Real Estate in doldrums: Time for Consolidation

The real estate sector in the country is in the doldrums as the slump in the residential segment because of poor demand and high inventory shows no sign of improvement. Lakhs of home buyers have been left stranded after a number of real estate companies have failed to deliver their projects on time. Leading companies like Jaypee Infratech is facing bankruptcy at the National Company Law Tribunal (NCLT) and the Supreme Court has asked the government-owned NBCC to take over all projects of Amrapali Builders and complete them as home buyers are stuck with incomplete projects for six to seven years and even much more.

With sales going down and prices flat to declining, cash flows have dried up and construction activities have slowed down dramatically. And now with bank lending rates rising, buyers may stay away from loan-backed home purchases. The situation is even grave for smaller real estate companies as they are starved of funds as banks are reluctant to finance residential housing and property prices have stagnated. Many small developers are going for joint ventures with bigger ones or sold their projects to tide over the crisis. Many developers are now looking at developing affordable housing because of government subsidy. The government has come out with lower GST rates and a credit-linked subsidy scheme to promote affordable housing.

Most real estate companies have over-leveraged assets, diverted funds to acquire more lands which led to crunch in funds for completing existing projects. The sector further went into a tailspin with demonetization, Real Estate (Regulation and Development) Act and Goods and Services Tax (GST). In fact, RERA and GST increased the compliance costs for developers, through these are customer-friendly policies.  With high inventory levels, developers are now focused on offloading inventory rather than doing new launches. Developers have now sought government intervention to tide over the grave situation. They have sought reduction in GST on construction services from 12% and better access to finance.

Slump in real estate

Property prices in Mumbai and Bengaluru have increased annually by just about 8% and 6%, respectively, between June 2013 and March 2018, according to National Housing Bank. In Delhi-NCR, prices have actually fallen and unsold houses have piled up, which will take at least another five years to clear. In the past 10 years, the real estate sector went through couple of downward cycles.

In the past, PE investments in real estate were an important source of funding. After the global financial crisis, private equity (PE) funds had cut investments in the real estate sector. Overall PE funding in the real estate sector have dipped 22% year-on-year to Rs 10,080 crore in June quarter from Rs 12,970 crore in the same quarter in 2017, according to Cushman & Wakefield. With the slump, PE investors are now cautious of fresh investments and are trying to recover their losses. Similarly, the banking system, which was the main source of funding, is vexed with piling non-performing loans. Moreover, RERA no longer allows the use of a customer’s money to do anything other than build the project they were sold. Developers have to put 70% of the funds received from buyers in a separate escrow, which means developers cannot roll the money for another project.  As residential real estate accounts for nearly 80% of all the real estate developed in India, developers are hamstruck. Moreover, rental yields in the Indian residential real estate market are very low as compared with other emerging nations. This indicates that the Indian real estate market is overvalued and unaffordable. In fact, ideally the rental yield should be close to the cost of borrowing.

Table 1: Change in Market Share of Developers Tier-wise

Data in %  Mumbai (FY18) Delhi-NCR (FY18) Bangalore (FY18) Pune (FY18)
Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4
Category A & B developers 41 54 45 58 63 80 48 70
Category C & D developers 59 46 55 42 37 20 52 30

Source: Axis Capital

In fact, the real estate sector across the country has been going sluggishness for the past six years. A study done by Crisil Research, an analytics company, shows absorption of new homes in 10 ten cities has slipped at a CAGR of 8% in the last six years. Moreover, RERA has forced developers to focus on completing their existing projects and sluggish demand has resulted in negligible new launches. Excess leverage has taken the debt levels of real estate companies to around Rs 4.5 lakh crore as of June 2018 from Rs 1.5 lakh crore in March 2011.

Table 2: Gross Rental Yields (Country-Wise)

Country %
Taiwan 1.6
India 2.4
Singapore 2.5
Hong Kong 2.6
Thailand 5.1
Indonesia 8.6

Source: Ambit Capital

Merger, Consolidation possibilities

The introduction of RERA, insolvency law, benami transaction law, shrinking balance sheet of developers, mounting debts and hit on brand name due to non-delivery of flats or delayed booking are all the likely triggers for increasing consolidation and diversification exercise undertaken by developers. Subdued demand and leveraged balance sheets have made it really difficult for developers to manage their debt repayment schedules. As a result, developers are declaring bankruptcy, which will further push the cause of consolidation in the real estate sector.

