Real Estate: A hard landing looms but will also create big winners

Inspite of a steady reduction in the number of launches over the past three years, demand is so weak that the amount of unsold inventory is still very high.

As per real estate broker, Anarock, unsold inventory in the National Capital Region stands at approximately 2 lakh which will take 62 months to get absorbed while in the Mumbai Metropolitan Region (MMR) unsold inventory is at approximately 1.8 lakh and will take 52 months to get absorbed.

The Maharashtra RERA website shows that 67 percent of property under construction in the MMR is unsold. Now, RERA and NCLT are combining to create a major disruption.

Despite the backdrop painted above, price correction in Indian real estate has been modest over the past 3-4 years.

Cumulatively, over the past four years, residential real estate prices appear to have dropped by 15-30 percent in Delhi, Mumbai and other Tier-2 cities of North, East and Western India. (The South continues to have a more stable real estate market, thanks to lower quantum of black money and less speculative activity.)

Because the price correction has been modest, rental yields (i.e. the annual rent from a property divided by the price of the property) are still incredibly low.

In most cities rental yields are between 2-4 percent whereas the cost of getting a home loan is still around 9 percent. In a sensibly valued real estate market, the two numbers should be more or less equal to each other.

My discussions with the lawyers specialising in real estate transactions and leading real estate brokers suggest the combination of RERA, NCLT and GST is hitting the residential real estate sector further.

To be more specific:

- RERA is allowing customers who have not been given delivery on time to successfully claim damages from the developer (i.e. all the monies the customer paid plus a penal interest rate on the money plus stamp duty).

Lawyers and real estate developers are in agreement that the real estate regulator is taking an extremely pro-consumer stance with customers’ complaint being dealt with within a week of the complaint being lodged. Developers who were once thought to be untouchable are scrambling on a monthly basis to rustle up cash to deal with such complaints.

- The NCLT process of bankruptcy and insolvency has already resulted in 62 large companies (with Rs 4.7 lakh crore of debt outstanding) standing on the verge of liquidation.

Through CY18, most of these companies are likely to be liquidated by insolvency practitioners (IPs). These IPs are already calling up developers and real estate brokers with offers of prime plots of land (owned by bankrupt companies) at discounted prices.

In addition to this, the NDA Government’s crackdown on black money, GST and the squeeze on the job market are negatively impacting end-user demand.

GST is a particular bugbear as it is payable at 12 percent on flats sold at the pre-occupation certificate (OC) stage but is not charged on flats sold after the OC has been granted.

This dynamic is resulting in customers being reluctant to buy until the OC comes through.

A hard landing for residential real estate is the base case.

I believe it is now realistic to say that the base case scenario is a hard landing for residential real estate in India driven by falling land prices (see exhibit below). I expect demand for land from real estate developers to stay weak due to the factors mentioned above.

The failed auctions for prime plots in south Mumbai and Oberoi Realty’s land purchase in Thane from GSK (at just Rs 9 crore per acre) are proof of this dynamic.

Furthermore, I expect the Insolvency and Bankruptcy Code to trigger distressed sales of hard assets in CY18. As land prices fall, real estate developers are likely to launch cheaper properties over CY19-20.

As cheaper properties hit the market, developers who own the unsold inventory could enter financial distress. (I am already seeing high end apartment blocks in south Mumbai coming to the market at 15-20 percent discounts.)

Furthermore, homeowners who are repaying mortgages which are far bigger than the prevalent prices of their property could start defaulting on their mortgages.

Investment Implications:

There is trouble ahead for lenders since their ability to refinance or evergreen stressed developer loans will progressively get compromised as the downturn prolongs.

Several listed lenders have more than 10 percent of their loan book (i.e. amounts in excess of their shareholders’ equity) exposed to real estate developer loans.

It is evident from my discussions with real estate sector participants that these lenders are using every trick in the book to make their books look clean. The situation reminds me of what the banks were doing through 2011-2013 with their rotten books containing Power, Infra and Steel loans.

That being said, the ongoing shakeout in Indian real estate will create big winners alongside the losers. Real Estate developers with strong balance sheets and strong brands will benefit.

I reckon the Real Estate sector will consolidate pan-India around a dozen players who manage capital sensibly, can execute projects at speed, and know how to manage the ecosytem.

Disclaimer: Saurabh Mukherjea is the CEO of Ambit Capital and the author of “The Unusual Billionaires”. The views expressed are personal. The views and investment tips expressed by the expert on moneycontrol.com are his own, and not that of the website or its management.