Detoriating Fundamentals of the Real Estate Sector The Indian real estate market scenario has changed rapidly, from a buoyant situation witnessed over the last 3-4 years (that lasted till early 2008) to a scenario that has become far less optimistic. The initial concerns of slowing demand due to rising unaffordability has been exacerbated further by the steep fall in market capitalisation and the ongoing liquidity crunch faced by real estate developers; consequently, affecting their financing plans for working capital and other requirements. As per a recent study conducted by CRISIL Research on eight major cities in India, real estate developers are expected to develop around 350 million square feet of residential and commercial space annually in 8 major cities. This development will entail a funding requirement of around Rs 700- 750 billion every year to meet the construction costs, through a mix of equity, debt and customer advances. Typically, equity financing (including customer advances, IPO's and private equity investments) meets 40 per cent of the fund requirement of real estate developers. This proportion has increased significantly in the last 2 years, due to buoyant capital markets. However, this source of financing will be harder to come by over the next 12-18 months, as real estate stocks have seen sharp erosion in their market values (more than 75 per cent in some cases, since January 2008). In addition, the woes of real estate developers will be compounded by postponement of purchases by customers, due to the high real estate prices and high EMIs. The balance 60 per cent of fund requirement is met through debt financing, amounting to around Rs 420 billion annually for just the eight cities covered (in this context, it is pertinent to note that the overall outstanding gross bank credit by scheduled commercial banks to the real estate industry stood at Rs 623 billion as on March 2008). However, availability of funds for the sector has been tough due to the stringent RBI guidelines (higher risk weights for exposure to real estate) as well as the tight liquidity situation in the banking system. Thus, in a scenario of funding constraint, financials of developers could be affected. This could lead to debt repayments being re-scheduled and potential defaults in cases where developers are highly levered. In addition, developers who are starved of funding could potentially delay their projects, leading to lower supply over the next 12-18 months. This phenomenon could be more pronounced in the commercial real estate space, given the muted outlook for offtake from IT/ITES sector, a key demand driver. Real estate developers are expected to develop around 350 million square feet of residential and commercial space annually. This development will entail a funding requirement of around Rs 700-750 billion every year for meeting construction costs. If we include the cost of land, the project cost involved goes up to Rs 1,000 billion annually. Large finances would be difficult over the next 12-18 months, as real estate stocks have seen sharp erosion in their market values. Customers have postponed their purchases in anticipation of price correction. The quantum of debt financing is not expected to materialise. Even in a scenario where supply reduces by 20 per cent, the required cost of construction will be around Rs 500-550 billion annually, while the project cost (including land cost) would be Rs 750-850 billion annually. Sharp erosion in valuations in the last 10 months: A huge dampener on capital raising The funding through equity, especially initial public offering (IPO) in capital market, has seen a sharp jump in the last 2 years. The IPO of real estate companies garnered almost Rs 173 billion between 2005-06 and 2007-08. Some of the large real estate companies issuing shares to the public during this period were DLF Ltd (July-07), HDIL (July-07) and Lanco Infratech Ltd (November-06). Changing valuation of realty stocks in India Return as Company name Issue Amt Stock Stock on Return as on Return 24 Oct-08 1 Jan-08 Price Raised Price on - Price on- over 28-Nov-08 over 28-Nov- (Rs) (Rs mn) 1-Jan-08 08 1Jan-08 issue price issue price Brigade Enterprises Limited 390 6,484 400 38 -89% -90% 3% Kolte Patil Developers Limited 145 2,755 249 22 -90% -85% 72% Purvankara Projects Limited 400 8,587 455 31 -89% -92% 14% Omaxe Limited 310 5,517 562 48 -90% -85% 81% HDIL 500 14,850 890 77 -85% -85% 78% DLF Limited 525 91,875 1,072 198 -81% -62% 104% Orbit Corporation Limited 110 1,001 930 45 -94% -59% 745% Akruti Nirman Limited 540 3,618 1,182 676 -48% 25% 119% Parsvnath Developers Limited 300 9,971 477 35 -91% -88% 59% Lanco Infratech Limited 240 10,673 835 111 -88% -54% 248% Total 155,331 -67% 152% Source: NSE, CRISIL Research However, this source of financing (IPO) will be harder to come by over the next 12-18 months, as real estate stocks have seen sharp erosion in their market values (more than 75 per cent in some cases, since