Real Estate Sector: Is The Worst Still To Come?

The difficult phase that the Indian economy has witnessed in the past few quarters is well known, where it has been witnessing slow growth and high inflation. Add to that other worries like a depreciating rupee, rising CAD and most importantly the additional burden being added due to the socialist measures taken by the government in terms of the Food Security Bill, the scenario has taken a turn for the worse. 

At five per cent GDP growth in FY13, the Indian economy grew at the slowest pace in the last decade. At 4.8 per cent of the GDP, the Current Account Deficit is at a multi-decade high. A fiscal deficit of 5.06 per cent of the GDP is anything but comforting. Besides, policy inconsistency and apathy towards the sentiments of the international as well as the domestic business communities have served to rub salt on the wounds. 

While India Inc. has been affected overall, there are certain sectors that are being hammered left, right and centre. Real estate is one of these. The real estate market has a very strong linkage with the economic growth of a country, and any signs of a slowdown in the domestic economy can have a cascading effect on the health of the realty market. 

Of late, the realty sector has been battling issues like higher interest rates that are impacting the sales volume growth and the highly leveraged balance sheets eroding the bottomlines. While the sector was already under stress, the scenario has worsened further with the RBI’s recent policy actions to scrap schemes like 80:20, which helped in generating good cash flows so far. While the sector was just trying to emerge from this jolt, the government came out with another shocker by passing the Land Acquisition Bill. 

With a plethora of issues at its door, the BSE Realty index has taken a good beating on the bourses. On a YTD basis, the S&P BSE Realty index is down by around 40 per cent. This is much higher as compared to the less than one per cent decline in the Sensex in the similar period. 

Naturally, the sentiments are not good for this sector, which was once expected to be the driver of the India growth story. Ahead in this story, we have tried to gauge what is in store for the realty companies, especially in a scenario where the new RBI governor feel that realty prices in India are inflated. 

A Problem With Old Roots 

While analysing the sector, we need to understand the root cause behind the problems. Huge liquidity post the opening up of the real estate sector for FDI in 2005 skyrocketed realty prices across India. This lulled developers into a false sense of confidence that real estate values and sales volumes will ceaselessly increase, with the skies as their limit. Hence, they deliberately leveraged their balance sheets to finance their ambitious expansion plans. 

However, the global meltdown in 2008 impacted one and all, and the realty sector could hardly be immune to it. From here, the financial performance of realty companies in India only deteriorated. Though the players managed to sustain or hold the prices, their highly leveraged balance sheets eroded their bottomlines. The fundamentals of the real estate sector – sales, operating profit and net profit – all declined by 11 per cent, 21 per cent and 43 per cent respectively in FY10. However, despite such an awful performance, the sector managed to escape liquidation primarily due to the one-time debt restructuring relief package offered by the country’s apex bank, the RBI.

The sales and operating profits for the real estate sector revived in FY11 and FY12, primarily facilitated by the stimulus package offered by the government in FY10. However, this did nothing to help the massive debt the companies were carrying on their balance sheet. One of the reports from Knight Frank indicates that the interest cost of listed realty entities as a percentage to sales grew from 12 per cent in FY10 to 18 per cent in FY12. 
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In FY13, the situation worsened further. Launches and absorption of residential projects in the top seven cities plummeted by 37 per cent and 23 per cent respectively during the past two years (FY11-FY13), thereby aggravating the structural problems of the sector. Real estate developers were caught in a quagmire of overambitious expansion, decelerating sales, hardening interest rates and weakening cash flows. Unlike the earlier occasions, the sector had no bailout package this time and alternate funding options also dried up. In a nutshell, the sector seems to be all in a mess.

To verify this, Knight Frank carried out a stress test on the leading listed real estate entities. The module calculates the gap between the Operating Cash Flow (OCF) and the debt serviced, which includes interest as well as principal repayment in a particular year. This gap, referred to as ‘stress score’, indicates the ability of business operations to service debt and interest obligation. A higher score would indicate an improving situation and a lower number would call out a worsening situation. Since the ‘stress score’ is calculated on the cash-flow basis, the test was conducted only on 11 out of the 25 listed real estate companies that had filed their annual reports till FY13. These 11 companies cumulatively account for 58 per cent of the total sales of the listed space.

The data shows that for FY13 the score stood at five-year low of -132. A noticeable factor is that the stress scores for FY11 and FY12 were also high despite the revival seen in sales and operating profits. As already mentioned, the inability to trim their massive debts made an impact on the quantum of interest that companies in the sector paid due to the heightened interest costs. This, along with the debt repayment obligation, exacerbated their ‘stress score’ to -102 and -95 in FY11 and FY12 respectively.

Funding Options Drying Up 

While the stress score cannot be overstressed, another pressing issue faced by realty players is the drying up of funding options. There are hardly any IPOs from the realty segment. Though there were some QIPs and FPOs, those were mandatory actions taken by the companies to adhere to the 75 per cent cap on promoter holding imposed by the SEBI. 

As a result, even private equity players have been keeping at arm’s length from the sector as there is no exit option available. Foreign investors also seem to be shying away from the sector. This is evident from the fact that while the overall FDI inflows in India have declined, the share of real estate has also declined to just three per cent (in January-June 2013) from the levels of nine per cent in FY12 and six per cent in FY13. The worst part is that the rupee depreciation has eroded much of the investment of foreign players. 

