Diversifying Investment with Real Estate

By Echelon.

Published on January 07, 2014 with No Comments

real-estate

With demand for space – office, retail, residential – on the rise, property is seen as an asset that can round off an investment portfolio. Direct investment options are limited right now with few listed real estate firms and property being an illiquid asset with even the smallest possible purchase unit being beyond the means of average investors. But anticipated increases in real estate prices could spell good returns for those buying land or apartments for resale or rent.

The way in which high-rise buildings are shooting skywards in Colombo and the suburbs, the city will be unrecognisable in a few years. The frenetic building activity underway in many places is changing Colombo’s skyline almost by the day. Both companies and individuals are pouring money into property – buying land and putting up buildings – in the expectation pent-up demand will yield high returns.
Sri Lanka is one of the most densely populated countries in the world and the popular investment advice, to buy land since it is not made anymore, even if not technically correct, still holds true. The land mass already has been extended with the Colombo South Harbour and the planned port city next to it will enlarge it even further, along with the proposed man-made island off Hambantota using material excavated to make the port. But reclamation is costly and reclaimed land expensive.
Given the inexorable increase in demand for both residential and commercial property, real estate could be part of a diversified investment portfolio. The security offered by real estate makes it a safe and solid investment, especially for the long term, although property bubbles do appear from time to time to catch the unwary investor who ignores sound advice to buy at the right location and at the right price.
“It is real estate that has been the traditional investment instrument. Stocks and bonds are relatively new investment instruments,” says Danushka Samarasinghe, Director-Head of Research at TKS Securities, a stock brokerage which recently did a study on the sector. “For those who can afford it, real estate could be part of an investment portfolio. But real estate is more of a medium- to long-term investment. Returns are much lower than higher-risk stocks and are slightly below that of bonds. But real estate investments are stable and more secure.”
Traditionally most people have inherited their homes. That’s changing now as more and more people look to build or buy their own homes when starting a family or for investment purposes. While demand is growing, still inadequate income levels and high construction and mortgage costs are a dampener. The cost of building materials is high and so are borrowing rates compared with other countries.
The real estate market’s driven by both institutional and individual investor demand – foreign and local firms renting, buying or building commercial and residential properties and Sri Lankan expatriates, returnees and migrant workers going for apartments and individual homes.
dhanushkaProperty prices rose sharply after the end of the war in 2009 and then moderated but are now seen as poised to rise again. Land values in some suburbs have shot up sharply given demand for these locations like Nawala and Maharagama. In some urban areas in the latter a perch fetches over Rs700,000, according to recent studies. That’s because there’s land available for building in these areas unlike in the heart of the city and also because it is more affordable than in Colombo for middle-class people
The impact of increasing land and construction costs could drive real estate prices too high.
“The sudden upsurge in land prices will have a medium-term impact,” says Gagan Singh, CEO – Business & Chairperson – Sri Lanka Operations of Jones Lang LaSalle, a financial and professional services firm specializing in real estate. “Construction cost is high, due to the need for importing most of the raw materials and high labour charges. If rental and capital values of finished products stagnate, there is a risk of a project becoming non-lucrative for investors.”
A real estate market study by the audit firm KPMG in 2012 evaluating land registration prices in Colombo 1 showed that in areas like Main Street a perch went for around Rs.9-10 million while at Sea Street it went at around Rs.8 million. In Colombo 3 a perch was around Rs5 million at the time and Rs4 million in Colombo 4 and Colombo 6. The audit firm forecast double-digit growth in the post-2013 period with illegal dwellings and encroachers on state land being cleared to make way for new developments, as is evident today. That would transform the future land market in the inner city area – such as Colombo 1, 2 and 3 – towards more exclusive, high-end use. “Those that do hold private property in the inner city areas are likely to witness significant appreciation in prices,” the report forecast.
Floor Area Ratio regulations that say only the larger plots, of over 3,000 square metres, can be developed into big property projects give an opportunity to big companies with land banks that have long remained dormant or occupied by old offices, according to an earlier study by NDB Stockbrokers. These could be put to more lucrative use with high-end mixed development projects. Some like Overseas Realty (Ceylon) have already done so. Others like Ceylon Cold Stores with eight acres in Slave Island have recently unveiled development plans. Hayleys has six acres at Foster Lane, Deans Road, Richard Pieris & Company over four acres at Hyde Park Corner and John Keells Holdings unit Whittall Boustead three acres at Vauxhall Street.