January 2008). This erosion in stock values of real estate companies can be gauged from the fact that real estate stocks were the flavour of the markets (between listing date and January 2008) and market capiatalisation of real estate companies had almost doubled. In addition, the woes of real estate developers will be compounded by postponement of purchases by customers, due to the high real estate prices and high Equated Monthly Installments (EMI). The sharp erosion in valuation of real estate stocks has led to many real estate companies holding their plans of listing and raise funds through equity route. There are many real estate companies who have filed the draft red herring prospectus (DRHP) with Securities and Exchange Board of India (SEBI), but still have not come up with the issue in the primary markets; they are waiting for the situation to improve. Private equity investors with high real estate exposure are cautious Another way to raise equity investments is through private equity investments. For developers, it is an easy route that requires less hassles, cost and time (but at a lower valuation of course). High valuations in the stock markets attracted many private equities (PEs) to grab the private placement and pre-IPO investments offers. These PEs were using the IPO or secondary market route to exit their initial investments at higher valuation; they made handsome profits. The last 2-3 years saw entry of many new PE funds focused on real estate. In the current situation, even PE funds are finding it difficult to finance real estate developers as the valuations have tumbled and many PEs are facing huge resource crunch. Uncertainty in the stock market has also declined the number of PE deals. PE funds have now become more selective and investing in high yielding projects. The asking internal rate of return (IRR) for PE funds, which used to be 18-22 per cent a year back, has now risen to 34-38 per cent. Thus, another alternative means of raising equity funds is also becoming difficult for developers High real estate prices and EMIs limit funding through customers advances Customer advances is another major source of funding for residential developers and considered as easy cost-free source of funding, which comes through advance sales. It is available only to residential builders, as commercial properties are generally not booked in advance. As the developer initiates construction (even before construction, in some cases), it starts getting bookings as a result of its marketing efforts and demand situation in the site area. In the current situation, customer advances continue to decline, accentuated by high interest rates on home loans. The growth in IT-ITES segment has been a major driver of real estate demand in past few years. The slowdown in the sector is also impacting demand considerably. Investors in real estate have almost disappeared due to sharp correction in real estate prices. This fall in proportion of advances can be attributed to two important factors: Developers found it easy to raise equity capital and reduce the reliance on customer advances to fund their projects. In some cases, developers sold units on completion, trying to encash on the high prices that completed units fetched in the market. Another explanation is that some developers have a higher mix of commercial project in their revenues. Funding constraints affect developer financials, leading to potential defaults and delayed supplies After assessing the fund requirement based on the upcoming supply in eight large cities, financials of real estate developers could be severely impacted on the topline (due to lower absorption and fall in price valuations), which will reflect in lower profitability. In some cases, developers will re-schedule debt repayments and there could be potential defaults where developers are highly levered. Smaller developers who rely more on promoter contribution and customer advances and do not have recourse to large bank borrowings will be hit harder. Developers who are starved of funding could potentially delay their projects, leading to lower supply over the next 12-18 months. This phenomenon could be more pronounced in the commercial real estate space, given the muted outlook for offtake from IT/ITES sector, a key demand driver. Need to explore setting up of REITs and REMFs as financing options for developers Given the funding constraints that developers would face, in the long term developers would benefit if funding is available from REITs (Real Estate Investment Trusts) and REMFs (Real Estate Mutual Funds) as alternatives. This will provide the much needed depth to the real estate market and provide long term funding options to the developer. The REITs and REMFs can help overcome the two factors that constrain the growth of the real estate sector; the lack of transparency in market transactions and lack of institutionalisation in the real estate industry.
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