Realty Check: The Indian Real Estate Story
  
 

Overview of Real Estate Sector

The real estate sector in India had undergone a metamorphosis on the back of healthy economic growth in the past few years. Currently, however, the sector is facing the pressures emanating from the ripple effects of global economic crisis. The sector had emerged as an attractive investment option for global developers due to the higher returns it offered but in the last fiscal it was engulfed in liquidity crunch woes. In this chapter we focus on the developments that took place in the Indian real estate landscape in the past few years and the challenges that are emerging in the current dynamic environment.

The Global Real Estate Market

The global real estate market had been growing rapidly in the past few years as real estate has been the most preferred option to diversify investment portfolios world over. Higher returns, portfolio diversification, and increase in disposable incomes have been the primary drivers of the global real estate market in the last few years.

Real estate has gradually become an established asset class and a preferred investment option alongside shares and bonds. It provides investors with an advantage of continuous returns that is similar to bonds and growth that is similar to shares. Since the past couple of years, there has been a remarkable improvement in cross-border real estate investment across the world. Investors have been focusing on new markets to increase their returns and to diversify risks. Globally, the investible real estate market is dominated by the US and Europe; however, on account of globalisation, the Asia-Pacific market is the fastest growing and emerging market in the global real estate sector.

The global real estate boom over the past few years has been also supported by introduction of Real Estate Investment Trust (REIT) in different parts of the world. In fact, the introduction of REITs provided the much needed boost to the development of the organised real estate sector. A REIT is a company that owns, buys, sells, manages and develops real estate assets. REITs, which work on similar lines as mutual funds, pool together investments from individual and institutions to invest in real estate projects. The investors receive a share of income generated through such property investments. Furthermore, REIT is also a company that is engaged primarily in the ownership of income-generating real estate and is required to pay out almost all of its taxable income in the form of dividends. A REIT boosts capital access and reduces capital costs for property owners. It also does not have to pay corporate taxes as long as it complies with the distribution and regulatory requirements.

The concept of REIT originated in the US in the 1960s and since then has become an investment instrument of choice all over the world. High degree of liquidity, security, and performance are the driving forces behind the robustness of the REIT market all over the world. The REIT culture is already operational in countries like US, Australia, Canada, and Hong Kong. Further, REITs are also making their way into other emerging markets and are expected to boost the real estate sector in these countries. Apart from the countries that are mentioned here that have listed REITs, there are many other countries like India, China, Philippines, Brazil etc who are contemplating the introduction of REITs.

Recent Trends in the Global Real Estate Market

Globally, the real estate sector is facing a severe downturn in contrast to the frenzy of bullish activities it had witnessed since 2003 due to cheap credit. The downturn started with the subprime crisis in the US that has resulted in global financial meltdown and eventually has affected the real estate markets world over.

The boom in the US housing, lending, and construction markets was sustained due to aggressive lending by banks and financial institutes in the form of loans given to consumers who could not afford mortgages. In due course the defaults of these customers increased and subsequently there was a downfall in the real estate market.

United States

The US real estate market experienced a boom during early years of the 21st century. During this period house prices in the US witnessed steep appreciation, which fuelled the growth of the non-prime mortgage market. Factors such as low interest rates along with low unemployment had increased sub-prime credit (loans given to sub-prime borrowers, defined as those with lesser ability to pay). However, from 2005, house price appreciation began to decelerate and interest rates started to increase. By 2007 house prices had declined considerably and there was a rise in mortgage delinquencies and also securities backed with subprime mortgages, widely held by financial firms. These firms lost most of their value, which eventually led to the subprime crisis. The sub-prime mortgage crisis that became apparent since 2007 caused property prices to plunge in the US. The data released by Office of Federal Housing Enterprise Oversight, US shows that the house prices in US which were on high in 2005 started declining in second quarter of 2007 as a result of sub-prime meltdown. The prices were at lowest in the third quarter of 2008 where it showed a negative growth of 2.55%. Although there is a slight moderation in the fall in fourth quarter of 2008, it still is in negative zone and does not yet point towards a strong recovery.