Opportunities for investing in real estate through listed firms are still limited though. Most companies listed under the Land & Property sector are relatively small residential or commercial property projects, as the NDB report noted. Their small size limits their prospects even though they would benefit through rising rental yields and property prices.
“The only pure property play on the stock market is Overseas Realty,” says Samarasinghe of TKS Securities. “The others like Access have property as part of their business portfolio. Access is now building a high-rise to rent out.”
TKS Securities sees a “huge opportunity” for both existing and future office space developers as city rentals are expected to increase sharply owing to shortage in supply. Rental yield for office space is now around 7-9% in key locations but could rise sharply.
Currently, rentals of A grade office space in Colombo more or less match those in more established markets such as Kuala Lumpur and Bangkok. “With growing demand and the supply deficit we believe the yields on grade A office space could increase 20-25% year-on-year in the medium term,” said a recent TKS Securities report on real estate. That’s because although many projects are in the pipeline they have allocated only limited space for offices, more prominence being given to apartments and hotels. The only sizeable designated office space in Colombo now is just over 2.0 million square feet with occupancy averaging at 98%.
“There’s strong demand for office space as available top-grade space is almost fully occupied,” explains Samarasinghe. Overseas Realty’s World Trade Center twin towers are almost full with occupancy about 99% while HNB Towers is full with the bank’s own offices. The Access Engineering complex will add 125,000 square feet and another 500-700,000 square feet could be added in the next 3-4 years by other planned mixed development projects.
“The demand for large office spaces of 15,000-100,000 square feet is promising, given the steady growth of the IT and BPO sector,” says Singh of Jones Lang LaSalle. “Since cost is a concern in this segment, the demand is skewed towards the more cost-effective suburban locations of Colombo, such as Welisara in the north, Rajagiriya in the east and Ratmalana–Moratuwa in the south.”
The demand for medium-sized office spaces of 3,000–15,000 square feet is fairly buoyant, and emanates primarily from domestic companies, especially the financial sector, she says. “The supply situation is weak, since there are not enough Grade A buildings in the city to cater to such demand. However, clients do have a range of medium-sized options in new and refurbished buildings to choose from within a radius of 10 kilometres of the Central Business District. Demand for small or start-up configuration office spaces of under 2,000 square feet is noteworthy due to the influx of many multinational firms. Such spaces are available all over the city, across commercial buildings and older residential houses. There are a few business centres or serviced offices that cater to requirements for even smaller sizes such as 100-500 square feet.”
Foreign interest in real estate is rising but government restrictions on foreign ownership are a dampener. “There is significant foreign interest, especially in tourism-related properties. But foreigners are deterred by regulations,” says Samarasinghe, who believes government policy is correct as unrestricted foreign buying of limited land could send prices beyond that of ordinary people. Jones Lang LaSalle reports a great deal of interest from Europe, Asia and the Middle-East.
“We are noticing many foreign companies showing a keen interest to invest in Sri Lanka,” says Singh. “The favourite sectors are tourism, hospitality and residential. There is interest in townships, large scale affordable housing and agriculture. International retail brands are positive about Colombo city, and franchising is the tried and tested model. Partnering with Sri Lankan companies also helps in easing out regulatory processes as KFC, McDonalds, Levis and Panasonic have done.”
Retail space is also limited and good malls even more so. Sri Lanka only has about half-a-million square feet of retail space in shopping malls out of which only Crescat Boulevard and the ODEL departmental store are of internationally comparable standards. “Currently, available retail space is fully occupied and top grade retail space yields 11-12% a year, which is the highest return among all property segments in Sri Lanka,” says TKS Securities.
About 1.8 million square feet will be added as luxury retail space within the next 2-5 years. With consumer behaviour shifting towards international brands, the influx of tourists and plans to promote the country as a regional shopping hub, Sri Lanka’s retail market would shift to a “whole new plane” and even a 400% increase in commercial capacity by 2016 would not lead to an over-supply situation in the city, the brokers say. Good quality ‘High Street’ retail space is also a challenge, as a result of which retailers are forced to resort to converting homes or refurbishing older buildings, says Singh of Jones Lang LaSalle. “Facelifts of heritage buildings and arcade lines in the Fort area is likely to add a lot of value to the retail scene in Colombo.”
Existing retail establishments are largely located along the high streets, either in the traditional retail sub-markets like the Pettah or in upmarket established retail sub-markets like Kollupitiya, Bambalapitiya and Wellawatte. The branded shopping destinations are towards the south of the city centre along Galle Road and Duplication Road. Other retail locations consisting of small outlets as well as malls are also emerging along the main arteries stretching out of Colombo. One is along the airport road, towards Wattala and Ja-Ela, another along the road to parliament (Sri Jayewardenepura Mawatha) passing Rajagiriya, a fast-growing locality for both residential and retail investments, and a third along Galle Road towards Mount Lavinia, Ratmalana and Moratuwa, considered the most developed of Colombo’s suburbs.
