Challenges in real estate project financing under RERA

Nishit Dhruva        Last Updated: September 25, 2017  | 17:32 IST
Challenges in real estate project financing under RERA
Mr. Nishit Dhruva, Managing Partner, MDP & Partners

The Real Estate and construction business inherently requires the investment of capital on a large scale. In Tier-I cities such as Delhi and Mumbai, this is magnified on account of the scarcity and high cost of land. All operations related to the field of the Real Estate business such as purchase of land, payment of premium on land, duties to be paid to the statutory bodies, cost of construction, rehabilitation of old occupants etc. require heavy capital investment. All these expenses are incurred way before the completion of the sale units.

Traditional Funding avenues prior to RERA:

Prior to the Real Estate (Regulation and Development) Act, 2016 coming into force, the usual practice for the builders and developers to raise initial capital was:

1.    Various private investors advancing money to the builders and developers and thereby booking multiple units in the proposed project at a price way below the ongoing market rates.

2.    The builders and developers launching various pre-launch offers and various schemes such as the 20:80 scheme (20% payment made at the time of booking and 80% at the time of possession) whereby the consumers / purchasers used to get sale units allotted in the proposed project in consideration for the payment advanced by them.

However, due to frequent project delays and malpractices by certain developers, the consumer faith in such pre-construction and under construction projects was dwindling. Developers used to accept bookings for projects without the possession of proper sanctioned plans and compliances in order.

RERA - but why?

To prevent such malpractices, restore consumer faith in the real estate sector, regulate the real estate sector and promote transparency within the Real Estate Field, the Real Estate (Regulation and Development) Act, 2016 was introduced.

Regulation of the use of funds specific to the project

One of the major implications of RERA is that the developer will now have to deposit 70% of the proceeds received from a project in a separate account, which can only be used for the earmarked project. This greatly affects the short term liquidity of the developers.

Further, the developers shall not be allowed to sell any units without the prior registration with the regulating authority which prescribes a number of compliances to be followed by the developers prior to the registration of the project.

A direct result of such regulations is that the developers cannot raise the initial capital for the initial stages of a project due to the sale of units being forbidden on account of the above regulations.

As a result, the developers shall have to rely on other avenues to raise the initial capital for their projects. The developer can avail of either debt financing or equity financing or a mix of debt and equity financing to raise the initial capital for their projects. The cash flow generated from the project subsequently can be used to help repay the same.

Developers must adapt to RERA

Funding for real estate projects can be obtained through multiple routes such as banks, non-banking financial institutions, or via external commercial borrowings. Debt investing in real estate is completely different from equity investing. Debt investing focuses on the maximum reduction of risk in order to earn a fixed rate of return wherein the financial institutions would advance funding to the developer against security provided to them by the developer. On the other hand, equity investing seeks to capitalise on maximum opportunities to compensate for the risk of loss on account of the poor business management by the developer. The critical distinction is that the debt investment is backed by a hard asset belonging to the developer as collateral / security, and not just a business plan of what the developer hopes to develop. Developers holding large land banks and other assets that could be given as collateral, would ideally opt for debt financing to ensure that the majority share remains with them.

REITs

REITs (real estate investment trusts) are quasi debt-equity transactions that function in a manner similar to that of mutual funds wherein funding is pooled in from a large group of investors and these funds are then invested in rental properties, offering investors not having the capacity / willingness to part with the large capital required to purchase such rental properties to diversify their investment portfolio.

Transparency in real estate projects

A number of stringent provisions have been introduced by the regulating authority such as declaration of carpet area, display of all project information on the website, display of all approvals etc. that may make investments more attractive to financial institutions. The financial institutions shall find it easier to carry out their due diligence before investing in a project. The project financiers shall find it easier to gather documents and judge the financial viability of a project.

The top tier large scale builders with a substantial project portfolio, a stellar land bank and a good reputation shall find it easier to raise capital by means of funding. However, the relatively smaller players in the real estate field shall find it difficult to get financial institutions to invest in them. A direct result of this shall be that the number of developers in the field shall reduce and only those developers with a sound business plan shall be able to carry on their business in the real estate sector.

Projects stranded:

The relatively unknown developers operating without a sizable land bank and huge resources / capital shall find it extremely difficult to proceed with their projects on account of the lack of avenues to raise capital. A number of projects being undertaken by developers who are facing liquidity issues shall be taken over by others who possess the means to raise such funding.

A major concern for financial institutions shall be the provision under RERA which states that the developer shall not transfer or assign his majority rights and liabilities in respect of a project to a third party without obtaining prior written consent from two-thirds of the allottees (purchasers of the flats), and without the prior written approval of the Regulatory Authority.

Some positives:

In the wake of the liquidity issues and the demand fall in the real estate market, a major positive to be drawn from the implementation of the RERA shall be: (i) the increase in consumer confidence in the completion of under construction projects and (ii) financial institutions having more confidence in lending to builders / developers on account of the regulatory authority and the stringent compliances to be followed by the builders / developers.

Ultimately, the introduction of the rules and regulations under RERA has given rise to a lot of project finance opportunities in the real estate field. Cautious financial institutions investing in projects after doing their legal due diligence and market research have a lot of scope under the changing landscape of the real estate market in India.  

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