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The mortgage led financial crisis wherein banks across the US and abroad made billions of dollar of losses spiraled into an economic crisis in the US. The resultant job losses (as per the US Labour Bureau, since Feb 2008 till Feb 2009, the number of unemployed persons had increased by about 5.0 mn), decline in consumer spending, increase in risk aversion among customers and tighter lending conditions led to a strong decline in demand for housing as well as other commercial real estate assets in the US.

The US housing conditions continued to worsen in 2008. Residential investment continued to drop for the twelfth quarter in a row (q-o-q basis); in the fourth quarter of 2008, these investments declined by 22.2%, thereby reflecting the decline in housing demand. According to the Housing Census Bureau, Housing Starts that indicate the number of new privately-owned housing units started, and housing re-sales in the US recorded unprecedented lows by the end of 2008 as compared with 2005-06, when these rates were at their peak. Housing Starts tumbled further to a record low of only 466,000 annualised units in Jan 2009. Significant job losses in the US economy, particularly in office space-using sectors such as financial services and real estate, and also job losses in the manufacturing and construction not only decreased demand for office and industrial space but also flattened their rents. Besides, retail construction, which is a key demand driver for new shopping malls and discretionary spending, has also stalled in many parts of the US along with the slump in homebuilding. The ongoing recession has made the US real estate less attractive to foreign investors in the short run.

Europe

After a long period of robustness, most European real estate markets are experiencing tough times. The unprecedented rise in commodity price that pushed up interest rates followed by a credit crunch has adversely affected the real estate markets in Europe. Lower interest rates and easy mortgage credit terms had supported the recent boom in most European housing markets. However, currently, the European housing markets are facing problems due to turmoil in financial markets and the ensuing recession. Declining investment volumes in the real estate market and tighter lending terms is reflective of the downturn in the real estate markets in most of the European countries. In fact, construction activity (GDP) witnessed negative growth in last three quarters of 2008. Also, with slowing demand and drying up of sources of fund raising, many projects have been put on hold, which could have contributed to slowdown in construction activity. The ongoing financial crisis has particularly affected the commercial office property market, as companies in the financial sector occupy a significant portion of the office space. The economic downturn witnessed in most European countries and consequent job losses have affected the demand for the housing sector in most parts of Europe. Moreover, the rising mortgage costs throughout 2007 and 2008 have also affected Europe’s housing markets.

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Due to the ongoing slowdown, the house prices in UK have been falling since the third quarter of 2007 and have registered a negative growth in 2008. The latest data from UK’s Communities and Local Government index indicates that the UK house prices in Feb 2009 were 12.3% lower than Feb 2008 owing to a decrease in average prices of flats, terraced houses, detached houses, semi-detached houses and bungalows.

Asia Pacific

Since 2005 foreign investments in the Asia-Pacific real estate markets grew impressively, and pushed up demand and prices to higher levels. However, the slowdown in the global market affected the real estate sector all over the world. Asia-Pacific, the fastest growing real estate market has been experiencing a fall in demand along with falling prices of the residential units. Rising inflation and uncertainty of jobs have kept a number of buyers off the property market, thus affecting demand. In the meanwhile, the demand for luxurious residential properties, which surged due to the presence of expatriates from MNCs attracted into many countries within the region, also declined due to the global slowdown. These MNCs cut down on their operations and expansions, which eventually axed demand for luxury housing. The residential properties in these geographic areas are also experiencing falling rental rates on account of global deceleration. Further, as most companies are deferring their recruitment and expansion plans, the demand for office space is going to be significantly affected in the Asia-Pacific markets.

Moreover, the declining spending power of consumers has affected footfall in malls; as a result, the region that once saw a tremendous growth in retail space is experiencing a slowdown and rise in vacancy rates at malls.

