The Hindu Business Line : PE returns to realty financing

Already there were some signs of a slowdown in the realty price spiral; and now the Indian realty sector has begun witnessing the impact of the sub-prime crisis, says Mr Rajiv Sahni, Partner, Ernst & Young, New Delhi. "Recently one of the largest and high-profile IPOs had to be pulled out because of the market jitters," he reminds. "Overseas listings have been deferred due to similar factors."

Mr Sahni, a fellow member of the Institute of Chartered Accountants of India, heads Ernst & Young's Transaction Advisory Services with respect to the real estate and hospitality sector in India. He also heads the debt and corporate recovery practice.

Having worked on various assignments - encompassing corporate strategy development, fund raising and joint venture partnerships for major real estate and construction companies involved in developing townships, residential/commercial complexes, malls, entertainment centres, schools, roads, hotels and amusement parks - Mr Sahni looks back at how 2007 was an eventful year for the global real estate markets.

"While on one hand the year saw a surge in global capital flows, on the other it was a year that unearthed the sub-prime crisis," he observes, in the course of a recent email interaction with Business Line.

"Global direct real estate investment touched $385 billion in the first half of 2007 growing by 25 per cent over the corresponding period of 2006 which itself was a boom year. However, the sentiment changed dramatically in the second half and continues into 2008," recounts Mr Sahni.

Excerpts from the interview, in which he analyses the options before developers and also decodes the trends in the country's realty sector.

With the public markets being off the radar for some time and the ongoing projects requiring capital, what are the options for developers?

Senior debt has been becoming more expensive and stringent in the past couple of years and, in any case, that cannot be the only source of funding.

To bridge the gap and to acquire new projects, structured finance products were becoming popular. However, these are now becoming increasingly high-cost.

Further the rigidity of their cost structure is fine in a rising market but not necessarily in a market such as what is prevailing now.

Hence, the pure private equity route could re-emerge as the primary source of financing, especially as valuations become more palatable.

What will be the clincher in the funding?

The underlying mantra irrespective of the form of funding would be the pricing for risk which will now move more and more towards meeting investors'/lenders' return requirements.

Along with this, a flight towards more viable projects and more established players could also be expected.

Are there any precautions that developers need to consider?

Developers need to be careful about the investors that they are choosing to partner with, as highly-leveraged investors may not be the best suitors even if they offer better terms.

Also, the typical phased-funding models would need tighter legal protection for the investee company/promoters (developers) to guard against the inability of the investor to put in the committed funding amount as the project progresses.

Do you see fundamental changes in our realty sector?

It is not really as some investors would like to believe - that the Indian realty sector has morphed from being a "seller's market" to a "buyer's market" as far as funding of transactions is concerned.

In the past, investors often felt that the valuation expectations on the sell-side were high, but then those expectations were partly fuelled by the liquidity created by the plethora of funds in the market.

What has really happened is that the days of the irrational exuberance are over with all players becoming more rational about cash flows, risks, returns, and the sharing of risks.

Sub-prime losses have been alarmingly ballooning!

True. What the total losses from the sub-prime situation are going to be is anybody's guess. Germany's finance minister had warned that these could reach to the tune of $400 million. But his guesstimates, like anyone else's in the beginning, have proved to be only a small fraction of the billions of write-downs that we have been seeing over the last 6-9 months.

Apart from the direct losses, the impact of this crisis is being felt and will continue to be felt in the global financial and real estate markets for quite some time.

The Joint Economic Committee of the US, headed by Senator Charles Schumer, in October 2007 evaluated the economic impact on wealth, property values and taxes, and concluded that approximately $71 billion in housing wealth will be directly destroyed through the process of foreclosures and more than $32 billion dollars in housing wealth will be directly destroyed by the spill-over effect of foreclosures, which would reduce the value of neighbouring properties in the US.

The forecast continues to be grim.

Yes. Unless action is taken, the number and cost of sub-prime closures will rise and spread to other geographies.

Typically, sub-prime foreclosure rates will increase as housing prices flatten or decline, and the effect of this crisis is likely to extend beyond the housing market to the broader economy. Decline in housing wealth will almost definitely negatively impact consumer spending.

Can real estate appreciation come to the rescue?

House price appreciation cannot necessarily disguise the financial precariousness of the borrowers whose sub-prime mortgage are about to reset.

When home prices appreciate, sub-prime defaults decline. The option (and ease) to sell or refinance should generally reduce delinquencies. If a borrower is struggling to make mortgage payments, but the value of his house has appreciated, he can solve his problems at least temporarily by refinancing the loan. The house can also be sold and loan repaid.

However, when house price appreciation does not create equity, borrower's financial weakness cannot be disguised, and default rate rises.

D. MURALI

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