First Things First
I believe some of you might be aware of this but for those who are not, let us state the problem at hand first. India’s real estate sector is in trouble, not any small trouble but a full blown crisis of gargantuan magnitudes which has thrown the entire industry into shambles.
How did this happen? What were the factors leading up to it? We’ll be discussing all of this in detail and if possible, would try to propose some viable solutions to this.
But even before that, let’s answer an even more important question. Why should we care about it? The reason is that this sector is the second largest contributor to the industrial sector after the auto sector (Gross Value Added) and is also the third largest employer in the country. This sector has a high propensity to employ unskilled labor and this makes it even more important as for poor people with lack of access to education and employment in the rural areas, this forms a major source of their livelihoods which makes it all the more important for this sector to revive quickly. Furthermore, in the midst of all the projects which have stalled over the past few years, we have the dreams of retired people with their lifetime worth of savings and millennials with huge loan burdens stuck in these projects waiting for the possession of their own house.
To help us understand this better, we’ll be talking about the demand and supply side separately, which albeit, are intertwined but ended up in this mess in their own unique ways.
The Demand Side
Ever since the time of our independence in 1947, while governments did make efforts to increase people’s incomes and improve overall standards of living, particularly among and rural and poor people by means of Operation Flood and The Green Revolution, these bore very abysmal results primarily because a majority of workforce was still engaged in agriculture with the industries and services sector being highly underdeveloped. Why was that so? That’s because a majority of the investments in the country were hogged up by PSUs. Think of a measuring scale for efficiency and imagine the biggest measure on it your conscience permits, that’s how these funds were deployed by the PSUs with a weak management & excessive political influence. As a result of this, job creation and value added by these sectors to the economy was still very low.
Then came the 90s when India decided to open her doors to economic liberalisation. This brought with it increased manufacturing activity as several foreign multinationals also decided to set up their units here and increased income in the hands of people. Consequently, there were greater investments in the economy and standards of living improved manifold.
However, a point of caution here. This growth trajectory taken by India was highly unsustainable as a majority of these investments found their way to the service sector where mostly, only a few high skilled high paying jobs were created and consequently, no large scale shift pof workforce from agriculture to industry or rural to urban areas as had normally been with economic liberalisation of other countries such as Japan and South Korea was never observed in India.
Nevertheless, the turn of the century saw the rise of a new India which now had greater incomes, wanted improved standards of living and above all, permanent housing. Similarly, with a rising number of businesses in the 90s, there was also a greater demand for office spaces in the early 2000s.
For combating this sudden surge in demand, real estate companies made massive investments in new and upcoming projects. Further, several new and unestablished players arrived on the scene. All this was funded primarily by credit. This consequent surge in credit demand was partly responsible for the emergence of NBFCs or shadow banks. Not that there was anything wrong with it. Banks were right in their own judgement when they gave out such massive sums of money and themselves invested in some projects. Afterall, with a rising middle class, economy growing at a great 7-9% and a much more open environment for inviting investments in the country, what could possibly go wrong?
In 2008, the great recession struck and took with it some of the major economies of the world into recession. While ripples of this crisis never managed to get a firm stronghold on Indian soil, there were consequences. Corporate profitability took a big hit, a weaker global outlook meant faltering production lines. All of this had a profound impact in the way people decided to consume. This crisis left people with lower salaries and wages. As a consequence, people were now forced to dip into their savings, often for basic necessary consumption as well. Further, they were now deferring consumption of ‘luxuries’ such as cars and housing. In a similar fashion, corporates chose to defer their dreams of owning their own office space. What followed isn’t hard to see. Demand for real estate took a huge plunge and the companies were now left with hundreds of unfinished projects with no buyers or buyers unable to pay. Since 2011, demand for property has never seen an uptick and has only gone one way; down. The twin shocks (or maybe let’s use the government’s favorite term – surgical strikes:) of demonetisation and a hastily implemented GST still suffering from teething problems resulted in even lower demand.
Such an unregulated expansion in any industry followed by a crash of blood curdling proportions is referred to as a bubble. Other common examples of this include the housing bubble in the US which was followed by the subprime mortgage crisis and the dotcom bubble.