United Arab Emirates (UAE)

In the UAE new multi-use mega projects are unveiled frequently. More than 60% of the Gulf’s mega projects are undertaken in the UAE, particularly in Dubai. Be it the tallest tower in the world (the Sky Tower), the largest mall (Mall of Arabia) or even the largest group of man-made islands in the shape of Palm or the World, Dubai has been the forerunner in the real estate sector. So far, the tremendous growth in the UAE’s real estate sector was driven by strong economic growth, rising oil prices, lack of investment avenues, abundant liquidity and relaxation of property laws. Due to liberalisation, many foreign companies have set up operations in the UAE, particularly in Dubai; as a result, there has been huge growth in demand for quality real estate assets. Further, according to the UAE Central Bank, the real estate mortgage loans have gone up from AED 10.60 bn in 2004 to AED 115.74 bn for a period of nine months in Sep 2008. Similarly the credit to construction sector has increased from AED 31.68 bn in 2004 to AED 107.24 bn in the period of nine months in Sep 2008.

However, the global slowdown has not spared the flourishing Gulf country as well whose real estate sector grew robustly in the past few years. According to Morgan Stanley the real estate market in Dubai is experiencing a slowdown with property prices falling by an average 25%. It also says that around USD 263 bn worth of projects have been cancelled or put on hold in the UAE. The UAE real estate sector is going through a difficult phase with builders either stalling or scaling down the projects and banks tightening the credit norms.

The Indian Real Estate Market

Over the past few years the real estate sector has emerged as the second-largest employer in the economy with backward and forward linkages to a number of ancillary sectors like steel, timber, brick, building material, and cement. Real estate has been one of the fastest growing sectors in India and has experienced tremendous growth in last five years, primarily driven by the commercial and retail segments. According to ASSOCHAM and the Investment Commission of India, the sector has been growing by 30% with returns in the range of 20-30% with, the domestic real estate market reaching around USD 14 bn in 2007. Despite the current slowdown, the sector is estimated to grow at a CAGR of 26.19% to USD 90 bn by 2015 according to ASSOCHAM. This indicates towards the fact that even though currently the sector is undergoing a slowdown, the long-term outlook of the sector is robust.

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The real estate sector in India has been an attractive investment option for global developers due to the higher returns it offered. Several foreign developers primarily from Europe, South East Asia and Middle East have entered into strategic tie-ups with Indian companies during the last couple of years.

Structure of the Indian Real Estate Sector

Real estate can be segmented into organised and unorganised sector where the unorganised sector commands around 70% of the market share.

The unorganised players are characterised by contractors and small builders who generally have only regional presence while organised players include private real estate developers and government affiliated entities. India’s real estate market can be classified into three segments: Residential, Commercial and Retail. These three segments have witnessed rapid growth in the past few years and have a tremendous growth potential. The commercial segment is further divided into office space, hospitality, and industrial space.

Residential Segment

The residential real estate segment is highly unorganised and fragmented and accounts for around 75% of the total turnover of the real estate sector in India. The segment is categorised into premium housing, mid-market, and low-cost housing. In recent years, maximum number of developments has taken place in the premium housing segment. The residential segment has been experiencing tremendous growth in the past few years. It has seen major transformation from its initial days of unplanned development to the present times when majority of players are introducing planned townships with enhanced product offerings. The segment is also characterised by increasing investments and growing FDI. However, much of this high growth was seen in the higher income (premium) category as developers primarily focused on this category and neglected the middle and lower income groups. Further, this development was majorly concentrated in the tier 1/metro cities. Nevertheless, the slackening demand in premium housing and changing dynamics of the business propelled by the global slowdown, falling stock markets and inflation compelled developers to shift their focus to development of housing units for the middle and low-income group categories which faced a shortage of affordable housing as well as in tier 1 and tier 2 cities; as a result, there has been a spurt in real estate projects in these cities with the regional players expanding their presence across India.