As foreign money dried up, most of the realty players opted for innovative schemes like 80:20 to generate cash flows. However, the RBI has recently scrapped the scheme, making matters difficult for the realtors. On the same, Mohit Goel, CEO, Omaxe says, “It has always been our submission that the RBI or the government must encourage innovation. Such schemes have enabled developers to speed up sales in an otherwise slowing economy. Such schemes had taken the burden off the young working class who did not want to bear the rent-EMI dichotomy. The RBI has attempted to block yet another opportunity to home buyers who otherwise stayed away due to rising home loan rates”. He added, “However, we believe developers using such schemes for a greenfield project are bound to suffer, but for those using the same for projects where the structure is complete do not tend to lose”. 

Gulam Zia, Executive Director, Advisory, Retail & Hospitality, Knight Frank India agrees with this view saying, “Stopping the scheme will impact the cash flows of developers. The already worsening liquidity position due to reducing sales will deteriorate further with the stoppage of the 80:20 scheme. This surely will have an adverse impact on developers. Those with deeper pockets can sustain, but the rest will have to either look at selling the core assets to bigger developers or reduce the price expectations from home buyers”. 

Banks, one of the largest lenders to the real estate sector, are desisting from lending as they are troubled in their own backyard with increased nonperforming assets, tightened monetary policy, currency depreciation and volatile debt markets. The new ruling about linking loans to the phase of construction has only added to the realtors’ woes. 

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All this clearly shows that the problems faced by realty companies today are fairly deep-rooted and the chances of a revival in their financial health during the current year seem bleak. The aftermath of the cheerless funds scenario is also apparent in the market, as some real estate companies have defaulted on their debt repayments. This seems to be just the beginning of doom for the highly leveraged realty firms. The run-up to the elections is generally characterised by a period of policy paralysis, and we expect the upcoming state elections as well as the general elections in 2014 to have the same impact. Realty firms are now in deep waters, and we definitely expect the sector to go through more pain in the foreseeable future. 

Will Realty Prices Decline? 

While realty companies are in trouble, their stock prices have not corrected in any meaningful way. What has sustained the prices so far is the willingness of developers to hold growing inventories of unsold apartments, shops and offices without offering price discounts. We have already stated that the volume of real estate transactions has slumped in India as developers have refused to offer discounts for fear of starting a market rout. If developers reduce the prices, investors will panic and it will become a self-fulfilling prophecy, causing a further slide in prices. 

Now, the situation is such that the builders now have to liquidate their inventory to avoid any further financial mess. We feel that the combination of above factors has produced almost unanimous bearishness about the short-term prospects for residential, commercial and industrial real estate in India. The prices would fall by 10 per cent in big Indian cities and 15 per cent on the outskirts of large cities, where many speculative projects have been built. Given the universal sentiment of the market, there could be a sharp correction from now until March 2014. 

The Right Time To Buy? 

However, all these indicators also rakes up the question as to whether this is the right time to buy property. After all, a buyer’s market has always been wishful thinking on the part of home seekers. Moreover, it seems many of the prospective home buyers who had put their plans on hold due to the threat of job loss and the inability to service EMIs in the wake of the recession are back in the property hunt.

The answer as to whether this is the right time to buy is not a simple “Yes” or “No”, but depends on a number of factors like whether a buyer is looking for the first or second house, for living or investment. If the house is for self-occupation, the right time to buy a house is now. The individual should not wait for a major correction in prices, though the right time and price for a real estate investment is of essence. 

These factors apart, certain markets hold out better prospects be it for first-time home buyers or investors. Let’s take a look at which these markets are. 
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Situation In Major Markets 

If we take a look at the top cities (viz. Mumbai, NCR, Chennai, Bengaluru, Hyderabad and Pune), Mumbai remains the most unaffordable market. Of the city’s total under-construction units, 29 per cent surpass the Rs 1 crore mark as compared to 11 per cent in NCR and just five per cent in Bengaluru. With 77 per cent of its total under-construction units falling below the ticket size of Rs 50 lakh, Bengaluru remains the most affordable residential market. 

In terms of unsold inventory, Hyderabad and Mumbai remain at the top slots, with quarter to sell (QTS) unsold inventory remaining as high as 9 and 7 respectively. The situation in Hyderabad is worse, with unsold inventory levels piled up to 28 per cent. Residential property in Hyderabad is relatively discounted, which provides immense opportunity for end users as well as investors. 

The health of the residential property market in cities like Bengaluru, Chennai and Pune has remained relatively stable over the last one year, with a constant QTS ratio of 6, 6 and 5 respectively since March 2012. Affordable prices, the right size of apartments and a higher share of properties worth less than Rs 50 lakh in new launches, among others, are some of the reasons for the steady performance of these markets. Additionally, the ratio of end-users to investors is highly skewed towards end-users here, providing a steady rate of absorption unlike in Mumbai and the NCR. 

Chennai and Pune have witnessed a decelerating trend in the number of new launches since June 2012, which has further helped in maintaining the QTS ratio despite moderation in absorption during this period. In contrast, the Bengaluru market has been able to maintain its QTS ratio at 6 despite the consistent rise in new launches since June 2012. This is because of the strong absorption that the city has been able to report during this period. Going forward, the prices are expected to marginally inch upwards in these markets as the QTS ratio starts declining. 

It is evident from our analysis that the Bengaluru, Chennai and Pune residential markets are in relatively better health as compared to those in Hyderabad, Mumbai and the NCR. Going forward, we expect the momentum in new launches to reduce significantly across these cities. This will help ease the inventory overhang in these cities, thereby improving the market health in the coming quarters.