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Stemming the rot

Business

Sachin Sandhir, MD & Country Head, RICS India, stresses on the significance of setting up and upholding the highest standards of excellence and integrity in the real estate and construction industry in India

Before talking about the need for standards in the real estate and construction industry, let’s try and understand how the US subprime crisis, which triggered off the global economic crisis, originated.

It started with a customer applying for a house loan through a mortgage broker and receiving approval in spite of being ineligible for the mortgage. The customer lacked the initial money required for down payment and was unsure of keeping up with regular EMIs.

The broker assured him that as house prices always go up, there was no need for a down payment. He was offered an adjustable rate mortgage with very low interest rate upfront without any income check or verifications.

The customer was happy and so was the broker as the latter didn’t really care about the customer’ ability to pay back the loan.

All he was concerned about was earning his brokerage.

While bankers extended credit with many such house loans, they realised these were bad loans which needed to be sold and relieved from the balance sheet.

They reached out to the investment bankers who created a security with these mortgages as collateral, called CDO (Collateralised Debt Obligations).

A number of these bad loans were pooled together (assuming that all loans would not default at the same time) and sold to investors who bought these on the presumption that they would get their returns as the mortgages get paid.

 

Going by the market sentiment that housing prices always go up, the investors like insurance companies and banks felt no need to worry.

In reality no one truly understood the underlying collateral and worked on the assumption that someone else had done the job. Investors relied on the credit ratings of the rating agency which interestingly is paid by the investment banks.

And then reality struck. Customers who couldn’t afford to pay the EMIs actually did not pay up. This resulted in huge bad debts and losses which affected everyone in the financial services sector. People realised that the assumption ‘housing prices always go up’ was a bad one. The banks learnt it the hard way.

Clearly, everyone in the mortgage industry had their own agenda. In their quest to become the biggest bank and gather higher returns, a nexus of entities created a financial mess, which shook the global financial system and plunged economies into recession.

Are there any learning’s for the Indian real estate and construction industry here?

While India has been somewhat insulated from the aftermath and our economy is still expected to grow at 6.5%, the booming Indian real estate industry, long known for unscrupulous practices, has started to feel the consequences of unsustainable practices of a few industry players.

In their hunger for capturing a higher market share, the developers, much like the US brokers and bankers, turned and twisted industry practices in their favour, assisted by the laxities in the existing regulatory framework and other challenges such as lack of transparency and reporting.

Bring in clarity

As most of us are aware, the real estate market in India is unorganised, fragmented and governed by archaic laws.

Some developers have also often been known to deal with large amounts of unaccounted money, obviating transparency and using unscrupulous means to acquire a variety of regulatory approvals.

Common areas with a lack of clarity include the number and size of projects being executed, the end use of advances given by buyers and the nature of consolidated debts and fund flows within the property group. The mushrooming of fly-by-night property players has exacerbated the problems.

The absence of an industry regulatory body, lack of transparency in land bank titles, absence of established standards for valuation and accounting of land and property have given rise to disputes pertaining to valuation of real estate companies and market value of land banks.

Such an environment leaves room for tweaking project valuations in their favour. As an example, let’s consider the following trend in valuation wherein the promoters of the project completely de-risk the business at net present value (NPV).

A group of companies raise money at the project conceptualisation stage and value it at NPV of the completed project to raise money for land acquisition and completion the project.

It is believed that in such cases the promoters transfer a majority of the risk to a new set of investors by diluting a small minority stake, while retaining the majority. An example of this is companies displaying the new land acquisitions in their land bank and raising money at the time when they have just signed an agreement for buying the land by paying the token money.

At this point, in the absence of any check, the discounting rates used for calculation of the NPV widely vary to suit individual interests.

In light of this example, there is virtually a situation of must-have standard techniques and procedures for property evaluation in India, that developers or real estate agents need to adopt to derive the current market value of a property. 

