REAL ESTATE SEEKING PERSONAL LOAN-Is it suicidal ?

I spent the entire of the last week interacting with the Deep-pockets. (sorry for the analogy, but true). I had the opportunity to showcase our research findings about the Delhi Master plan MPD 2021 to the heads of a couple of large Realty funds, and some real estate investors who traditionally have been supporting the Real estate developers in north India with their earlier projects. In both the above cases, a Million $ was being spoken about as loose change.

 

At no point am I trying to play judgemental in my mind. Each to his own, and one gets paid in the same coin as one would have invested in the past. Hence, in the following lines if you see one segment trying to take advantage of the other, remember, they are only reverting a deed received earlier.

 

Though, there were some factors in common between both, the institutional investor as well as the individual investor.

 

a)Both were conscious of the fact that they have the strength of “Cash is King”, and rather proud of the fact. (In one instance, aggressively trying to assert superiority).

b)Both were extremely sure that the time is now for them to use the money as the ‘weapon’, rather than the tool for their pound of flesh.

c)Both have the virtue of time being on their side, and seem blessed with the patience of a vulture waiting for the prey (read developers requiring funds) to start bending their knees.

 

Like I said, no one wants to be judgemental, least me. Let me try and bring to fore my observations in an objective manner.

 

Around the mid of last year, there was this report in one of the leading business magazines which was co-authored by a friend & colleague. It forecasted the imminent over-supply in the commercial office space domain and projected a very bleak picture emerging. Over the media, it was a heated debate and the stake holders contested it hotly. My organization kept reminding the financial pricing pundits amongst some of the optimistic developers of the imminent situation emerging in the residential markets, but to no avail. Most of those who predicted an ebullient offtake in 2008, do feel the heat now.

 

Hang on! Hang On! I will come to the moot point and would definitely invite you to comment on it. Please bear with me till I weave some more background about my question.

 

Sometimes in the beginning of this year, the offtake of real estate products started seeing an actual downward slide. Towards the third quarter of this year, we almost hit the rough patch of about 60% drop in sales. I wouldn’t like to say that things are on predicted lines… remember, even our topline & bottom line becomes susceptible to the markets shrinking.

 

I started this point with a few questions in mind, which is:


 

Many developers are borrowing short time funds at interest costs in excess of 30% p.a. These funds are being utilized to complete some projects sold earlier. In one instance, I know of a developer paying a monthly interest of 3.5%. That makes it an annual interest payable @ 42%. Isn’t that much higher than the personal loans being sold in the market? Is that a sign of things to follow? Has an aberration become the norm in the real estate industry? Can this industry sustain a drop in demand coupled with a forced increase in the prices?


 

This morning news edition of ET got me thinking. The front page announced that Citibank has contested an award by the Consumer forum that 3% monthly charge is too much. They have gone to the Supreme Court and contested the allegation that Citi overcharges. They justify that charge since the loan ticket size is small, and the risk is too high.

 

If we equate the same logic of the interest rate being proportional to the risk, following are the questions that we better ask as sellers & buyers of real estate.

 

  • ARE THESE BORROWINGS BY THE REAL ESTATE COMPANIES FRAUGHT WITH RISK?
  • Are the small investors in these companies susceptible to losing their money? Would many of the announced projects of these very developers see the light of the day, or even, get completed within the announced time-lines?
  • Who are these lenders in the market and what is the protection that they take, as collateral OR guarantee for their money and returns?

 

 

  The point that I want to be debated in the public domain is twofold, namely?

 

  • These extremely high rates of interest, short term or long term – Wouldn’t the end impact of this reflect on the product pricing?
  • The challenge here is more from the developer end. Had his project or product been acceptable in the public domain, wouldn’t it have been subscribed earlier? Wouldn’t it have offset the challenge of the working capital & cash flow? Is that a reflection of the retail buyers’ lack of confidence in either then brand OR non acceptance of the product or pricing features?
  • Given the current market conditions, isn’t the debt risky from the developers’ point of view? Would the market read the borrower company as a ‘not so well managed company’ which misread the signals and did not manage their finances well?
  • Given that the above would be the understanding, the developer company might have to lose their say in their own company for strategic matters, and the lender might have a much bigger say. As for the retail investor / buyer, would it mean that experts of real estate development are not at the helm of affairs?

 

Please pardon my intrusive thoughts, but, I am a firm believer of one philosophy… which is part of the vision statement of the organization that I work for.

 

“EVERY ACTION OF OUR’s SHOULD START & END WITH THE CUSTOMER”


 

If the above is true for the developers too, how come the end buyers’ perspective is not accounted for into the projects at hand?

 

Some more points to ponder, and reply.

