Kuldeep Tikkha | Prashant Ved
The real estate sector in India had been facing significant headwinds much before the COVID-19 crisis struck. The sector suffered from a lack of availability of funding from banks, NBFCs and HFCs. Besides, certain structural changes implemented by the government in the recent past, such as demonetisation and introduction of GST, had also adversely impacted the demand for residential real estate and led to built-up unsold inventories with developers.
With favourable initiatives undertaken by the government with a view to bringing transparency in the sector, reduction in GST rates for new projects, and lowering of lending rates, the calendar year 2020 was expected to herald a recovery in the real estate sector in India. However, the COVID-19 pandemic and its economic fallout would now delay the recovery in residential real estate.
Most of the residential real estate projects in India have been historically funded by banks and NBFCs. However, with funds from NBFCs drying up, the capital required for completing under-construction projects is likely to come from real estate funds and Alternative Investment Funds (AIF) willing to provide last mile funding against the security of project cash flows on a priority basis. The government has already committed to providing debt funding for completing stuck projects through setting up of a dedicated AIF in the form of SWAMIH.
The prices of real estate have been under pressure since 2014 due to lower demand. There is a significant pile-up of unsold real estate units with developers. In a recent webinar discussion organized by National Real Estate Development Council (Naredco), Deepak Parekh, chairman of HDFC had advised the developers to reduce the prices of real estate units to accelerate the liquidation of unsold inventories. This would significantly impact the value of unsold inventories held by the developers.
Further, after COVID-19, the recovery in demand for affordable housing is expected to be faster compared to other segments given the economic conditions of buyers.
Given the expected adverse impact on sales and cash flows in under development projects, it will be important for funding agencies to factor the impact of COVID-19 in their evaluation of the project. Here are some areas that need to be adequately covered as part of due diligence on under development residential real estate projects.
A stress test on sold receivables
Sold receivable from a project represents balance cash inflows from sold inventory. Sold receivable for a project would include a) amounts which are demanded against completed milestones but not yet paid by customers (Amount due) and b) amounts to be demanded in future on completion of future milestones (Amount not due). Value of sold receivable is one of the key securities for loans granted to a developer.
Diligence procedures on such sold receivables should involve understanding the proportion of such sold receivables (both due and not due) from sales which are not backed by a registered agreement of sale. While such unregistered sales were always subject to the risk of potential cancellations in the past (and thereby, reduction in the corresponding value of sold receivable), the probability of customers opting for cancellations due to COVID-19 would significantly increase.
The risk of such cancellations is very high in case of unregistered sales where the customers have only paid nominal advances (5-10% of Agreement value). Besides, registered agreement for sales is also subject to the risk of cancellations especially in markets where stamp duty and registration costs are not significant.
A comparison of customer equity in the project (i.e. the amount paid by the customer including stamp duty) with loss due to decline in the market value of the unit may provide an indication of units which may be subject to the risk of cancellation.
Funding agencies would also have to understand the contractual rights of developers towards cancellation penalties under the agreement for sale with customers.
Value of sold receivables from a project may also be impacted on account of any subsequent discounts being offered to customers by the developer with a view to either pre-pone the timelines for recovery of the remaining balance or for customer retention.
In certain instances, customers may request for deferral of timelines for milestone linked to the installments due to the economic condition of the customer. This may lead to deferment of collections towards completion of the project instead of construction linked milestone payment.
To summarise, diligence procedures on sold receivables should include customer analysis of sold receivables to assess the risk of potential cancellations. They should appropriately factor any discounts/deferral of collections agreed with customers. Analysis of such receivables should also factor the economic condition of the customer and proposed manner of funding (bank funded or self-funded) to gain further comfort on the collectability of sold receivable.
Value of unsold inventories
The level of unsold inventories with real estate developers was already higher prior to COVID-19. COVID-19 would further lead to a dent in customer demand. Oversupply of inventory without adequate demand may lead to a reduction in selling prices for these units. This would impact the underlying value of the collateral being offered to the funding agency. Besides, the timeline for liquidation of such unsold inventories would be further elongated amid tepid demand.