The IL&FS crisis which unearthed itself in late 2018 was partly caused by this unregulated doling of credit to the real estate sector. The arrival of the CoronaVirus pandemic which further contracted people’s faltering incomes, reduced employment opportunities and shut down businesses as a result of the harsh lockdown imposed in an effort to curb it has forced people to defer purchasing housing, cars and so on in favor of saving for a probable health emergency. This has further reduced the prospects of a revival in demand for housing and office spaces. The shift which was required to survive in this pandemic, from physical workspaces to virtual, has further reduced the demand for land for office spaces, has further crippled demand for office spaces, owned as well as rental as businesses struggling from the economic fallout of the lockdown desperately tried to reduce their costs. Halted construction activities and existing buyers waiting for their homes has shaken the faith of already pessimistic buyers and investors which has served to become both cause and effect of accelerated downturn in the sector.
The Supply Side
The supply side i.e. the real estate companies are presently caught in the tweezer grip of delayed project deliveries, lack of funds, high unsold inventory and a growing proportion of stalled projects. Unproductive assets in the form of under-construction, stuck or delayed projects are estimated at 560,000 homes worth approximately USD 65 Billion across the top seven cities.
As stated earlier, in the early 2000s, there was a massive surge in demand for housing and commercial spaces. In the initial phase of this boom, finances primarily came in the form of foreign investments and PE Funds’ acquisitions. As housing demand further boomd, it was funded majorly by home loans but as we reached the end of the first decade of the 21st century, the commercial banks started to arrive at their exposure limit for this sector.
This marked the entry of alternative lenders, namely shadow banks i.e. NBFCs. Developers entered a cycle of repaying these NBFCs from project cash flows and refinancing them and this continued. In no way was this cycle vicious and why would it be, healthy sales were driving margins meaning there was no dearth of liquidity for the developers.
You know what happens when there is a source of bright light in an otherwise dark room, it attracts moths, not one or two but lots of them. In our story, the real estate sector with its super normal margins, lax regulations and easy financing was the bright light in an otherwise moderately growing economy and moths started getting attracted to it in the form of businessmen with no experience and track record in this industry launching their own projects and existing developers overextending and overleveraging themselves by announcing new projects with an utter disregard for the basic principles of demand and supply. Suddenly, this otherwise booming industry now had a glut of housing and commercial units with no one to buy them. This meant that developers’ margins now started disappearing and consequently, innumerable of them entered insolvency. While commercial projects were in greater trouble as there are no loanable funds to back their financing costs, finishing even housing projects became a going concern. That is because in their blood thirst for announcing newer projects, developers did something fraudulent. They transferred the home loan funds they received from banks towards development of newer projects. Ultimately, it was both, the old as well as new projects which were left stuck and the money of naive buyers which went down the drains.
This was a clear indication that the industry was heading towards a full blown crisis, however, the thing is that this wasn’t exactly being touted as a crisis in its early years. You see, a widely cited opinion was that in its boom years, the real estate market had seen a disproportionate rise in prices and that now it will see a major price correction as developers, in a bid to escape insolvency, would enormously deflate their prices (see why its called a bubble?) in order to sell off their unsold units. Simultaneously, this would have meant that developers’ valuation would have dipped, cutting off further investments in the form of bank/NBFC/HFC loans meaning that banks would no more be giving out good money after bad. Hence, going in the opposite direction, developers decided to instead sell their properties at even higher prices. While this created a delusion of higher valuations of developers letting them borrow even more.
The above has in part, been responsible for the rising pile of bad loans over the past few years. While loans from banks were drying out, NBFCs stepped up during this time and increased their proportion in credit extended top developers. Nevertheless, it was still expected that residual demand for affordable housing would still take the industry forward and enable it to prevent entering a crisis.
