial real estate, especially the office space supply will be delayed by almost one quarter, and since buyers/occupiers are also likely to face liquidity issues, demand is expected to be sluggish. It is likely that developers will not want to invest in Occupancy Certificates, unless a threshold level of lease is reached.

For US and Europe based companies, which lease out space on an annual basis in India in advance, impact on their economy and demand will have a chain effect on demand for lease space too. A sharp reduction in total demand for lease space is expected. Also, lease rentals might also be pushed downwards significantly, as companies might like to renegotiate rentals to reduce costs.

While the short term challenges will eventually wither away, what is expected to remain in the long term is the behavioral changes and transformation in the way we work and live. This will certainly impact the way businesses function. As with most of the crises, tough questions asked during these times will lead us to sustainable business solutions to ensure value driven business growth.

Keeping an eye on the long term, the key questions developers, investors and board members need to be asking themselves are:

1.    Is this going to impact the way people live and work? How?

The pandemic has made all of us experience a new way of life. What was expected to come in a decade in future, was forced upon us suddenly. And exhibiting the genuine human resilience, we adjusted to the new ways of conducting businesses, expecting the blurring boundaries between homes and offices, and embracing technology through increased use of telecommunication. This trend is going to continue in future. Not all companies will shift their operations online, however, the forced working environment has given us the taste of possible benefits. A study estimates that the saving in cost of having a telecommuter in place of an onsite worker for half a year in a low paying job is approximately US$11,000. This is significant sum for small companies and start-ups.

The more the crisis continues, the more is likelihood of transformative and lasting changes in behavior.

Real estate developers might want to increase the basket of commercial offerings with flexible working spaces with strong technology support, to address the future needs.

The other trend will be higher focus on personal health and office hygiene. All new developments will have to consider these values in planning/designing the structures.

2.    How will this impact the valuation of assets?

There is going to be a deep disparity in valuation of prime and second grade assets, since the later have larger uncertainty regarding tenants' capacity to pay rents and vacancy risk. Tourism and education related assets are already facing the brunt of the public policy options chosen. The uncertainty regarding valuation is accepted and documented in the form of exemplary caveats by Royal Institute of Chartered Surveyors (RICS) and Australian Property Institute, advising the clients to attach less weight to comparisons with past trends, as the crisis and ensuing conditions are unprecedented.

The investors and developers who are not going to face liquidity and capital stress in the near future will want to hold on their assets. This will affect the supply of assets in the medium term, until the valuations return to their basic levels. This hold out strategy will force the investors to look for properties, which are not single use. A likely trend, as identified by McKinsey (2020) is that developers and investors will look to acquire operating companies, large asset portfolios and public real estate investment trusts. Assets with tenants with fixed/certain incomes will see high valuation, such as those with government agencies as tenants. Whereas, retail spaces might see a restructuring, as those with operational inefficiencies might not be able to sustain and use this opportunity to shut down and rethink.

3.    What new technology options are available to be adopted? What investments in technology are required to address the future embracing safety and remote working?

This is the opportunity to move quickly to adapting to digitize and provide a better tenant and customer experience. The leap towards technology is forced upon us. The real estate companies which have already invested in technology options to improve the customer experience, especially in residential segment, such as online leasing and rental systems, tele-platforms based delivery services, virtual tours of the properties with augmented reality will benefit from these investments in the current times of limited mobility and lockdown.

Even when the lockdown is lifted, mobility levels will be low. Investing in technologies for preserving and enhancing customer and tenant experience, such as tele-health, online virtual communities, contactless access to residents and guests etc. will make companies stay ahead in the value curve in the post Covid-19 world. These are sure to create brand loyalty for the times to come.

4.    What is expected to be the model for future – centralized or property level decision making?

While it is very tempting to attempt identifying possible impact of Covid-19, analyze the trends using analytics and come up with models which are one-size-fits-all. However, the impact is likely to be significantly different across geographies, between big cities and smaller towns and even among real estate properties. Therefore assigning significant operational decision making authority to asset managers at lower levels of hierarchy will be beneficial in attending issues faced by tenants and investors. Concessions and abatements will be asked for by tenants across asset classes. Bargain will be the key word to protect margins on a case to case basis.

However, to keep the liquidity constraint in check, centralized cash management can be a solution for ensuring efficiency. Capital allocation and portfolio management decisions are to be centrally taken keeping an eye on change in valuation. Developing protocols for what can be decided at the property level and what has to be taken to the central level decision making is required to ensure justice to the tenants and will go a long way in avoiding reputation risks.

Most developers, smart as they are, will realize the short term challenges and take the required decisions to ensure safety and well-being of their stakeholders. However, the future will belong to those who are smarter and ready to go beyond just adapting. Those who are ready to take bold decisions to strengthen the relationship with their employees, tenants and other end users.

Reference

•  https://www.bloombergquint.com/coronavirus-outbreak/three-ways-to-assess-covid-19s-impact-on-indias-real-estate-sector
•  The Economic Times, April 15, 2020: Real Estate Prices may crash up to 20% post Covid-19 – Deepak Parekh. Accessed at https://economictimes.indiatimes.com/markets/stocks/news/real-estate-prices-may-crash-up-to-20-post-covid-19-deepak-parekh/articleshow/75136953.cms
•  https://www.anarock.com/research-insights/covid19-impact-on-the-indian-real-estate-sector
•  https://www.pwc.com.au/important-problems/coronavirus-covid-19/guidance-on-tax-obligations-and-relief-for-businesses-affected-b1.html
•  https://www.rics.org/globalassets/rics-website/media/upholding-professional-standards/sector-standards/valuation/impact-of-covid-19-on-valuation-vn2.pdf
•  https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/commercial-real-estate-must-do-more-than-merely-adapt-to-coronavirus#

Author

Dr. Astha Agarwalla

Dr. Astha Agarwalla is an Associate Professor Adani Institute of Infrastructure Management, Ahmedabad, Gujarat. She is also Fellow of the Indian Institute of Management, Ahmedabad (IIM-A), specializing in Public Systems, and a Masters in Economics.