Friday, September 12, 2008

Real estate developers caught in downturn

DNA has a article on the pithfalls of the use of leverage in the real estate business. Expect rapid unwinding in Mumbai and land prices in developing areas of all cities in Mumbai. The wind below the PE wings have been taken out. With the collapse of Lehman, Fannie, Freedie and impending doom of Washington Mutual and Wachovia, we are in a very deep downturn. I think Mumbai prices will collapse 50% under these circumstances. Antything over 5-6k per sq/ft is not capable of being repaid using a loan based on Indian salaries. so prices have to drop to these levels whether funded by black, white or yellow money. If prices don't drop there will be zero buyers for all expensive properties owned by builders. They can keep it and rent it out for 20-30k a month. If the PE guy comes callingthey better have a good way to repay their debt, maybe by raising money on the black market at 4% a month

Increase in interest rates, private equity players’ demand for assured returns hit realtors, delay project launch
MUMBAI: Increase in interest rates and demand from private equity firms for assured returns have landed a double whammy on realtors: a severe liquidity crunch that’s delaying projects and launches; and, two, narrowed fund-raising avenues.

Till some time back, developers preferred to invest money in one project at a time. So, if a realtor injected Rs 1,000 crore into a project, he would wait for free cash flows to come in before announcing the next project.

But the realty boom of the last two years saw many developers aggressively announcing multiple projects.

As a result, over 1,000 million sq ft was earmarked for development with a fund requirement of Rs 205,400 crore over five years.

Spurring their aggression was the entry of private equity investors, who invested heavily discounting the risks.

When the market slumped this year, PEs turned chary of investing so started demanding assured returns.

For realtors, this meant funds wouldn’t come as easily as they used to.
Pankaj Jaju, head of the real estate practice at Enam Securities, said deferred cash flows are affecting the rate of return on projects.
“And there is more pain in store as capital values are expected to correct across markets and input costs have increased, which would lead to contracted margins of the developers,” Jaju said.
Another action that lead to funds crunch is that developers who had easy access to liquidity started jumping the gun when it came to projects.
In a recent report, Enam elucidated how this happened and who is paying for the sins.

Earlier, if a realtor had two projects in hand —- say A and B —- worth Rs 1,000 crore under development, he would invest the entire amount in the first project, complete it and after getting returns on A, and then invest in B.

With PEs coming in, builders began splitting the Rs 1,000 crore into two equal chunks, investing in both A and B at the same time and expecting PEs to contribute 50% of the net asset value (NAV) of the project (or half of Rs 1,500 crore).
The real estate company having Projects A and B first starts executing Project A by investing Rs 500 crore in a special purpose vehicle (SPV).
The PE investor brings in 50% of the project NAV - Rs 750 crore, into the company, taking the total equity capital to Rs 1,250 crore.
A debt to equity ratio of 1:1 meant the builder is able to raise debt worth Rs 1,250 crore. Thus the total investment in the project becomes Rs 2,500 crore.
With the project cost at Rs 2,000 crore, the company’s estimated free cash flow stands at Rs 500 crore at the end of the first project.
This Rs 500 crore is invested in Project B, which is a bigger project with a bigger project NAV. The same procedure of bringing in a PE investor etc is again followed with Project B. The real estate company thus ends up with an estimated free cash flow of Rs 1,000 crore.

But trouble came when the estimated free cash flow didn’t arrive because construction work started getting delayed, land acquisition became a problem and costs shot up by more than 50% of estimates.
The crunch is affecting realtors who have stretched their balance sheets thus, and did not achieve financial closure for projects.
The exit of investors, who were one of the biggest sources of working capital for realtors, landed another blow.

Realtors therefore sought quicker rotation of capital by putting money into high-earning activities of land banking, which left many a developer in the lurch.
Things have come to such a pass, says the Enam presentation, that developers are pitching projects against each other at lower costs to gain sales volumes and earn much-required cash to resolve working capital issues.
“No heed was paid to real estate cyclicality, slowing demand or aggressive execution,” the report said.