Commercial Segment

The commercial segment includes commercial offices, IT parks, and trading spaces such as hotels, and restaurants, industrial buildings such as factories, government buildings, and special economic zones (SEZs). The outsourcing boom coupled with economic uptrend has created a huge demand for office space in India and this in turn has boosted the commercial real estate segment. Further, the hospitality sector is experiencing tremendous growth in India on account of increased domestic as well as foreign tourists. The surge in number of travellers, both leisure and business, has fuelled demand for hotel rooms. Further, the FDI policy that has permitted 100% investment through the automatic route in hotels and tourism has attracted several international hotel chains. According to the Ministry of Tourism, currently India has 110,000 rooms but there is a shortage of around 150,000 rooms and this demand-supply gap is expected to further boost the demand for real estate in this segment.

Currently many SEZ projects are either complete or are in progress. As the fiscal benefits on the IT parks are expected to end in 2009, the construction of SEZs is on full swing and many developers are planning to construct SEZs. There are around 552 formally-approved SEZs in India, out of which 274 are notified since the SEZ Act came into force in 2005. Out of these, the IT/ITeS parks account for around 61% of the formally-approved and 66% of the notified SEZs. The development of SEZs attracts both corporate houses as well as developers. However, with the companies, particularly the IT & ITeS sector, differing their expansion plans due to the current economic conditions this sector is experiencing a slowdown in demand.

Retail Segment

The retail segment has undergone a major transformation as unorganised players have given way to the organised sector (malls and multiplexes) gradually. The Indian organised retail sector has good growth prospects and hence prominent corporate houses have entered this segment under multiple retail formats and have announced major expansion plans. Moreover, many international players have entered the segment and some more have plans to set up operations in India. Some of the retail formats operational in India are specialty stores, department stores, supermarkets/convenience stores, hypermarkets and discount stores.

Over the past few years, the organised retail space has expanded rapidly. According to ASSOCHAM the organised retailers occupied a space of around 1 mn sq ft in 2002, which shot up to nearly 14 mn sq ft in just 5 years in 2007. The number of retail outlets in the organised sector in 2001 was around 3,000 and it covered an area of about 3 mn sq ft. In 2006, the number of outlets grew to around 27,000 covering an area of 31 mn sq ft. Further, a number of big retailers had lined up expansion plans and had geared up to tap new markets however, the current crises is expected to act as a dampener for these expansions plans. The retailers are now turning their focus on tier II and tier III cities and are also focusing on rural areas. Many corporates have opened rural malls like Chaupal Sagar (ITC), Aadhaar (Godrej) and Hariyali Bazaars (DCM Sriram - focusing mainly on agri products) where the aim is to cater and to leverage the opportunity available at the bottom of the pyramid. This is fueling the demand for retail real estate.

Demand Drivers

The real estate boom, led by economic growth, has been driven by interplay of several factors. The demand drivers of each segment have been discussed below:

Residential Segment

The residential segment is the largest segment in the real estate sector and is expected to remain so for some time. Changing income levels and higher disposable incomes are driving people to buy a new house or a second home, which is driving demand in the residential sector. Further, the sector is also witnessing growth on account of the growing trend of nuclear families. The increasing pace of urbanisation in search of better opportunities is yet another demand driver. Moreover, the tax incentive extended by the government on housing loans has prompted people to buy a property on loan. This phenomenon was further supported by easier access to finance and longer loan tenures.

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According to the recent United Nations Population Fund Report, the population living in the urban areas is slated to grow to 40% (approximately 590 mn) by 2030 from the current 28%, which will fuel the real estate growth. Further, according to the 2001 Census, for a requirement of 55.8 mn urban households, India had a housing stock of only 50.95 mn, implying a demand-supply gap of 5 mn units. According to a report submitted by a Technical Group on Estimation of Urban Housing Shortage constituted by the Central Government, the housing shortage in 2007 was around 24.71 mn units and the shortage during the entire Eleventh 5-year Plan is estimated to be around 26.53 mn dwelling units. This demand-supply gap is expected to provide further impetus to the residential real estate as developers and government entities try to bridge this gap in future. The Indian SEZ Act allows 65% non-processing development that includes housing and other support infrastructure, which has further boosted the residential segment within the various SEZs coming up in the country. According to the Ministry of Commerce, the total investment in the notified, state/private SEZs set up before 2006 and government SEZs was around Rs 935 bn as on Sep 30, 2008.

