India’s large infrastructure deficit and the need for fixing it is almost universally known and accepted. I’ve also written about it in my book Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World.

Investing in India

The apathy of the previous government that ruled India for almost a decade and the myriad corruption scandals that have plagued the country resulted in a state of policy paralysis that scuttled almost all large infrastructure projects in India. It appears (at least for now) that the new government in India might reverse some of that policy paralysis and might speed up decision making and clearances. However, government support alone will not help build India’s infrastructure, it will also need to be financed. Even though India has a savings rate that exceeds 30% of GDP, a large portion of that savings is in the household sector. Within the household sector, a large portion of savings are directed toward physical assets like land and gold. Of the portion of household savings that is invested in financial assets, a disproportionate amount is invested in government savings schemes and bank deposits and less than 2% is invested in risk assets like fixed income securities and equities.

The Indian banking system has become completely disillusioned with lending to infrastructure given their experience over the previous seven years and is unlikely to participate in financing it . Households in India are unlikely to meaningfully participate in fixed income securities linked to infrastructure. The equity markets and private equity have fallen out of love with the stocks of so called infrastructure companies as they have existed in their earlier dispensation due to their track record of poor execution, poor capital structure and extensive financial embezzlement and siphoning. How then will India finance its much needed infrastructure build-out?

A similar problem existed for India’s commercial real estate industry about 15 years ago. Real Estate in India historically meant residential real estate. Builders would (almost always) buy plots of land, announce projects and sell apartments even before starting construction and would use the proceeds to finance the construction of projects. Bank funding for builders was not common. Commercial developments like offices and retail were few and far between and developed identically to residential developments. Builders would sell individual office units or individual shops inside larger developments to end users before starting construction and would use the proceeds for construction like in residential developments. All this started to change as India started liberalizing its economy and as India’s IT sector started growing. Multinational companies rapidly increased their presence in India and the office space requirements of India’s IT sector exploded. MNCs as well as IT companies preferred to lease space instead of buying space and they discovered that there was almost no supply of quality leasable space in India.

A few builders like RMZ in Bangalore, DLF in Gurgaon and Raheja in Mumbai realized the scale of the opportunity and focused on developments that were in tune with the needs of the evolving commercial real estate market. They hired salespeople with MBAs who wore suits and were comfortable making PowerPoint presentations. They spoke the language of their customers as air-conditioners became HVAC systems and diesel generators became power backup systems. They built commercial buildings to suit client requirements and financed the entire construction themselves. In fact, one of the reasons that cities like Chennai lost out to Bangalore in the growth of its IT industry despite having a deep talent pool was the absence of builders like RMZ and DLF and the non-availability of quality leasable space.

The growth of the for-lease commercial real estate market gave rise to entire new businesses like property management, security services, janitorial services, landscaping services etc. International real estate agencies like Knight Frank, Jones Lang LaSalle, CB Richard Ellis etc. rapidly expanded their India operations and started providing one stop solutions to their lessee clients.

Financing the boom in commercial real estate was a challenge for these new age builders as their internal resources were limited. Their model was to construct buildings using their internal resources, to lease them to high quality companies for long durations and then to sell the tenanted properties to investors. The reason I am familiar with this is because one of the first funds I tried to raise in 2002 was a real estate opportunities fund. Foreign capital had not seriously started looking at India, domestic risk capital was in limited supply and yields on tenanted properties (cap rates) were between 12% – 14% (8% to 9% today). Furthermore, thanks to Mr. Greenspan, interest rates around the world had plummeted and borrowing rates for 10 year money were between 8% – 9% (12% to 14% today). With banks willing to lend up to 75% of the value of tenanted properties, before tax returns on equity were in the region of 24%. I was not successful in raising the fund because I was looking overseas and foreigners were not ready to look at India … yet.

As we headed into 2003, 2004 and 2005, India started growing rapidly. The size of office spaces with single tenants became larger and domestic investors did not have sufficient equity capital to invest $3 – $4 million in buildings of 250,000 square feet each and larger. During this period India also witnessed the start of a retail / mall construction boom. This time around, malls like offices were built on a for-lease only model. Given that most malls were half a million square feet or larger, the capital requirements of commercial real estate continued to grow. The vacuum was filled with foreign capital. Private equity funds and proprietary foreign investors poured money into Indian commercial real estate. Singapore and London became favored destinations for listings of Indian real estate trusts.

What has happened in the Indian infrastructure sector in the previous 15 years? The previous NDA government (1999-2004) realized that the Indian government did not have the funds needed to build the country’s infrastructure. Therefore it decided to embark on a PPP (Public Private Partnership) model where the private sector was roped in to build infrastructure. The rush started with roads, followed by power, followed by ports and airports and later spilled over into everything. A number of companies entered the infrastructure space and became stock market darlings. By the end of 2007, many of these infrastructure companies with billions of dollars of debt with debt to equity ratios in excess of 3 and 4 were trading at more than 3 or 4 times price to book values.

There were mistakes that were committed on two fronts, one on the capital markets front and the other on the policy and government front. On the capital market front, infrastructure companies became infamous for their complicated business models and their opacity. It was not clear whether companies were pure EPC players (Engineering Procurement and Construction) that typically undertake construction contracts as service providers, whether they were infrastructure developers who typical conceive and manage projects or whether they were infrastructure owners who typically collect rents over long periods of time. Companies deliberately confused their message to investors and lenders and ran gigantic ponzi schemes where

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