Safeguarding Indian Realty from Evergrande phenomenon
Safeguarding Indian Realty from Evergrande phenomenon
While the above issue does raise concern, however, before one addresses the above, a more fundamental question needs to be answered :
“Why do developers end up borrowing more than they can chew ?”
And the answer lies in the structural uniqueness of real estate business.
1. Capital requirement remains unpredictable
A developer typically plans his funding through three sources :
· Own equity
· Borrowings from banks etc.
· Customer Advances
Owner’s equity has physical limitation, bank borrowings too are limited by regulatory norms. Since customer advances remain unpredictable, financial closure quite often remains a puzzle. Further when the projects gets completed, developer’s capital requirement comes down significantly, therefore, developer would prefer capital that can be repaid after the project.
To address all the above concerns, developers end up raising “quasi-equity” which is in the form of structured debt, mezzanine equity, high yielding bonds etc. This capital addresses all the above issues but comes with a caveat. The investor in quasi equity expects a share in the upside but in case of a loss he wants an assured rate of return.
Such products work well when the going is good.
But when demand for under-construction units is low, the first tool the developers use is to start promising customers an assured return (another form of quasi equity). Having made such a promise, a developer is left with no option but to continue increasing the price every quarter. However, at higher prices the real customers ( the end-users) show resistance. The developer then raises another form of quasi equity like structured debt. Developer hopes that the business will sometime pick up. If it does, everyone gets paid through sale to end users. But bear cycles in real estate can be highly uncertain, awfully punishing and extremely long. Therefore, the project can reach a situation when all those who have stake in the project are only financial investors.
Now, why is finding so many end users difficult even at reduced prices ? One of the biggest triggers in home purchase is ‘urgency’ or FOMO (Fear of Missing Out). With so many sellers, there is no FOMO and we then have an Evergrande like situation where there is only valuation and no buyer.
2. Limitations to growth
Like any entrepreneur, every developer has the basic hunger for growth. Due to regulatory and other local factors, developer can successfully operate only in limited geographies. The options for growth, therefore, remain. In India, inappropriate titles make the problem worse. So, when a one acre plot in a prime area like Juhu / Malabar Hill is on sale, besides business rivals, a developer also faces competition from rich industrialists, stock market czars, film stars etc. These people want the plot for their personal use and therefore are more likely to pay a fancy price.
The developer, either has to forego his hunger for growth or to high risk to grow. Tech entrepreneurs, having hunger for growth, have the option of using VC money. VC money is non-recourse money (no assurances on return of money) and VCs are also comfortable with founders stake being as slow as 5-10%. However, in case of real estate projects, investors will expect promoter’s stake to be at least 50% and would want promoter guarantees. So again the option for developer boils down to quasi capital.
The Solution
The above problems being structural in nature can be addressed only through fundamental changes in regulation and through re-calibration of risks in real estate. Since the quantum of housing this country’s needs can be only met through a large number of developers having sustainable and stable operations across India, it is imperative that we work towards the solution. There are three possible approaches :
a. Reducing the need for quasi capital
Larger under-construction sales can play a big role in reduced reliance on quasi equity. Now, the current GST structure (5% GST on under-construction and 0% on ready purchases) penalises customers who book under construction. The same should be rationalised by making it 2.5% for under-construction as well as for ready apartments. And if all govt revenues can be collected only on Occupation Certificate from the Escrow account, it can significantly reduce banks’ exposure to real estate sector.
b. Reducing the cost of quasi capital
Quasi Capital is expensive largely due to approvals related risks. If private professionals are authorised to approve plans with appropriate checks and balances, the approval related risk and the cost of quasi equity can come down considerably.
c. Offering more growth options to developers
Setting up of Mediation & Reconciliation Centres to enable settlement of 3 crore pending land disputes can bring large amount of good quality land in the housing market. Developers will find enough opportunities for growth. Land transactions will cease to happen at fancy prices. All would work towards making homes more affordable.
While the scale of Evergrande kind of incidence is unlikely in India but its miniature version too can be disturbing. Home purchase is after all the biggest expenditure in one’s life.
- Deepesh Salgia
testing for comment
ReplyDeleteDear Deepesh,
ReplyDeleteYou have given some very humble and pragmatic suggestions.
One of the problems with Real Estate in India is the burden that the state actors impose upon real
estate projects;
They levy and appropriate a very significant share of the total project revenues by way of GST, Stamp Duty, FSI /FAR/TDR , Fungible FSI premiums , Approval Costs and several other charges.
I am not counting the rent seeking costs and the costs of delays intrinsic and incidental to obtaining approvals.
So State actors burden the project with costs, delays, higher capital requirements , higher interest and higher risks. It will be illuminating for CREDAI , NAREDCO and other Builder & Developer. associatons to enlighten customers about the total take out of the State by way of premiums & taxes in all kinds of projects- from affordable to luxury.
Not just do State Actors impose the huge burden , they also insist on collecting most of the imposts upfront and definitely before customer inflows commence in full flow.
The State has little or no concern as to from where and how will the developer arrange these funds and his plight as has been narrated by you in arranging funds at high costs.
The State also has little or no concern in collecting Stamp Duty from Customers; the customer is more often than not grappling with challenges of arranging their life time savings & borrowing funds in their quest of putting a roof over their head ,
The state is impervious to his /her plight and collects Stamp Duty upfront irrespective of whether the poor customer gets his roof over his head or not. Its not unusual for customers to wait 5 to 10 years for getting possession or not get it at all. Where is the justice or equity in collecting such imposts ?
Ideally therefore, Stamp Duty should be collected upon possession as is the case in some states.
Moreover basic housing is as essential as basic food which is GST exempt; The Govt is already collecting Tax on construction material and services. On top of it there the 5% GST or 12 % GST with ITC , on top of which is 5 to 6 % Stamp Duty and registration charges. When GST has been charged , stamp duty should be subsumed under GST. So the govt policy is to clearly make any aspiration of having a roof over one’s head being subjected to high taxes.
We are 70 years post independence but our very own people – represented by elected govts are impervious and callous to the common man and the business man who are driving the economy.
If they state can show a little sense of care or concern , the least they can do is to align their collections of imposts alongwith collection of GST.
This one measure can be a big relief to the Real Estate industry and the its Customers.
It can have the following consequences:
1.When state revenues are linked to collections in the project, the state will have to change its stance from being an impervious collector to becoming vested & invested in the projects which will yield them tax revenues.
2.They will be constrained to become expeditious in approvals, or risk delaying and obstructing their own interests embedded in swifter and robust revenues from the projects.
3.The lopsided front loaded Capital requirements will be more evenly balanced over the project period providing relief to the developers and customers.
The sector will witness a sea change in the way the state becomes a collaborator and partner in projects as against being a burden and a drag on them.
Many thanks for the detailed reply, Sanjay. Agree with almost all that you have said. We look forward the authorities to take a positive approach in creating a healthy real estate sector.
ReplyDelete