The real estate sector is facing serious challenges in fund-raising, with limited options at this critical juncture. Serious beating down of stocks by the market precludes fund-raise through public issues. Many developers have en masse restructured their loans in 2009, precluding another round of restructuring now. The increasing interest rate and volatile economic outlook has started dampening housing demand, making banks and non-banking financial companies (NBFCs) wary of fresh lending to the sector.
In a perfect market, one could expect a sharp correction in real estate prices to help clear inventory, and the sale of non-core assets and land banks to improve liquidity, and to meet loan repayments. But neither of these is being witnessed today.
Many small and mid-size developers prefer to hold on to the prices (at super-normal profit margin levels) and hope for indulgence by their lenders, a classic example of ‘moral hazard', of having accommodated such a request from the Real Estate sector in 2008-09.
For the large players, emergence of a parallel funding mechanism in the form of Real Estate Private Equity funds has provided much-needed holding power; they would otherwise be leading the correction in real estate prices. Significant amounts, running to a few billion USD, have been raised by Real Estate Private Equity players in recent years. Such funds invest their proceeds as project-level funding of reputed builders (Top 5 within the city), though part of it is typically given as ‘take out' to the developer, to support its other ongoing projects.
Typical investment could take the shape of a hybrid security, with a mix of debt and equity characteristics; for example, land is taken as primary security, with additional collateral in the form of earmarked escrow of cash flows from other ongoing projects . Return expectations are in the range of 20-24 per cent for debt structures, and almost 40 per cent pre-tax internal rate of return (IRR) for equity structures!
Developers who are willing to compromise on part of their profits for the sake of better demand and liquidity are likely to survive the current challenges facing the real estate sector. Similarly, investors and lenders should also temper their return expectations to realistic levels to protect the value of their exposure in the long run.
(The author is ex-Director Ratings, CRISIL and Co-founder, RiverBridge Investment Advisors.) http://ChaseCut.blogspot.com