Commercial Segment

The office space dominates the total demand in the commercial segment driven by a number of factors like growth in the IT and ITeS sector. According to Nasscom, the IT and ITeS sector accounts for almost 75% to 80% of the total office space absorption, which makes it the primary demand driver. Today, India is a preferred destination for outsourcing; therefore new companies are setting up operations and are pushing up demand for office space. Further, economic growth has set the banking and financial services sector in India on a higher growth trajectory, in turn generating demand for office space. Locations like Bengaluru, Chennai, Hyderabad, Noida, and Gurgaon are emerging commercial destinations apart from the traditional centres like Mumbai and Delhi.

Economic and industrial growth and the resultant expansionary business trends have rapidly accelerated business travel, and fuelled demand for hotel rooms. Likewise, the government’s efforts to promote India as a tourist destination for domestic as well as international tourism, and the rising levels of disposable income of Indians has boosted the demand for hotels/resorts etc.

The emergence of low-cost airlines in India has made traveling easier and cheaper and has provided the much-needed impetus to the leisure and business travel, and in turn has also fuelled demand for hotel rooms. India is also fast catching up as a preferred destination for medical tourism owing to its high-quality healthcare services and low-cost advantage. The country is seeing an increase in the number of well-equipped hospitals, wellness spas etc. This thriving medical tourism segment has also boosted the demand for hotel rooms.

The Special Economic Zones (SEZs) Act 2005 has also boosted the real estate sector. Fiscal incentives offered by the government are expected to attract greater investments from the real estate developers towards developing SEZs. With the facilities and incentives available to the units in SEZs providing impetus to the demand for commercial space, most of the investment by real estate developers in SEZ would be targeted at constructing commercial and office spaces to accommodate the companies setting up operations in SEZs. The developers are expected to save on cost of construction and also benefit from lease rentals once the projects are completed.

Retail Segment

Retail is undoubtedly one of the most prospective sectors in India in terms of sheer growth potential. There are a number of factors that are responsible for the growth of the sector.

Changing consumer preferences and lifestyle have played a key role in driving demand in this sector. There has been tremendous growth in the personal disposable income of the Indian consumers over the past few years; as a result the Indian consumer has more money to spend on discretionary items such as clothing, footwear, entertainment and leisure activities. This is one of the primary reasons for growth in retail. Rising income level has also raised the standard of living of the people and has led to an increased demand for branded and lifestyle products, which in turn has fuelled demand for retail outlets. Further the partial relaxation in FDI regulation (51% FDI in single brand retailing) has attracted many international retailers (like Wal-Mart, Shoprite, Tesco, Metro etc) to the country and has boosted the retail segment growth. The increasing trend in organised retail and the entry of many global brands in the Indian market are the main demand drivers in the retail real estate space.

The rising level of disposable income coupled with demographic changes has also propelled demand for multiplexes, which is further supported by the entertainment tax benefits for multiplex cinema developers.

Supply Scenario

The real estate sector in India is currently dominated by a number of small players and is largely unorganised. The sector is characterised by higher prices, smaller size, and shortage of good quality space. The Housing Boards of each state and state-owned development bodies largely control the supply of urban land in respective areas.

The availability of surplus land and the emergence of knowledge industries have made the major metro cities an attractive destination for real estate development. A number of residential and commercial projects have been coming up in these regions facilitating the residential and the office segment. In the residential space, the supply is largely in the form of townships, whereas in the commercial space, supply is mainly in the form of integrated campuses, IT parks, and SEZs. Regional developers dominated the supply of the residential as well as the office and retail space in these areas. As the population grew and the rate of migration increased in the nearby areas of these metro cities (most commonly known as satellite cities) the developers started focusing on these areas to supply housing units.

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Although the supply of office space was majorly concentrated in metro cities, the shifting focus of the major IT companies to the tier II and tier III cities compelled developers to expand their horizons and look beyond tier I cities. Owing to this, the supply of office space in these cities increased sharply and in turn boosted the demand and the subsequent supply of residential units. The development of SEZs in various states has also boosted the supply of office space in the last couple of years.

