Many of you have asked us why we have slowed down our listings and investments in India over the past few months. I thought I would write to you directly to explain our strategy and why we think this is not the best time to invest in office assets in the country.
Private funding starts drying up...
The macroeconomic environment worldwide has changed dramatically over the past few months. We started seeing headwinds earlier in the year when private funding started drying up for tech companies (refer chart 1 below).
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Fig. 1: VC Investments – India
...Tech company IPOs perform poorly...
Many of the tech company IPOs performed poorly leading to lower returns for venture funds and losses for retail investors who participated in those offerings. Zomato, Nykaa and PAYTM are c. 49%, 55% and 69% down from listing price (see chart below). Large tech companies which have been growing at speed over the last 10-15 years have also slowed down and started laying off employees. Recent examples of US tech companies laying off include Stripe, Microsoft, Amazon, Lyft, SNAP, Meta, Twitter.
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Fig. 2: Tech IPO Performance – Zomato, Nykaa, PayTM
...Indian tech companies start laying off as funding dries up...
Indian startups used to funding losses through a steady flow of venture capital had to adapt to a new market reality. Without free capital and limited runway, many of the biggest tech firms have started laying off employees including unicorns like BYJU’S, Chargebee, Cars24, LEAD, Ola, Meesho, MPL, Innovaccer, Udaan, Unacademy and Vedantu. This should reflect in lower demand for office space which should in-time affect both rents and office absorption in the medium term.
Fig. 3: Startup Layoffs in India
...Russia invades Ukraine...
In Feb'22, Russia invaded Ukraine starting the Ukraine War which had a debilitating impact as gas and oil prices skyrocketed, leading to a cost-of-living crisis in the world. Russia supplies 16% of the world's gas requirements and accounts for 45% of EU's gas imports. The rise in gas prices increased the cost of goods worldwide with inflation reaching double digits in many of the developed economies like the US, EU and UK
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Fig. 4: Crude Oil Price
...Rising prices and loose monetary policy leads to high inflation...
Monetary support provided by governments around the world both in the form of near zero interest rates and financial support to businesses during the COVID-19 pandemic had led to an unnaturally high money supply in the economy. This coupled with the high cost of gas prices stemming from the Ukraine War led to an unprecedented rise in inflation leading to the cost-of-living crisis. Cost of food and basic living expenses have started rising rapidly while salaries have remained the same leading to strikes and industrial action in the West last seen in the 1980s. This has depressed demand leading businesses to cut jobs and hold off expansion plans.
...Central Banks raise interest rates...
When inflation starts going up, the first line of defense for any government is increasing interest rates. The US, UK and EU have increased interest rates from 0% to 2-4% over the last 10 months. India has increased the repo rate from 4% to 5.9% in the same period. This means that the risk free rate in the economy goes up raising rates on government securities, fixed deposits, savings deposits, corporate debt and so on. This in turn should directly impact rent yielding real estate like commercial and office assets which trade at a risk premium to the risk free rate. The chart below compares histrorical inflation with office property yields in the US and shows the relationship between office yields and interest rates.
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Fig. 5: Central Bank Rates – US, UK, EU v/s US Office Cap Rates
...Asset prices come down and yields go up...
This has clearly been the case in developed countries where asset yields have gone up (and prices down) in-line with inflation and interest rates. Historically, the highest returns have been made when investments have been made in periods of high inflation and interest rates as this is usually followed by periods of lower inflation and interest rates. We are currently seeing this in the UK where the last asset we funded (Walton Summit) was reduced in price twice by the Seller Threadneedle Investments.
...While developers in India are still holding on...
However, we are yet to see this correction in India, where asset owners and developers continue to hold on to mid single digit yields. As has been the case in the past, developers are loath to reduce prices until the very last moment. What they fail to realise is that the interest cost on their debt on the balance sheet is going up and has started eroding some of their equity value already. At some point, interest payments are going to completely wipe out the equity. We saw a similar trend in the financial crisis of 2008 where many developers went under while others who cut their losses, reduced debt and sold ended up being stronger for the period of high growth starting 2010. We are therefore concentrating our focus on markets like the UK where we see asset prices at levels that can lead to significant upside for investors.
…Our focus is on returns and not growth…
UK: In the UK, our strategy is to look for high quality institutionally owned logistics / warehousing assets with long leases and AAA tenants in locations with low vacancy and high demand. We believe the underlying growth story for logistics is very strong in developed economies like the UK given more and more people are working from home and online shopping has gone up signifcantly increasing the demand for warehousing.
India: In India, we believe commercial office continues to remain a very strong bet but the pricing needs to moderate further before we see risk adjusted returns for investors. We are using this downtime to focus on managing our existing assets by regearing leases and providing exits to investors.
While growing our Assets Under Management by listing new properties is a strong incentive, we believe in the current situation this will lead to lower returns and possible loss of capital for investors in the long term. When we look at the "smart capital" - institutional investors like Blackstone, KKR, Brookfield - all have held off investments in the last few months and are waiting for prices to correct further.
…Learnings from the 2008 crisis…
I was a first hand witness to a very similar cycle in the 2008 financial crisis while I was investing in Blackstone, the world’s largest alternative investment fund. We decided to pause all investments between 2008 and 2010 during which time all large PE funds who had actively invested lost capital and left India. This included Och-Ziff, Merrill Lynch RE fund, Whitehall/Goldman, Morgan Stanley RE fund (MSREF), Deutsche Bank REF (DBREF) etc – big names in the institutional real estate investing universe. In 2010, Blackstone was the only fund left with dry powder and we had the pick of the highest quality assets at very low prices – this was the time we made the most lucrative investments in the fund which was later sold very profitably through the REITs.
…We are well capitalised…
Having recently raised external capital (US$ 47 million from Westbridge Capital in Jun’22), we are well capitalised, with enough dry powder and therefore able to wait longer for better value for you, our investor. We believe the distress in the startup space has only just started and we foresee many weaker players being wiped out taking investor capital with them.