Then came four deadly blows one after the other and this time there’s nothing to speculate upon, the real estate industry has definitely entered into a crisis phase. The first was the Real Estate (Regulation & Development) Act of 2016, commonly known as RERA, which passed several pro-consumer legislations in the form of stricter than before regulatory norms, restriction of raising finances from prospective buyers and penalties for delayed projects. Up next, there was demonetisation which crippled the ability of prospective buyers to purchase houses and a portion of developers’ funds (largely because a large portion of payments in this industry is made via unaccounted cash). After this, there was the hastily implemented GST of 2017 which further incapacitated developers and just when people were thinking couldn’t go bad any further, there was a final bombshell in store.
Remember when we talked about how NBFCs emerged as developers’ knight in shining armour when credit from banks ceased? Apparently, not only did the NBFCs cover this shortfall of funds, they went a step ahead to make riskier investments in the form of proposed projects- projects which were largely just a blueprint. Leading up to late 2018, it was a general wonderment that if banks’ pile of bad loans has risen so spectacularly over the past few years, how come NBFCs aren’t seeing the same proportion of NPAs considering they have an even toxic culture of doling out loans. Finally, it came to light in late 2018 that all this time, they had just been grossly under reporting their bad loans and the collapse of IL&FS was how this came about. Subsequently, more NBFCs ran illiquid after this. Banks also became risk averse to these shadow banks and with that, the developers’ last remaining reservoirs of funds ran dry. Consequently, construction activities slowed down, project delays became even wider and unsold stock piles went through the roof. Aside from the fact that this crisis has taken several prominent builders such as Jaypee, Unitech & Amrapali to the bankruptcy courts, it has also had a profound impact on several related core sectors of the economy as well such as mining, cement, iron & steel, etc.
As of June 2020, developers have a whopping INR 6 lakh crores worth of unsold units. Just when things couldn’t have gotten worse, the great Coronavirus pandemic arrived which further worsened their troubles in the form of halted construction, laborers migrating back to their homes, delay in procurement of construction materials and machinery as a result of logistical troubles induced by the nationwide lockdown.
Authorities In Damage Control Mode
To ease the present situation, the government has granted builders a six months extension for the completion of their projects under RERA. Further, the loan moratorium is also expected to provide short term respite to the developers.
The key concern for the sector continues to remain liquidity crunch. To address this, the RBI as well as the government have made regular changes in various provisions so that various injections and infusions can be made in this sector. It includes allotment of funds to national housing banks (NHBs) on regular intervals so that they can ease the liquidity and credit drought for developers.The most recent infusion was in August 2020 for Rs. 5,000 crores. Further, shadow lenders have been also provided with similar monetary support including some framework changes which aims to improve the availability of funds to the real estate developers. Under RBI’s Targeted Long Term Repo Operations or TLTROs, a separate window of Rs. 50,000 crores has been booked for NBFCs and MFIs, paving way for developers to seek funds.
Under framework changes, one major relief was the relaxation in ECB end use norms last year. In the case of the real estate sector, under old schemes, the borrowers were restricted to use External Commercial Borrowings or ECBs for real estate purposes only. Under the relaxation scheme, now the borrowers coming through 100% FDI route will be exempt from the above restrictions. Further, the RBI, in June 2020, proposed to double the minimum requirement of Net Owned Capital with an aim to let companies have a strong capital base. Unlike the aforementioned measure, this seeks to mitigate the risk originating in this sector.
Addressing the issue COVID-19 distress, the RBI has extended the Date of Commercial Operations as the sector was facing project delays due to halt in construction activities. As per the government estimates, around 4,58,000 housing units are stuck across more than 1,600 projects as of June 2020, but since this lockdown was beyond the control of developers, the extension was awarded.
In addition to this, the government has also directed the state owned mini-ratna developer, National Buildings Construction Corporation (NBCC) to take over and complete some of the unfinished projects. However, the viability of this solution is highly questionable considering that the NBCC itself would need funds for this which it doesn’t have in sufficient quantity. Further, all these unfinished projects are of diverse categories, ranging from small 2BHK housing complexes to luxury mansions. With NBCC’s unfamiliarity with these projects and lack of experience handling such types of profiles means that this route may not be very efficient and may result in further cost overruns, the brunt of which may have to be borne by the scanty government coffers.