 

When realtors came to play

While the credit crunch was unprecedented, the realty sector was heading for a cyclical slowdown even before the economic slump. Over the last few years, increasing demand had pushed up prices, with speculations leading to further inflation.

Inventory piled up as buyers refused to pay unrealistically high prices. Many transactions took place between speculators and investors without any limit to the amount a customer would be willing to pay.

Gradually the slowdown in demand saw inflation move into double digits earlier this year, while raising construction material prices. Realtors overshot their budgets and projects had to be stalled.

The liquidity squeeze followed as the government sponged away cash from the system to control inflation. With increase in home loan rates, people struggled to pay installments and potential buyers stayed away.

In a nutshell, oversupply, coupled with a reduction in customer advances on new construction, increasing land values, rising interest rates and increased difficulty in arranging capital added to the industry’s woes.

The key to success

While it may not be incorrect to state that the market correction was inevitable, irrespective of the global crisis, existing industry characteristics pose a threat to the industry which could be headed towards a much bigger crisis (similar to the subprime crisis) in the years to come, if stringent actions are not taken.

Although some corrective measures have been initiated, a lot needs to be done. Apart from the regulatory reforms that are required such as modifications in land laws and rationalisation of stamp duties, industry standards addressing key challenges need to be set and streamlined.

Moreover, India has inadequate data on the real estate sector. No one tracks housing starts, an indicator that is regarded in many countries as an important yardstick of economic health.

An institutional mechanism to review professional standards, education and training requirements ought to be created. We need to set up a reliable industry-wide database and computerise land records to provide industry players with accurate information.

Equally needed are standard valuation techniques (which are at par with international valuation standards) and a professional valuation body. An awareness of internationally recognised best practices such as construction standards, quality safeguards and guarantees, design and technology, and green environment and sustainability will help developers gearing up to manage large projects than they have been exposed to.

The expert valuation has to be based on recognised professional courses of study, certified by a statutory body. At the same time, valuers need to adhere to a proper code of professional conduct with an institutional mechanism for review and discipline in cases of misconduct. Education and training requirements in valuations need to be standardised along with valuation methodologies and reporting formats.

With rising construction demand and lack of skilled labour supply, it will be critical to impart relevant education and training through specialised institutions and vocational courses. To prevent future malpractices, setting up of a grading system for developers as well as certification of developers and brokers will go a long way in instilling customer confidence.

 

Setting future trends

While the cyclical market correction will continue to create temporary turbulence possibly over the next year, once this phase ends, land and property prices will be corrected to rational levels and the sector will have stronger fundamentals. The demand is bound to rise driven by a large, young workforce, a high rate of consumer and private-sector savings.

The current middle class population of 260 million is expected to increase to 600 million over the next three years, pushing up infrastructure demand. Self regulation coupled with gradual government regulatory reforms, presence of a professional valuation body and exposure to international standards and best practices will determine whether the industry realises its potential or falls prey to yet another and possibly bigger crisis.

Founding Fathers

Rohin R Shah, MSc, FRICS and Managing Director, Meghraj Properties Limited
Pranay Vakil, FRICS and Executive Chairman, Knight Frank India
Anuj Puri, FRICS and Chairman & Country Head Jones Lang LaSalle Meghraj
Anshuman Magazine, FRICS and Managing Director, CBRE – South Asia
Verendra Singh, FRICS and Director – Technical Operations, Currie & Brown
Nimish Gupta, FRICS and CEO, Eigen Technical Services Pvt Ltd

Who we are

The Royal Institution of Chartered Surveyors (RICS) provides the world’s leading qualification in professional recognition of land, property and construction. In a world where more people, governments, banks and commercial organisations demand certainty of professional standards and ethics, attaining RICS status is the recognised mark of property professionalism. RICS is an independent professional body originally established in the UK by Royal Charter.

RICS India offers membership to those professionals working at the highest levels of land, real estate, and construction sectors. It is a unique organisation bringing together the different skills involved in real estate decision making. It provides a globally recognised brand to represent the highest professional standards, in-depth knowledge, and competency.

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