The real estate sector was caught in a conundrum last year with flattening demand, a challenging funding environment, and increasing compliance-based costs. The onset of the pandemic exposed the fragile financial health and business models of real estate developers in India. The financial health of developers in the preceding 12 months can be seen in two parts – the lockdown phase and the unlocking phase.
Lockdown phase:
The lockdown was preceded by flattening sales in the residential segment while developers with commercial, retail, warehousing, or hospitality assets saw a growth phase with increased investment activity. However, the impact of the pandemic was such that all segments saw a sudden contraction in the activity. This can be witnessed in a drop of 23.0% in institutional capital inflow into India (while credit offtake as per RBI statistics registered a growth of only 0.25% in H1 2020 after 1.5% growth M-o-M in FY 2019-20. This reflects the challenging conditions both on the compliance side and risk attributed to the sector. Apart from Grade A developers and developers with a good credit track record, many struggled to attain financial closures and raise capital.
Cashflow issues compounded this issue for developers due to a drop in collections from pre-sold stock, loss of demand for existing or new supply, and pressure to keep with debt repayments till relaxation was announced in May 2020. Intense lockdown for a period of 60 days took a toll on marketing, requiring additional investments into online marketing models while yield generating assets suddenly saw active renegotiations or a drop in rental revenues. This issue was compounded in assets like malls which until Q1 2020 saw active institutional investments. These issues led to significant erosion of value in underwritten assets for banks, NBFCs, and returns fell for equity investors urging capital flight to assets that proved to be resilient to the pandemic like warehousing and Grade A commercial projects. This is reflected in the fact that commercial and warehousing assets had institutional capital investments same as 2019 while the residential segment fell by 60% and hospitality saw a drop of more than 80%.
Unlocking phase:
The difficult demand situation created a stark mismatch in debt and interest coverage ratios that required funding institutions to re-evaluate their funding strategies to developers. RBI's timely intervention providing one-time restructuring of loans prevented many developers from going insolvent or from initiation of recoveries under SARFEASI or IBC 2016. The assistance in the reduction of the stamp duty, statutory costs, low-interest costs, and extension of benefits in the budget assisted better cash flow due to induced demand due in Q4 2020. However, legacy issues have prevented developers from raising fresh capital for projects which were in the early stages of the execution cycle. This period saw funding acceleration for last-mile funding, especially by SWAMIH Fund 1, which invested INR 12,000 crore in unfinished projects enabling completion.
All these silver linings, however, were only for a small segment of the development community. Alongside funding issues, the cost of compliances went up in 2020. Many developers facing litigation under RERA had rulings in favor of buyers adding to their financial burden. Further, impairment write-off increased under accounting in 2020 for many developers, thereby reducing the balance sheet's asset values reducing the ability to raise capital. This was also significant for yield generating assets held by developers like offices and retail assets due to rent deferrals, renegotiated rents, etc., reducing the ease with which the developers could raise capital under LAP and LRD routes.
The sector saw significant consolidation with the development management model being very active, where more prominent solvent developers took over projects of developers in financial difficulties. Funding institutions or invested equity partners orchestrated these arrangements. Further, this period saw special situation funds backing grade A developers to acquire developers' stressed assets from their funding consortiums, enabling speedy resolutions. This meant a reduced market share of the grade B and C developer segment and, in some cases, companies' acquisition. However, in the last six months, the better demand environment is likely to buoy this segment of developers looking to raise funds through innovative capital structures. However, the continued issues in the NBFC segment and tighter regulations of HFCs are likely to keep them grounded and will take at least 24 months before emerging out of trouble.
The recent order of Hon. Supreme Court of India requested banks to start open the insolvency window and allowing banks to record NPAs, the pressure to ensure no operational and financial liabilities defaults that can spell the end for the development company. However, many institutions that are carrying out diligence of the developer accounts are likely to restructure the loans to prevent an increase in reported NPAs. Also, given that the average resolution time of insolvency cases is almost 374 days, the difficulties in monetizing assets and resolutions requiring significant haircut to principle and interest recoverable, operational creditors may look at resolving issues outside the jurisdiction of IBC. In contrast, financial creditors would look to have better developers take over to ensure that the principle is preserved and recovered.
The rule of the book approach cannot resolve the financial difficulties of the development community. Still, they would require some smart understanding of the value creation chain and rigorous financial discipline combined with solid statutory support.
The author is Managing Director Valuation Services (India) at Colliers.
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