The RBI was also approached by CREDAI and NAREDCO along with All India Forum of RERA for one time loan restructuring. This is because banks are unwilling to give out loans until the previous ones are restructured and of course, this move by banks is justified considering their already huge pile of bad loans, isn’t it? NPAs are at a record high and in this critical time, developers are approaching the banks for loans for payment of salaries so you can probably imagine how big the problem is. Complying with the above mentioned request, the RBI has directed the lenders for one time loan restructuring without classifying them as NPAs (only those whose loans are in default for not more than 30 days as of March 2020). Further, the Centre and RBI have informed the honorable Supreme Court that the loan moratorium is extendable for two years thereby, originating a fickle ray of hope during this crisis of brobdingnagian proportions.
Despite the far reaching nature of the above measures, I believe they are still short term in nature. To combat this long running crisis, capable of carrying far reaching prodigious effects, once and for all, we need a structured and systematic plan capable of mitigating the innumerable problems ailing this sector on a long term basis.
The Way Forward
For this highly germane sector to see daylight again, a lot of prerequisites have been listed out by industry experts over the years. I would like to take the liberty to list out a couple of the most consequential of those:
(i) A Crucial Regulatory Change
A common reason why investors are apprehensive about deploying fresh capital in delayed projects in the pre-bankruptcy state is that these fresh investors get no seniority in the liquidation pool meaning that the committee of creditors is primarily run by the customers. This causes fear in the minds of potential investors regarding investing in these projects as there is a possibility of losing the money as existing lenders, customers or suppliers can still take the project to the bankruptcy court under IBC. Hence, it is important to provide incoming investors with a say in the project management along with a defined time frame to show results will help alleviate the fears of new investors.
The matter at hand is an elephantine task of replacing/funding 1,600+ projects spread across the country which can only be achieved by experienced investors with deep pockets and unquestionable risk management capabilities. Hence, regulatory changes are needed to ensure that the new investors are insured from the liabilities and fraudulent actions of the developer. Further, incentives are also needed to invite them such as institutional credit guarantees or tax refunds in reward for taking part in the revival of these projects. In the lack of such incentives, the homeowners are being forced to take impractical routes such as themselves taking the reins of the projects.
(ii) Adam Smith’s Invisible Hand Needs Help
Several stuck projects are facing the major hurdle of lack of cash flows for servicing their lenders with assets being a miniscule fraction of the debt and interest. This has caused the pricing for future sales being even lower than the present prices quoted by the developers. Hence, outside interventions are required to be made for syncing the project prices with market realities so as to make their revival viable. This may also require existing stakeholders to recognise their losses and step aside, something which they have been reluctant to do in the past. This will allow fresh funds to come in and clean up the sea of stalled projects.
(iii) Real Estate Revitalization Ecosystem (RERE)
This creative solution has been proposed by Gautam Vashisht & Om Chaudhry, the CIO and CEO, respectively, of Fire Capital Fund, one of India’s first PE Funds in the real estate sector.
Recently, the central government announced the setting up of an Alternative Investment Fund (AIF) worth Rs. 25,000 crores as a means of securing priority lending for the stalled projects. The solution proposed by the aforementioned experts aims to multiply this capital and make sure that these funds reach all projects, big and small, irrespective of where they are located in the country. For this, they propose that the government should set up a Fund-of-Funds (FoF) vehicle in which the government’s contribution of Rs. 25,000 crores is matched equally or even higher by experienced fund managers, turnaround experts development managers. With such experts having a skin in the game, their investment vetting, technical and operational monitoring, divestment expertise and network effect can be used to resolve these problems on an expedited basis. WIth several downstream realty projects requiring fund infusion in large quantities immediately, the proposed FoF mechanism can make that happen.
There are no more official confirmations needed to know that India’s real estate sector has plunged deep into a crisis, this is now a harsh reality we have to now accept instead of living in a dark cloud of profligacy and giddy optimism like the government and some of the developers. I believe there is no further need for me to tell you why this sector is important for our economy. With lakhs of jobs, dreams of crores of people and trillions of rupees on the line, there is an urgent need to revive this sector otherwise, there will be far reaching consequences, some of which may permanently scar India’s already wobbly growth story. This will require dedicated efforts on part of the government, developers and financial institutions to make this a reality.