Firstly, with the introduction of RERA, there will be consolidation in the real estate sector in India as smaller cash-strapped developers will have to partner with larger developers or raise equity from institutional investors. With subdued consumer demand and leveraged balance sheets of builders, repaying loan schedules have become difficult for developers and banks are looking at piling non-performing assets. Developers will have to be adequately funded and meet all the regulatory and compliance issues. This will invariably reduce the number of unscrupulous developers, who were gaining the loophole in the system to benefit themselves.

Secondly, with the Insolvency and Bankruptcy Code (IBC) gaining momentum before the NCLT, mergers are acquisitions are likely to happen in the real estate space. Some of the firms have approached market regulator Securities and Exchange Board of India seeking an intervention. The tentacles of non-performing assets (NPAs) of banks have hit the real estate sector and the IBC will be a key driving force in fostering the M&A activities in the sector. The entities under IBC will provide a conducive environment for the financially healthy entities to look for inorganic growth opportunities. Tata Sons’ subsidiaries Tata Housing Development Company and Tata Realty and Infrastructure will be merged, as a part of the consolidation process at Tata Sons.

Thirdly, possibilities of distress sale of land from cash-strapped developers will see the first phase of consolidation in the sector. Joint developments or joint ventures between small and large developers will happen as smaller entities will need cash to finance their projects. Most organised players are witnessing increased opportunities for project acquisition through the JV/JD route. Acquisitions of a portfolio of projects of smaller companies by larger developers are also likely to happen. The speed of consolidation will be determined by the quantum of equity available for investment into real estate by domestic and foreign players.

Strong brands, balance sheet to gain in consolidation

Real estate developers with strong balance sheets and strong brands will gain in the consolidation process. According to a report by Ambit Capital, companies such as Godrej Properties and Sobha Developers are well placed to gain share in the stressed sector which is consolidating pan-India around a dozen players who manage capital sensibly, can execute projects at speed and have to technical expertise to manage the ecosystem.

Typically, in any industry consolidation happens towards the end of the downturn, a trend very much visible now in the real estate industry. Large scale consolidation would begin from smaller towns and gradually shift to metros as big players will have the capacity for long haul. RERA bought in transparency, accountability and financial discipline which were completely missing with most developers. Apart from compliance, builders will have to upgrade their billing systems and train vendors, contractors and other stakeholders to ensure 100% compliance to RERA and GST norms. Smaller developers will face difficulties in the compliance which will result in a liquidity crisis and exit from the business.

Insolvency and home-buyers

Homebuyers are duly recognized as creditors. The Insolvency and Bankruptcy Board of India has mandated that any resolution plan for the insolvent company must also include plans for safeguarding the interests of all the stakeholders and not just banks and financial institutions that had lent money to the troubled company. A major provision introduced is that if any part of the Code is violated then a fine ranging from Rs 1 to 2 crore can be levied depending on the gravity and magnitude of the indiscretion.

Going forward, the insolvency court’s ruling on Jaypee will set a precedent in the real estate industry. If the insolvency fails to meet the demands of home buyers, middle class home buyers will get a jolt as their hard-earned life’s savings are at stake.

Under the Insolvency and Bankruptcy Code, once a case is referred to the NCLT, the tribunal gets 14 days for accepting or rejecting the case. Once the case is accepted, a resolution plan has to be implemented within six months, extendable by three months. In the absence of any resolution plan, the company goes into liquidation. With RERA tightening the noose around the developer community, some of them will find liquidation proceedings or the bankruptcy law as an avenue to escape the ambit of the state regulator. Insolvency cases are likely to go up as builders will be able to transfer the losses to property owners.

Also, various states governments are giving exit options to beleaguered builders. The Uttar Pradesh government approved an exit settlement policy where builders can get out of the project they are unable to execute by surrendering a part of the land allotted to them on which construction is yet to begin. Two companies – Wave Infratech and Unitech Group – have surrendered their land to the government as they do not have funds to execute the project. If the trend continues across the country, this could trigger distressed sales of hard assets and bring down land prices.

The construction and real estate sector is of systemic importance in India’s economy. From FY12 to FY16, the sector has contributed 23% to India’s GDP and around 32% to gross capital formation. The sector continues to be one of the largest employment creators in the non-agricultural category. The sector supports ancillary industries such as steel, cement, paints, construction equipment, electrical fittings and fixtures, gadgets, furniture, tiles, banks, housing finance. Strong growth in real estate will give a fillip to demand of all these industries.  It is imperative that the real estate sector comes out of the slump and gather strength through consolidation, mergers and joint ventures.

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