“Malls are still thin on the ground and those that exist are relatively small,” says Singh. “However, larger projects are being planned. These will largely be components of integrated mixed developments such as Havelock City, Colombo City Center by Abans-Silverneedle, Shangri-La, and Property Alliance Capital who all have planned mall spaces within their developments. The actual delivery of these spaces still appears to be about five years in the future. Overall, there currently is no new supply available on the market.”
One of the key driving forces of the property market, apart from tourism-related demand, is the growth of the transport network – the building and modernisation of roads and railways which makes travel easier and faster. Colombo’s urban sprawl will spread and get denser as suburbs get linked by continuous development of built-up areas southwards towards Kalutara and northwards to Seeduwa.
“The ‘hot’ locations in Colombo are 1, 2, 3, 5, 7,” says Samarasinghe. “But given the urban development plan Colombo 11, 10, 8 and Crow Island area could transform significantly and could become desired locations for residential and commercial use and also recreation. Then, given the successful implementation of the urban transport mechanism and creation of the ‘Ring Road’ circling the Colombo metro region, peripheral suburbs like Malabe, Kottawa, Piliyandala, Moratuwa, Kiribathgoda, Ja-Ela, Seeduwa and Katunayake could witness a sharp surge in demand. This demand and price appreciation will further spread inland along the paths of the highways, currently the Southern Expressway and thereafter the Kandy highway.” Also there is growing demand in regional towns like Kandy, Galle, Trincomalee and Jaffna.
At the high-end of the condominium market, demand has been led by Sri Lankan expatriates and returnees, who have been snapping up the majority of apartments in high-rise projects, often even before they are built. Most of these are bought for investment purposes like renting, not to actually live in them. At the other end of the market, there is sustained interest from migrant workers with some correlation seen between remittances from overseas and property prices. In locations like Colombo 6, in apartments priced in the mid-range, there appears to be some overcapacity as people who originally bought apartments return to their original homes in the north and east.
gagnRental yields, except in retail, are not as high as could be expected in a developing property boom. That’s because the high price of land and construction make it costly to build while average incomes have not yet risen to comparable levels. Construction costs are comparable with international levels and are high because of rising prices of raw materials most of which are imported, shortage of skilled labour and delays in getting approvals for mining and quarrying. Comparatively high mortgage rates are also a dampener.
“Returns are not better because land and construction costs are high,” says Sashreeka Abeysinghe, an Investment Analyst, who was part of the team which prepared the TKS Securities property report. “Almost all construction materials are imported. Also the depreciation of the rupee has raised costs.”
Says Singh of Jones Lang LaSalle: “Rental returns for luxury apartments in the Central Business District fall in the range of 4–5%. The resale values of apartments there appreciated significantly until 2012, but have stabilized after that up to the current time. One needs to keep in mind that the base also has been low.”
High prices of residential property means potential in housing with annual demand estimated to be around 80-100,000 units. But again the constraint is the slower increase in personal incomes. A decent home in a Colombo suburb costs at least Rs15-20 million – unaffordable for most middle-class people – mainly because of high construction costs and inadequate incomes. Although individual incomes have risen in recent years, property prices have outpaced increases in income levels and mortgage rates remain high. This market will get activated if the government reduces import tax on construction materials and lending rates to make borrowing to buy or build homes cheaper. Rental yields remain a low 2-3% owing to high construction costs but are seen improving.
Like in any investment, real estate has its own risks. “The biggest risk is liquidity,” says Samarasinghe of TKS Securities. “You can’t sell in a hurry.” Furthermore, the real estate market is not as organised or as professional as in other more developed countries in the West or in East Asia. There are few professional real estate agents and middlemen or brokers have a bad reputation. There’s a marked lack of transparency in property transactions, which are mostly informal. Fraud is rife with forged deeds being routine. Constantly changing government regulations, especially on foreign ownership, is another risk as is the poor state of official land records and property registration.
The other risk is that of the property bubble. Many property developers made losses in the boom of the latter half of the last decade when a ceasefire led to a surge in building especially of condominiums followed by a bust when the war resumed. Already, KPMG has warned that buying by expatriate Sri Lankans, who are driving the condo market, may have peaked or be nearing its peak, given their finite numbers. Foreign buyers might also be deterred by higher risk perceptions of doing business in the island.

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