Indian residential real estate sector is currently witnessing a significant consolidation phase. Along with sluggish sales and supply overhang being faced by the industry; multiple external forces are threatening to change the residential development model forever. Players who are flexible and are willing to recognize these forces while also learning their lessons from the current downturn are likely to survive the turmoil and emerge as potential winners when the next bullish phase in the industry commences.
Respect the cyclicity: Real estate industry is cyclical in nature and this should be accounted for while formulating business plans and projecting the future sales velocities and cash flows in a project. In last 20 years itself, starting with a downturn, the industry has witnessed two complete cycles comprising two phases of distress with each followed by a bullish phase. We are currently in the middle of third cycle with the current downturn already about three years old.
The expected prolonged length of current downturn notwithstanding, each phase (bearish or bullish) has typically lasted for an average of 3-5 years. Recognition for cyclicity would mean conservative sales velocity projections and creating adequate margin of safety in future cash flow realizations, especially for larger projects where the execution and sales could last for 7-10 years.
Actual financial closure is critical: Technically, financial closure is achieved when the total project cost in terms of land, regulatory approvals, manpower, raw material, etc. is balanced with the sources of finance in the form of promoter contribution, external equity, debt and some amount of internal accruals from the project. Problem arises when financial closure unrealistically put heavy reliance on internal accrual based on aggressive sales velocity and product pricing. Later, in the absence of such sales realization, especially in sluggish market conditions, such unrealistic projections could lead to execution delays due to cash flow shortage eventually causing a desperate fallback upon high cost debt. In the period of prolonged slowdown, such situations could spell disaster leading to project falling into debt trap, a complete erosion of developer margin, project coming to a grinding halt and customer litigation. Conservative financial closure plans keep minimal allowance for customer receipt while relying heavily on other means of finance at the business planning stage itself.
Minimize financial leverage: A typical project requires debt to reach financial closure and to reduce the cost of capital as debt is always cheaper than equity. A high financial leverage is expected to amplify financial return to promoter during high growth phases but could prove to be quite disastrous during stagnation as debt is a fixed liability and its servicing or repayment are never linked to a decline in project profits. This is especially true for a business which is prone to cyclicity and which suffer from high operating leverage (ratio of fixed cost to total cost). Since, real estate development business tends to possess both the above characteristics, it should be extremely conservative in relying upon financial leverage for project closure.
Promise only what can be delivered: One of the key reasons for the current slowdown in sales, besides lack of affordability, is a breakdown of trust among the buyers for the developers. The current situation is a result of multiple years of callous attitude displayed by section of developer towards fulfilling promises made to the buyers at the point of sale. These commitments in terms of timelines and quality of product were often broken with impunity. Lengthy and delayed legal remedy only added to the buyer frustration, eventually leading to the trust deficit and current stagnation. There is a great need for developers to market their product transparently. This would help manage customer expectations during the project execution and product delivery stage thereby preventing unnecessary heartburn, litigation and consequent dilution of developer brand equity.
Account for bureaucratic delays in project planning: Many developers, who otherwise would have done well in creating a trust bond with customers through an excellent product delivery often complain about lack of government support. They feel that their projects got stymied due to either delays in the creation of supporting urban infrastructure (e.g. Dwarka Expressway, Gurgaon) or unnecessary hurdles and delays in project approvals and sanctions. Unfortunately, such delays would continue to remain a way of life in India in the foreseeable future as well as it would perhaps require decades of reforms in bureaucracy at the state and local municipal level to be eradicated. Till then, it would be best to create adequate margins of safety in terms of delivery timelines, cost escalations, etc. at the project planning stage itself to ensure the safeguard of reputation with customers.
source:indiatimes