The Indian hospitality sector has got a fillip due to the sustained growth in number of tourists - both, domestic as well as international and also the rise in the number of business travelers. This phenomenon is further supported with the entry of low cost airlines which changed the skyline of the tourism industry in India boosting the demand for hotel rooms across all categories. According to the Ministry of Tourism, Government of India, the supply of hotel has seen a considerable growth since 2005. The total number of hotels (all categories) grew from 1,190 in 2005 to 1,297 in 2007. Similarly the number of rooms in all categories of hotels increased from 67,631 in 2005 to 83,316 in 2007.

According to ASSOCHAM, currently the organised retail real estate covers an area of around 40 mn sq ft and generates a business of USD 4 bn. The space requirement is further expected to go up to 22 mn sq ft and a size of USD 22 bn by 2010.

However, owing to the slowdown in the economy, investment1 plan in the real estate sector dropped from a high of Rs 1,153 bn in the first quarter of FY09 to just Rs 225 bn in the third quarter of the same fiscal. The global financial crisis, credit tightening measures and high interest rates has resulted in decline in real estate investment plans. Developers are shying away from making huge investments owing to subdued demand. According to ASSOCHAM, the real estate sector witnessed a 50% deceleration in demand which pulled prices down by around 15% to 20% during the first 3 quarters of FY09.

In the first quarter of FY09, 16 projects worth Rs 1,153 bn were announced but the number of projects came down to 10 in the second quarter and to 11 in the third quarter of the same fiscal owing to the economic slowdown.

According to ASSOCHAM, currently around 40 mn sq ft of organised retail real estate space is available in India and an addition of around 100 mn sq ft is expected by the end of FY09 from over 300 mall projects. The Ministry of Tourism forecasts that the total number of hotel rooms in 2010 and 2020 will be around 2.9 mn and 6.6 mn, respectively.

In a significant move, the Urban Land Ceiling Act (ULCRA) was repealed in some states, and this move is expected to bring in some large land parcels for development. However, the impact of this on land prices remains to be seen. Also, it is expected that the repealing of ULCRA will encourage public sector units or companies that own large tracts of land to make available their land for commercial development, which will increase supply of commercial land. 1

Key Government Policies

Repealing of ULCRA - The real estate sector in India is heavily governed by Central and State Government laws. The sector has largely remained unorganised due to these regulations. An important law that governed the real estate sector was the ULCRA Act, 1976. Under this Act individuals were prohibited from owning more than 500 sq mtrs of land. Any excess land owned by individuals over the stipulated ceiling was acquired by the government. However, the Act was repealed by ULCRA Repeal Act, 1999 in most of the states in order to free up the locked urban land for development, fuelling growth in the real estate sector. The Repeal Act is in force in Gujarat, Haryana, Karnataka, Maharashtra, Madhya Pradesh, Orissa, Punjab, Rajasthan, and Uttar Pradesh. However, ULCRA is still in force in Andhra Pradesh, Assam, Bihar and West Bengal.

It is estimated that the repealing of the Act has freed up approximately 2,00,000 hectares of land for development creating a huge opportunity for the real estate developers.

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SEZ Act 2005 - The Special Economic Zones (SEZs) Act 2005 has further boosted the real estate sector. The Act laid down the regulatory framework and rules for setting up and operation of SEZs. With extended tax holidays up to 15 years — from the previous tax holiday of 10 years — the SEZ Act managed to generate considerable level of interest among developers and investors; as a result, the number of SEZs witnessed a sharp rise in a matter of a few years. The Act envisages promoting exports of goods and services, promotion of FDI, creating employment, generating economic activity, and most importantly, developing infrastructure. In order to attract investors and builders towards development of SEZs, the government (through the Ministry of Commerce & Industry) has laid down several incentives, like 100% income tax exemption on export income, exemption from minimum alternate tax, service tax, dividend distribution tax and central sales tax, duty free import/domestic procurement of goods, single window clearance and exemption from customs/excise duties for development of SEZs.

