Bangalore Realty: Expect near-term outperformance

Meaningful resilience in sales; mixed-bag leasing indicators

•  Slew of new launches and controlled pricing kept market momentum steady in Bangalore, even after a robust 2QFY12.
•  Commercial demand-supply equation and vacancy levels are favorable.Current mixed bag indicators for leasing transactions are not strong enough for a negative conclusion of IT sector’s slowdown.
• Market outlook for the next 9-12 months is stable, with moderate pricing  uptick amidst steady volumes. Some short-term challenges could emerge

Sector strategy: Despite sustained under performance and cheap valuations, a challenging macro environment and distressed  fundamentals dilute the strength of immediate catalysts for the Real Estate sector. We prefer stocks with stronger balance sheets and superior operating performance – Oberoi Realty, Prestige Estates, Phoenix Mills and Sobha Developers (not rated), or stocks with near-term triggers – DLF, which offers a play on deleveraging together with valuation comfort.

In CY11, the Real Estate sector has been hit by several headwinds, both operational and regulatory. The outlook for physical markets has been dented due to

(1) plummeting sales volumes,

(2) overhang on commercial leasing due to global slowdown,

(3) delays in approval, launch and construction of existing projects.

Despite such slowdown across the country, Bangalore developers have shown meaningful resilience. We met the regional team of Jones Lang LaSalle (JLL), a few real estate agents, and managements of Prestige Estates and Sobha Developers to understand the market outlook over the next 12 months. We present our key takeaways.

Initial slowdown mitigated with slew of new launches post 1Q:While in the initial three months of FY12, new launches were scarce due to delays in approval, there has been a huge pick-up in momentum since early 2QFY12, with a slew of new launches. 50-60 new projects have been launched across segments (mid-income to ultra-luxury) over the past 9-10 months.

Continuing outperformance in absorption: Amidst declining volumes across other key real estate markets like NCR and Mumbai, the southern markets in general and Bangalore in particular has shown commendable resilience. In 2QFY12, Bangalore-based developers
outperformed peers, with a strong uptick in launch and sales numbers. Our interactions with market experts hint at continued outperformance post 2Q.

Controlled dynamics and pricing mechanism – keys to greater resilience: Bangalore’s higher resilience can be attributable to rational pricing movement on account of:
(1) availability of huge land parcels across the growing periphery,

(2) more competitive and less collaborative environment among developers – every developer enjoys similar demand,if pricing and product positioning is done properly; even a new market entrant can enjoy its share of success,

(3) price mechanism has been a direct function of “cost + margin” – unlike speculative demand-supply in Mumbai and Gurgaon, and

(4) higher proportion of end-user sales – post 15-25% price hike from FY09 levels (mainly due to cost inflation and demand recovery), investors see no meaningful upside and their participation is very low.

Commercial indicators favorable till date: Commercial absorption over CY11 bounced back to over 10msf/year as against ~9msf in CY10 and ~6msf in FY09, largely driven by some SEZ/STPI space uptake. More positively, most of the new leasing (80-85%) can be classified under fresh acquisition (not consolidation by existing customer by surrendering old space). Vacancy levels for the overall city are 13-15%. For Outer Ring Road (ORR),  vacancy levels are 4-6%. Whitefield has high vacancy levels (30%+), but due to lower rentals and limited ready space availability in the ORR stretch, it has been witnessing strong spillover demand. Rental movement has been controlled, but rentals have surpassed 2007 levels (declined 15-20% in 2008-09 and then recovered). Rentals are INR45-49/sf/month at ORR (sub-INR40/sf/month a year ago), INR25-32/sf/month at Whitefield, INR45/sf/month at Bannerghata Road, and INR80-100/sf/month at CBD (no major supply). Leasing activity in North Bangalore has been subdued due to limited space (apart from Embassy STPI). Outright sales of commercial properties are not attracting many buyers, as developers
expect 9-10% cap rate (they can get alternative money from lease rental discounting at 10.5-11%). In the Retail space, the number of upcoming malls has declined sharply due to change in plans by developers. The three major malls launched in CY11 -

(1) Ascendas (Whitefield),

(2) Phoenix (KR Puram),

(3) Meenakshi Mall -

are fairly pre-leased.

Current signs not strong enough for negative conclusion: There are no conclusive signs corroborating concerns of slowdown in IT sector (accounts for 60-70% of Bangalore commercial volumes) spending in current market behavior. Recent transactions depict mixed response. Accenture has taken ~1msf at Mysore Road, while another IT company has surrendered 0.5msf recently. Long-term growth outlook remains strong, though near-term challenges could emerge.

Amidst cautiousness, outlook largely stable for next 9-12 months: Due to huge stock availability and inherent nature of pricing mechanism, barring cost escalations, residential prices are likely to remain stable, with only 5-10% natural appreciation. Large availability of projects at affordable cost would ensure steady off-take. In the commercial vertical, supplydemand equation remains favorable, with ~70% of under-construction buildings already pre-leased. However, upcoming supply in 2012-13,  which is likely to be high despite possible phasing out, would restrain sharp rental pick-up.

Views shared by managements on market outlook

•  We interacted with the managements of Prestige Estates and Sobha Developers to understand their market outlook. Their views largely match with our channel check takeaways – concerns relating to IT slowdown are voiced, but yet not visible.
• Sales momentum has been robust even after a strong 2Q. Prestige sold another INR2.5b (post INR7.8b in 2QFY12), taking its total sales value to INR12.4b till November 2011 as against full-year guidance of INR15b-16b. Sobha’s projects have also shown
  resilience, with sales of INR10b-11b over 8MFY12 v/s FY12 guidance of INR15b. However, unaltered guidance is indicative of managements’ underlying cautiousness.
•  Prestige’s management sees no downside risk to its FY12 leasing guidance of 3msf,given 1.8msf leasing transactions concluded in 1H, and 4-5 big-size (0.3-0.5msf) transactions lined up for its Shantiniketan, Tech Park project. According to Sobha management, Infosys is planning to start a large campus in Bangalore next year,which will house thousands of employees.
•  Approval process has been fairly fast, and there are no major delays in Bangalore,unlike Chennai