Real Estate Sector - DOC by wanghonghx

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									   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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