Foreign Direct Investment - In 2005, the government allowed 100% foreign investments through the automatic route in housing, townships construction, and infrastructure projects. The relaxation of FDI norms, initiatives like Real Estate Mutual Funds (REMF) and the drive to raise capital through IPO has helped the developers to improve their transparency as well as liquidity position and thereby attract foreign investors. These initiatives are likely to increase capital supply over the period and will eventually lead to large-scale developments, which will reduce the demand-supply mismatch. Nonetheless, for FDI investments, minimum capitalisation of USD 10 mn for wholly-owned subsidiaries and USD 5 mn for joint ventures is mandatory. The liberalisation of FDI norms has encouraged foreign developers to enter the country, which has boosted the residential and commercial construction.

Apart from these Acts, which proved to be a booster to the real estate sector, other Acts governing the sector are Transfer of Property (TP) Act, Registration Act, Land Acquisition Act, 1894, Rent Control Act, and The Indian Stamp Act.

Sources of Funding

Real estate developers have been aggressively expanding their operations by announcing projects like large residential townships, IT parks, mega retail projects, and SEZs. While most part of the residential project is funded by advances taken from customers in terms of booking amounts etc., the large commercial projects need external funds. Lately, alternative sources of funds like FDI and real estate funds have emerged along with the private equity players. Some of the sources of funds are discussed below:

Bank Loans

Bank loans were the most favoured option for funding for the developers. The total bank lending to the real estate sector has been increasing steadily. According to the RBI, gross bank lending to the real estate sector has increased from Rs 135 bn in FY05 to Rs 623 bn in FY08.

The private sector banks with a share of 45% had the largest exposure to real estate sectors (inclusive of both direct and indirect lending) as at end-Mar 2008 in terms of their share in total loans and advances, which was closely followed by foreign banks (23%) and public sector banks (15%). However, the RBI has been monitoring the growth in lending to the real estate sector. As a result, the risk weight on commercial real estate exposure was increased from 125% in Jul 2005 to 150% in May 2006, which resulted in deceleration in real estate loans. Further, to mitigate the concern raised due to high credit growth and to maintain the asset quality, the RBI raised the provisioning requirements for the real estate sector. The provisioning requirements on the residential housing loans beyond Rs 20 mn and commercial real estate loans were raised from 0.4% to 1.0% in May 2006 and further to 2% in Jan 2007.

As a result of these policy measures taken by the RBI to control overheating of the real estate sector, the growth of banks’ lending to the sector decelerated from 80% at end-Mar 2006 to 42.3% at end-Mar 2007 and further to 19.8% at end-Mar 2008. This has put constraints on real estate funding compelling the developers to turn to other sources of funds.

Foreign Direct Investment (FDI) Policy

The new FDI policy passed in 2005 that allowed 100% FDI in real estate has prompted international developers (like Emaar Group from Dubai) to enter the Indian market and reap the benefits of this booming sector. The real estate sector witnessed stupendous growth and was one of the sectors that received highest FDI equity inflows in FY07. According to the Department of Industrial Policy and Promotion (DIPP), the FDI inflows to the sector increased from USD 38 mn in FY06 to an astounding USD 467 mn in FY07 and further to USD 2179 mn in FY08. Further, the FDI inflow in the real estate sector for the 10-month period from Apr 2008 to Jan 2009 was USD 2,408 mn.

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FDI is allowed in development of housing, townships, hotels and resorts, commercial premises, educational institutions, hospitals, infrastructure, and construction development projects. This has enabled Indian developers to tie up with foreign players (like Emaar Group from Dubai, Evan Lim from Singapore, Edaw Ltd from the US) and raise capital for projects. However, there are certain guidelines for foreign investors willing to invest in real estate sector.

Initial Public Offer (IPO)

Over the past few years real estate companies have been tapping the equity markets to raise funds. During the equity market boom, several real estate and construction companies listed themselves on the Indian stock exchanges through initial public offer (IPO). During the past couple of years prominent developers like DLF, Kolte Patil, Purvankara, Sobha, DS Kulkarni, Mahindra Lifespace, Omaxe, and Parsavnath have released their public issues. However, with equity market conditions being sober and subdued demand for real estate, this avenue of funding has all but disappeared for developers.

