Real Estate: In search of risk capital

Real Estate: In search of risk capital

( also published in Moneycontrol.com)

The solution to uncertain cash flows, from middle ages to the times of Miller & Modigliani, has come through risk capital.

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Q : Dear Common Man, What is the first thing that comes to your mind when you think of Real Estate Business ?

Ans: Land

Q :  Dear Banker, What is the first thing that comes to your mind when you think of Real Estate Business ?

Ans : Risk

Every human is subjected to gravitational force. Hence, every human craves for his piece of land. Real Estate business caters to this basic need of a common man. And for a banker, this fundamental need for land provides an ocean of opportunity but the risks associated with real estate business restricts his potential. Bankers love businesses with steady cashflows ; the core of Real estate business, however, is uncertain cashflows.

The solution to uncertain cash flows, from middle ages to the times of Miller & Modigliani, has come through risk capital. Be it in the form of seed capital, equity capital, guarantees or otherwise. Risk capital swims and sinks with the fortunes of the entrepreneur and therefore remains an entrepreneur’s true partner.  

While risk of an enterprise generally reduces as business progresses, in real estate business risk has a very unique pattern. Real estate business starts with a piece of land which hardly has any risk  Land can easily be sold or transferred. The end product (whether apartment or bunglow or office) too is equally safe. The problem lies in the middle zone i.e. during the construction phase. A highly valuable asset called land, suddenly becomes a risky asset called ‘land under construction’ and it remains so for the entire duration of the project. The moment completion certificate arrives, the asset again becomes safe.

Such discontinuous risk pattern would ideally call for a sophisticated structure for Risk Capital. But the real estate developers have historically addressed the need for risk capital through a simple product called “bookings from customers (a.k.a. investors)”. While accountants may treat Customer Advances as ‘Short Term Liabilities’, Indian real estate developers have always treated customer advances as quasi equity. Reason being, it was very rare that a developer would actually have to return the money to the customer. Even if he had to, there was hardly any component of interest. Customers would also accept the delay, primarily because of lack of enforcement. And in all likelihood, prices would have increased by the the time apartment was delivered so there was enough room for settlement where no one actually lost money.

Things, however, have changed now. Real estate prices are more volatile than before, the regulation is much stricter now. Both these have increased the business risk for the developer. What makes matter worse for the developer is the fundamental tenet of RERA that the Customer will not take no project related risk has completely changed the game.  Risk that was earlier divided between the developer and the property purchaser, now remains largely with the developer.

In earlier times, Joint Development was a popular structure for reducing developer’s risk since the landlord was paid in terms of area and not as upfront cash. Post RERA, considering larger legal liabilities of all joint developers, landlords are increasingly averse towards Joint Development and prefer upfront cash. For developers, it means larger business risk.

Further, RERA now mandates compulsory registration before the developer can demand more than 10% of the transaction value from the home buyers. Earlier buyers could defer the registration and stamp duty cost or even completely avoid it by reselling it without taking the possession.  This new provision (though well intentioned) has worked towards reducing the glamour quotient of investment in under-construction property. For developers this has meant reduced supply of Risk Capital.

If this was not enough, GST @ 12% is applicable for under-construction property but zero for ready property. By disincentivising purchase of under-construction property, GST has created a big barrier in flow of risk capital to the developer.

In short, the increased business risk now demands large risk capital but the supply of risk capital has actually reduced owning to larger barriers like GST, early stage stamp duty, etc.. Private Equity can hardly address real estate business’ need for risk capital since they invest largely through structured debt.

The dearth of risk capital is normally addressed through spreading the risk over larger investor base. But considering public interest, Regulators are generally cautious towards spreading the risk base. While regulator has been very pro-active when it was the issue of creating financial structures for risk capital for industrial enterprises, the same gusto has been not seen for real estate business. 100 years back, risk capital for industrial enterprises was allowed through the managing agency system; when that outlived its life, regulator worked towards developing capital market ; it then allowed mutual funds, then GDR, then ADR etc. Thus industrial enterprises continuously got their dose of risk capital

The historical bias towards industrial enterprises is understandable considering the employment potential of industries then. But now with, real estate offering huge employment opportunities and also considering the large the need for housing, it is high time the regulator realizes that risk capital is a basic need of real estate business and therefore it is pertinent for it to develop regulation and financial structures that have enough gravitational force to attract large risk capital towards real estate business. The target of Housing for All by 2022 cannot be met alone through debt funds, a proportionate increase in risk capital is a must.