While diligence procedures by funding agencies should include detailed analysis around average selling prices and sales velocity across different units, historical trends in average sales rates and velocities may not be indicative of selling prices and velocities in the future. Funding agencies would have to build appropriate sensitivities around sales prices and velocity for liquidation of unsold inventories while estimating future cash flows.
COVID-19 would also lead to reductions in instances of walk-in purchases and would require developers to re-engineer selling and marketing plans. This would include, among other things, digitization of the sales process, which may lead to additional investments.
Vendor payments may be stretched and there may be claims from vendors for losses due to idle time. Disputes with vendors would further impact construction progress thereby impacting the overall project completion timelines.
A proper assessment of vendor liabilities and claims should be done as part of diligence. Diligence procedures should include a reading of vendor contracts to understand the commercial terms agreed, including the right to such idle time claims.
Developers may also enter into barter arrangements with vendors where vendor liabilities are settled against handover of units in the project. Such arrangements, if not appropriately documented and disclosed during diligence, would impact the value of unsold inventory being underwritten. Detailed analysis of vendor liabilities and settlements would therefore, become all the more important. Confirmations from developers may be obtained to ensure that all such unusual arrangements are disclosed.
COVID-19 would impact construction and project completion timelines. The period of such delays may vary across developers and projects and may even extend beyond timelines committed under RERA, at times. Diligence procedures should include a careful reading of Agreement for Sale entered with customers to understand the committed timelines, force Majeure clauses and customers’ right to interest claim and cancellation for delays.
Further, the agreements registered prior to the implementation of RERA in case of units sold in Maharashtra would continue to be governed by erstwhile Maharashtra Ownership of Flats Act (MOFA). The timelines for the handover of units in such cases and the corresponding interest obligation for delays would therefore, be governed by clauses of MOFA.
Potential interest payable to customers for delays in hand over of units should be appropriately factored as part of cash outflows.
Developers’ obligation under the subvention scheme may also be impacted on account of delays in completion of the Project due to COVID-19. This may lead to an increase in subvention cost for the developer in cases where the tripartite agreement specifies that the developer would bear the interest up to the date of actual handover of a unit to the customer.
The estimated cost to complete
The estimated cost to be incurred to complete under-construction projects may undergo a change following a delay in project completion and on account of increase in labour cost, change in construction norms (social distancing, sanitization of sites) and changes in prices of steel/cement. Thorough technical diligence would have to be done to assess the revised estimates of balance cost which should be appropriately factored.
Appropriate assessment of the funding gap
Considering some of the matters discussed above, COVID-19 would severely impact the sources of cash flows in real estate projects with delays in customer collections due to the economic impact of COVID-19 and unwillingness of banks and NBFCs to provide further funding.
The shortfall in cash inflows would have a corresponding impact on a developer’s ability to meet its obligation towards monthly/quarterly repayments to lenders and payment of dues to construction vendors. This would lead to mismatches in monthly cash inflows and outflows, thereby leaving a funding gap. The funding gap, if not addressed through moratorium from lenders or alternate means of cash inflow, would lead to delays/default under lender agreements.
As part of diligence, an investor should obtain and analyse the mapping of projected monthly cash inflows and outflows to understand funding gaps. This would help the investor obtain a better assessment of overall fund requirements and timelines for the same.
Terms of lender agreements should be read to understand the status of historical compliances with loan covenants, securities given, and other terms. Diligence should include understanding the level of debt not just at the project level but also at a group level.
Cross default clauses in lender agreements may have to be appropriately evaluated and addressed. Besides, conditions attached to any loan moratorium availed and its impact (including any restrictions) on the utilisation of future cash flows would have to be evaluated.
We believe that funding agencies and banks would have to do robust diligence across financial, legal, technical and commercial aspects of a project to make an appropriate risk assessment of factors affecting the project due to COVID-19. Funding agencies may have to devise innovative means of structuring a transaction with the objective of protecting its investment and cashflows in projects.(The authors are partner and national leader, Transaction Diligence Services, and Director, Transaction Diligence Services at EY India)