Apart from the options mentioned above, the other funding options that developers regularly tapped include private equity, venture capital funds, Real Estate Mutual Funds (REMFs), Alternative Investment Market (AIM), Singapore Stock Exchange, Dubai International Financial Exchange, and Qualified Institutional Investors (QIPs).

However, the changing dynamics of the business in the current scenario and the tightening of credit flow by banks have compelled developers to look at alternative funding arrangements. An emerging source of funding for developers is lease discounting or lease rental discounting (LRD), which is typically used to fund ongoing commercial projects. Under LRD the banks lend to developers against the future rent that they plan to receive from leasing out their commercial properties. LRD is a safer mode of lending for banks as the property is also mortgaged with the bank along with an LRD agreement, which assures the bank a guaranteed return.

Issues and Challenges

High Stamp Duty

The real estate sector in India is plagued by many drawbacks. The most important one is the high stamp duty rates. The stamp duty in India is not uniform and varies from state to state (14.5% in Uttar Pradesh and 12.5% in Haryana) ranging between 10-15%. According to the Planning Commission of India, the rate of stamp duty is one of highest in India as compared to most developed countries like Singapore and Europe where the duty ranges between 1% to 2%. In some cases states levy double stamp duty, first on the land and then on its development.

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Due to this, many transactions are unregistered and properties get transferred through the power of attorney route, which results in huge revenue losses for the government.

Fluctuating Prices of Raw Material

The changing or fluctuating cost of raw materials is another challenge that the developers face. During the phase of implementing a project, the developers are dependent on many components such as steel, cement, wood, sand, gravel, bricks and paints. Any adverse movement in prices of these raw materials puts pressure on developer’s margins.

Access to Funds

On account of the ongoing slowdown in the economy the biggest challenge faced by developers is access to funds. The companies in the real estate sector have leveraged substantially over the last 2 to 3 years. Their expansion plans were primarily funded by short-term debts. In the near future, these developers will face debt redemptions; however, now that the banks have become cautious in lending to the real estate sector, raising capital is a big challenge for the developers. Further, during robust times, developers had acquired lands at exorbitant prices to build their land banks but the slowdown has decelerated land prices drastically and developers are not able to sell these parcels of land at the same cost that they purchased it. In the current slowdown, many buyers who had booked the flats at peak rates are now rethinking their decision to buy and are even demanding a refund from the builders, which is further exerting financial pressure on the builders. In such a scenario, the developers who are not equipped to handle these challenges will struggle to survive, in which case the sector will see consolidation, as these developers will merge or sell their business to other strong players in the market. However, in-spite of these challenges, the sector has outperformed in the last couple of years and has provided high returns to investors.

Recent Developments

Real estate prices rose sharply beginning 2005 and have been on the growth trajectory ever since. However, currently the real estate sector is facing a crisis on account of slackening demand, increasing input costs, and rising interest rates due to the slowdown in the economy. The recent slowdown in business volume has affected the expansion plans of builders and has put severe pressure on their cash flows. The slowing economy along with job uncertainty and pay cuts has compelled buyers to cancel or postpone their plans of buying residential property, thus slowing down demand in the residential segment. Similarly, demand for office space has been severely affected due to freezing of recruitment and expansion plans by many companies, particularly IT and ITeS companies who are the biggest buyers of real estate. The retail segment is also under tremendous pressure due to the slowdown in demand across the board; many companies have shut some retail outlets, thus increasing vacancy rates in malls. Overall, the weakening economy has adversely affected all three segments of the real estate sector.

The Indian government, the RBI, and the Indian Banks' Association (IBA) undertook several measures to revive the real estate sector. Some of the measures that were taken between Dec 2008 to Jan 2009 are mentioned below:

These initiatives are expected to boost demand and address the credit needs of the sector. The measures will help to restore customer confidence in the sector.

 

1 ASSOCHAM

 

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