Sunday, October 9, 2011

Real Estate Sector needs Realistic Expectations

Indian Real Estate Funding– Rational Expectation is the Need of the Hour!

Indian Real Estate sector is facing serious challenges in fund-raising with limited options at this critical juncture. Serious beating down of stocks by the market precludes fund-raise through Public issues. Many developers have en-masse restructured their loans in 2009 precluding another round of restructuring now. Increasing interest rate and volatile economic outlook has started dampening housing demand, making banks and NBFCs wary of fresh lending to the sector.  At the same time, high commodity prices, mainly cement and steel, together with serious labor shortage is delaying pace of progress and the resultant cash flows from ongoing projects.

In a perfect market, one could expect a sharp correction in real estate prices to help clear inventory, and sale of non-core assets and land banks to improve liquidity and to meet loan repayments.  But neither of these is being witnessed today in a meaningful scale and the reasons are not too difficult to fathom.  

Many small and mid-size developers prefer to hold on to the prices (at super-normal profit margin levels) and hope for indulgence by their lenders, a classic example of ‘moral hazard’ of having accommodated such a request from the Real Estate sector in 2008-09. Many of them also seriously under-estimate the extent and duration of the liquidity crunch facing the industry, hoping for return to normalcy soon.

For the large players, emergence of a parallel funding mechanism in the form of Real Estate Private Equity funds has provided much-needed holding power, who otherwise would be leading the correction in real estate prices.  Significant amounts, running to a few billion USD, have been raised by Real Estate Private Equity players in recent years. Such funds invest their proceeds as Project Level funding of reputed builders (Top 5 within the city), though part of it is typically given as ‘take out’ to the developer to support its other ongoing projects.

Typical investment could take the shape of a hybrid security, with a mix of debt and equity characteristics; for e.g., land is taken as primary security, with additional collateral in the form of earmarked escrow of cash flows from other ongoing projects (2x cover is a standard expectation). Return expectations are in the range of 20-24% for debt structures and almost 40% pre-tax IRR for equity structures! With such high return expectations, the chain is bound to snap somewhere – the buyer, the developer, the lender or the PE investor – should there be a serious economic shock.

Rational expectation is the need of the hour.  Developers who are willing to compromise on part of their profits for the sake of better demand and liquidity are likely to survive the current challenges facing the real estate sector. Similarly, investors and lenders should also temper their return expectations to realistic levels to protect the value of their exposure in the long run.

N. Muthuraman is ex-Director Ratings, CRISIL and Co-founder of RiverBridge Investment Advisors Pvt. Ltd., a boutique financial advisory firm.

This is the blog of the Print Version published in Business Line dated 10th Oct 2011

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