National Conclave on Stimulating Housing Sector Reforms
November 19, 2001, New Delhi

Presentation on 'Resource flows in the housing sector' by Mr Ramani Sastri, Vice President, CREDAI

It is indeed a pleasure to be here today to address a session on ‘Finance Resource Mobilisation’. This convention provides perhaps the best platform to take stock of the Indian Housing Finance System – where we currently stand, what changes we would like to see in future and more importantly, how these changes can be effectively implemented.

To start on a positive note, that last 3 budgets have provided enough incentives and the drastic reduction in interest rates, making easier for the common man to achieve his distant dream of a home come true. But on the supply side very little has been done to ensure that developers who are the producers of homes get access to the required funds. It is conferences like these that helping us carve out solutions for a better tomorrow.

The trade and industry was fairly to blame in the 80’s when there were not many professionals in the building trade. It is still one of the largest unorganised sector in the country, but slowly companies deeply committed to housing are becoming more responsible, accountable and transparent.

Like other industries, real estate developers are also processors and producers of goods (i.e. the home) which is a tangible product and has enormous cost from concept to completion. It is impossible for any developer firm to bear the entire cost, hence the need for real estate financing.

The customer preferences have moved away from under construction to nearing completion or completed projects and hence the investments in the projects have changed.

Strangely other industries get financed by the same financiers for process as well as end product (i.e. the automobile industry). The banks and Financial Institutions have exposure to the producers and the purchaser but when it comes to developers the very same Financial Institution shy away.

Now coming to the issue of funding developers – norms have been laid out and rating should be made mandatory.

The one time pure vanila product “construction finance” is no longer available and it has out lived its purpose. Now the time has come for innovative products as the market conditions have changed in the past 5 years.

Receivable discounting - is one option where projects in advanced stages can be financed. The balance amount receivable against sold flats can be financed by Housing Finance Institutions/banks (practice which is being followed) to infuse liquidity and enable developers to complete the project within stipulated time period.

Escrow Account Mechanism

During the boom period between 1991 and 1995 developers had invested heavily in land by diverting funds from other project and taking on huge liabilities from banks and financial institutions. With the crash in the markets the value of these investments were eroded. Most banks and financial institutions today have frozen all their lending to the developers community. The main reasons for this being the inability of the developers to repay their debts. To instill confidence in the lenders the developer community would need to organise themselves and bring about greater transparency in their operations. In this respect developers must explore the ‘Escrow’ mechanism to tap funds from Banks and Financial Institutions . Under the Escrow mechanism the loan amount is decided after doing a thorough due diligence of the accounts of the developer. All transaction (inflow and outflow) are routed through a designated Escrow Account, the control in which remains entirely with the lender. The progress of construction is monitored by the appointed auditors who submit periodic progress reports. Disbursements are made strictly on the basis of the progress reports. This system will not be successful without the co-operation, commitment and support of the developer community.

Position on project / Venture Capitals – The financiers takes a position like private placement of area to be constructed at discounted rates and funds the project. On completion of the project or during the construction, the developer sells on behalf of the institution and gets their investment back with return. All loans originating from these sales should go to the institution which funded the project. This the financiers can do after due diligence as listed below:

Risk evaluation and mitigation

Essential to establish counter – party risks and mitigate them before offering construction finance to borrowers.

Finance available to builders with established track record.
* Minimum Net worth Criteria
* Track record of successful completion of projects
* Established source of cash flow and revenues

Loans are usually project specific.

In addition to builder risk, saleability of project depends on
* Location
* Demand & Supply of flats
* Pricing
Opinions from consultants are sought to mitigate these risks.

Due diligence of all transaction documents including

* Title documents
* MOU for land
* Power of Attorney
* Municipal clearance

Line of Credit - Like working capital advanced by banks, in this case, builders with track record are able to work out their financial requirement and line of credit is approved by Housing Finance Institution. This is for a minimum period of 4 –5 years renewable on a year on year basis. This covers all the projects of the developers. This can be availed after the institution is satisfied about the following items-

Critical Lender Requriements

Builder to obtain statutory approvals prior to loan disbursal

Loan to be secured by mortgage of the property of the proposed project.
* Property should have clean title
* Property should be easily marketable
Exclusive charge on company’s receivables

Additional collateral could be in form of
* Additional property with its development rights assigned in favour of the lender
* Personal guarantee of the promoters
* Escrowing of the receivables
Builder to provide undertaking for minimum price as incorporated in the cash flow projections.
* To minimise the risk of sale through cash
Builder to main a minimum stipulated debt service coverage ratio
* Any breach to be treated as default
Loan repayment would accelerate in case property sale happens faster than envisaged.
Or follow the standard debt to equity norms of 25% equity and 75% debt provided the land value is fully paid for.
All the above brings us back to the issue of confidence and transparency in the developers faternity, credibility apart from track record is also assessed by availability and response of the developers.

Real Estate Investment Trust/Real Estate Mutual Fund

The setting up of a Real Estate Mutual Fund can also provide some support to the cash starved housing sector. The Mutual Fund industry in India has received a tremendous boost but presently mutual fund are not permitted to hold real estate assets. But there already are sector funds where the public invests money exclusively in companies belonging to one sector. This concept just needs to be taken further to allow investments in real estate. Besides, a Real Estate Mutual Fund would, through the pooling in of resources, allow individuals with small amounts of cash to also take advantages of the returns available from the real estate market.

The concept of Real Estate Mutual Funds in India is not new. Introduction of these funds had been proposed almost a decade ago, but the authorities were sceptical due to the erroneous notion that such funds could be speculative in nature. But fortunately today, the mind-set has changed. In fact, at the initiative of SEBI, the Association of Mutual Funds in India (AMFI) had set up a committee to advise on the introduction of real estate Mutual Funds. The committee has submitted its report and it is currently being studied by the authorities.

Apart from an increased flow of funds towards the housing sector, the advantages of Real Estate Mutual Funds includes imparting greater liquidity into the industry and bringing about the much needed “Professionalisation” into the industry –
- First, by employing legal professionals to evaluate and pass judgement on the legal compliance of the property and thereby help reduce the risk of defective titles and
- Second, by employing professionals to provide service to keep the properties in good shape or what is now more popularly referred to as ‘facilities management’.
Though it is expected that the authorities will take time before permitting such funds, one hopes that it will be sooner than later.

Foreign Direct Investment (FDI)

One of the most plausible options to alleviate the acute cash shortage in the housing sector is to permit Foreign Direct Investment (FDI). The government has very recently permitted Foreign Direct Investment in housing sector. Of course, granting infrastructure status to housing, but not acknowledging it as a core sector does appear to be contradictory.

Conclusion

Finally, consolidation in the real estate industry is a must. There has to be a change in the mind set of the developer community. Instead of doing separate projects through different companies, it is better to build larger companies. That gives a larger net worth. Banks and financial institutions will be more comfortable lending to growing companies.