Capture the essence – Real estate Finance

Preventive measures are better than breakdown maintenance; it’s a common phrase being used in heavy machinery maintenance industry. Same applies to banking. Once few major loans default we tend to avoid exposure in the sector. Instead of doing so preventive measures if taken at right time the sudden collapse of the sector or defaults could have been avoided up to a certain extent.

Even before COVID issue, realty was in bad shape from banking point of view. Due to global economic slowdown as well as key initiatives by government to control the cash economy didn’t go well in favor of the realty sector where lot of cash was involved through unorganized developers. Of course overall in the long run the transparency in terms of delivery of projects & transactions will go in favor due to government initiatives however the system is gradually getting accustomed to new normal of majority checque payments.

At the same time developers are facing negative growth quarter on quarter in overall revenues where volumes as well as prices both are in downwards direction. Thanks to COVID the situation worsened.

Apart from moratorium comfort and restructuring, out of the box thinking is required to revive the sector and bank funding of realty.

We need to understand the sector’s peculiar nature while doing the appraisal to fund the projects.

It is the need of the hour that either we create a separate institute for the sector like TFCI made for hotels or by creating a separate system for appraisal of real estate financing within the existing fabrics. 

Most of the banks have one single appraisal note for across the sector first of all there should have been a separate appraisal note itself. Few peculiar nature of real estate projects are as follows which shows that a different treatment required for the sector:

DSCR

Debt service coverage ratio in real estate is as standard formula of EBIDTA/ (Principle + Interest) rather here entire fixed assets which is being created from loans is being sold out so it is again going to be add back or in simple way there shall be entire sales can be used as operating income excluding the sales portion which is being used towards completion of the projects since the not even the margin rather the fixed assets being created from loan is also being used to repay the loan. 

For example if we give 100 crs loan to a project where total project cost shall be Rs. 300 crores  (Rs. 50 crores of equity + Rs. 100 crores as debt + Rs. 150 crores from sales advances) and sale value is Rs. 450 crores then DSCR as per standard method shall be 1.5 however actually it shall be 3 {Rs. 300 crs (net cash flow excluding the sales being used to complete the project)/ Rs. 100 crs } since entire debt and equity being taken to create the assets actually being used to complete the finished product which shall be sold and fixed asset shall be zero.

Lot of housing finance companies or funds evaluate the project this way only however still banks need to see from this approach and avoid standard DSCR process at all for these projects since its irrelevant.

DE ratio

Earlier till 2010 when mezzanine funding just entered the Indian real estate market the transaction used to be under Compulsory convertible debentures which generally used to be shown as unsecured loan. It was new to bankers hence lot of very good transactions used to get delayed due to this lack of understanding of bankers however later it has been understood and most of the banks considered it as quasi equity while calculating DE ratio.

One big mistake is considering the sales and advances as part of promoter contribution made task easy for developers. Of course without considering sales and advances as part of project it can never be completed hence there shall be a cap on this as a part of project cost to avoid any future uncertainties in sales velocity as well as market prices. Like it cannot be more than 25% of the project cost.

Most of the good project always stuck up due to land value being 200 to 100o times of book value (incase land is bought more than 10 or 20 year old). If the land is treated as on book value basis in such cases the project hard cost figures on book value basis will not do justice while in prime location of Metros. For such cases valuation of land on DLC rates should be treated as land cost while doing assessment for project DE ratio. 

Apart from this there has to be a different team for appraisal of real estate project. SBI has taken this initiative by putting separate RM for real estate sector however this should be extended to separate credit officer or a separate team like lot of banks has created SME hubs district or region wise. This step will make things faster and that will avoid most of the projects getting into default. Even restructuring and reassessment of project shall be appraised through those specifically dedicated cells or units. 

After sales service

This is a major issue with public sector banks where they nurture the baby or a project by doing the project finance at initial level and taking high risk but once it starts generating surplus cash flow it is being taken over by private banks or any other financial institution. Why not an automated system of cash flow linked credit system shall be there which updates the rating and lowers the interest rates or offers higher eligibility. What is happening today with public sector banks specially is that they have been left over with tight cash flow or default status project and all creamy or high rated companies prefer to go to private banks. This issue has to be addressed.

Reliance on external agencies

Instead of relying on our on appraisal, bankers started to refer external credit rating agencies as well as valuers for appraisal. A clear ratio of DLC rate to market value can be set region wise and that can be a bench mark for valuation of the land or assets same can be revised on annual basis. This should be basis for major valuation. Nowadays online availability of real estate prices made it very transparent and made the task easy for evaluation. 

As far as ratings are concerned there cannot be a credit rating significance for a new project hence there should not be major emphasis on such funding, for restructuring or takeover of existing assets it can be treated however internal assessment should be in primary focus. Even today lot of banks do have system of internal rating and external rating mapping but implementation of that system itself create delays in appraisals which ultimately delays the project and tend to go towards default.

End use 

End use of bank funding should only go towards the construction of the project and not towards anything else like approvals, land payments or interest funding. This can solve major issues. To fund approvals or any other cost which is required at pre construction stage it is always advisable to fund it through equity or quasi equity. 

Whether economy is in upswing or in downward directions these simple steps can solve lot of major issues in real estate bank funding.

Now that REIT is already getting attraction in organized developers across the country, there is a big source of funding has already opened up for commercial. As far as residential projects are concerned lot of projects will now be part of affordable housing schemes created by government which ultimately get easy funding through banks & financial institutions hence very soon the sector will come up from these hard times.