10 comments

  • Andrei, San Francisco

    It depends on inflation and core interest rates. I.e, if inflation is 50% a year, borrowing at 36% might be a very good idea (happened in ex-Soviet Union in 1991-1998). If inflation is within a norm (2-8%), borrowing at 36% against illiquid asset and paying monthly (which is 43% compounded interest) is suicidal indeed.

  • Actually the answer is pretty much the same. If the developer is a speculator and can BUILD & sell his property at prices that work it’s not suicidal – just risky beyond reason. Of course it’s not sustainable in the long run so you can’t build a ‘development’ business that way.
    But you might make zillions of Rupees profit.
    I know I sound facetious but I’m serious. You need to know what business you’re in. You need only look at where I live in UAE to see that a property bubble can last quite a long time. People will get burned as they always do in a bubble. The skill/luck is in the timing.
    India is the same to me.

  • Amit Agarwal, Mumbai, India

    Ramesh- Not sure if suicidal, surely it is risky though.
    I am not a real estate expert….however would try to answer it from pure financial perpective..!
    I think for a real estate developer funds are a bloodstream and more critical than to any other industry. Unless he raises additional funds and finishes the project and realises it, he runs the risk of oringinal huge investment being eaten up by alarming 12-13% inflation which anyways is a direct loss.
    Therefore so long as the negative gap between his realisation and the original investment is not more than (or is around) the inflation, it is not financially suicidal…bankruptcy risk is higher though….nevertheless there are greater probabilities of saving the original investment..for which there is no escape but to wait for economy to come back and economics to become sane.

  • For all those who are dreaming to own a house despite the high home loan rates, there is some good news. The costs of residential properties across four major markets of the country have stabilized during the April-June period. According to the report by global realty consultant, Cushman & Wakefield on India’s residential sector, the availability of new supply, shrinking demand from investors and increasing rates have led to the stabilization of capital values in both high-end and mid-range residential segments across the National Capital Region (NCR), Bangalore, Mumbai and Pune in the second quarter of 2008.

  • Ramesh – this is tough time for the real estate sector indeed. With global illiquidity plaguing the sector, there is a severe funds crisis with all sorts of liquidity in the form of public money, bank debt etc drying up. In such a scenario, the developers are left with no other option but to look for either private equity or private debt, which in both cases has become too expensive unless one is a blue chip developer with steady cash flows. Even for the private equity players, the minimum IRR expectations have risen from 20-22% levels before this downturn to 25-28% levels now. Some aggressive investors are even quoting 30%. However borrowing atr an interest rate of 36% is indeed extremely risky and poses a complete pressure on the cash flows. But yes, this is how the real estate market works in India.

  • Vaibhav Sankla, Director Adroit

    Yes, it is suicidal………………. but for lenders.
    The point is that their businesses are down at the time they increased their capacities like never before. Further, no signs of residential and commercial demand picking up anytime soon. In fact, I feel that the demand is more likely to go south from the current levels which will further deteriorate their finances. I truly feel that this is just the beginning.
    Cheers
    vaibhav

  • It depends on the stage at which his project is. its not sustainable for long periods, however if project would be executed within few quarters leading to sales & increased liquidity it could be considered as a last option. Selling for lower prices is a better option, though.

  • Rakesh SUd, CFO, India Ops

    Borrowing is always a basket. What is important is the average cost of borrowing and not the marginal cost.
    Borrowing at 24% essentially is throwing good money after bad money unless it is a temporary move with an exit strategy planned or is something which does not significantly impact the average cost of borrowing (ie volume is low).
    It seems unlikely that there will be a sudden spurt in real estate prices in India which are already at unviable levels and given this scenario the word suicidal may be quite appropriate

  • Ramesh – The answer, in my opinion, is no, the developers cannot sustain the growth and assure a healthy return to their investors. This sounds like a recipe for disaster. Real estate markets can turn fast. Believe, me, I know from personal experience firsthand.
    The Atlanta, Georgia, USA market was hotter than ever these past few years, and now many developers are facing bankruptcy. And the rates of interest being charged was well south of 10% – the highest being 9.25% (Prime plus 1%) when the Prime Rate hit 8.25% awhile ago. Rates have since reduced considerably and borrowers still are struggling.
    The scenario you explain appears to be a case of developers scraping for money from any source just to stay alive. Any developer borrowing at these rates is deluding themselves, or is on the brink of going out of business. Just my opinion.

  • I just landed on this question by chance but I believe there is no way a 24% cost of funding could land a profitable investment unless in a scenario of rampant inflation including asset prices. I don’t think this is the case in India , so unless the funding is to cover locked-in projects and the funding is only to bridge to complete developments as opposed to funding developments the scenario can be viable.
    However, I believe in the scenario of a stable real economy which i am bullish on and suitable adjustment of capital values in rental yields … real estate will over time perform as good or better than many other asset classes on a risk adjusted basis.

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