The impact of slowdown is already being felt on the real estate market with residential segment witnessing sluggish demand across all the major cities.
The Economy and Realty Glance for the Month of October 2011 of Knight Frank India analyses the financials of the real estate industry.
Highlights:
Global economic slowdown and uncertainty in the financial markets is finally having its consequences on the Indian economy with all the lead indicators of growth showing a downward trend. Index of Industrial Production (IIP) grew at 4% in August 2011 which is at one of the lowest levels since April 2010. The manufacturing Purchasing Managers Index (PMI) is at its two year low of 50.4 for the month of September 2011 raising serious questions about the growth momentum of the economy.
PMI is a survey based compilation by HSBC of manufacturing sentiment and is considered a good indicator of factory output. An index level above 50 indicates expansion, and higher the index above that threshold greater the growth.
The impact of slowdown is already being felt on the real estate market with residential segment witnessing sluggish demand across all the major cities. Apart from demand slowdown, impact of rising cost of funds, increasing construction cost and delays in government approvals is worsening the already dismal condition of the sector. Like any other sector, the aforementioned factors clearly point towards a price correction in the real estate market.
However, residential prices in most of the cities have either remained steady or increased marginally in the past few quarters. This implies that demand-supply conditions are not having any significant impact on the residential market prices in the short term and there are other factors at play which are having a greater influence on price.
Financial condition or holding capacity of real estate players is one such factor which influences the price movement in the market to a great extent. A reasonable estimate of the stalemate between buyers and developers coupled with an understanding on the holding capacity will provide the direction in which prices may move in the market going forward. For the purpose of understanding this relationship, we have conducted a financial analysis on a group comprising leading 19 realty players.
Since FY08, revenues and profits have dropped by 19% and 70% respectively despite property prices witnessing an increasing trend. On the other hand, debt and interest outgo have increased by 1.5 and 2.3 times respectively in the same period. Although networth has also strengthened during this period, it happened mainly during FY08 when equity markets had a flair for real estate Initial Public Offerings (IPOs) and many realty companies raised large amount of equity through this route.
However, fund raising through this route has slowed down considerably in the last couple of years due unfavorable market conditions for realty companies. Since studying absolute debt and equity numbers does not provide much insight, it is better to analyze the liquidity ratios for understanding the financial stress of the sector.
Debt equity ratio of the industry has improved over the last five years from 1.9 to 0.8. Although this ratio has improved, the ability of the industry to service this debt has deteriorated over the years. Interest coverage ratio, which is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, has consistently fallen since FY08 from 12.5 to 2.7. Even the Debt Service Coverage Ratio (DSCR), which is a better measure of gauging liquidity since it takes into account both interest and principal repayments on debt, has dropped from 1.54 to 0.56 in the last four years. The lower the interest coverage ratio and DSCR, the higher is the company’s debt burden and greater the possibility of default.
In FY08, when the global economy was going through a recessionary period, the stress level of the sector was at its highest level and many developers were on the verge of defaulting on their debt payment. However, the Reserve Bank of India (RBI) had allowed banks to restructure the debts of these companies keeping in mind the recessionary condition of the economy and hence giving the much needed breather. But the possibility of this happening in the current scenario is very bleak and looking at the stress level of the industry in FY11, the road ahead for real estate industry looks bumpy.
The liquidity condition of the real estate industry may look grim but it does not necessarily imply that the players will default on their debt or interest payment. Ideally, the operating cash flow of a company should take care of the interest and debt repayments. However, when a company is not able to generate enough operating cash flows, it raises additional long term funds to meet the short term requirement.
Over the last two years, developers have raised huge amount of debt and equity through private routes and have now practically exhausted this option. Additionally, the rising interest rate scenario and dwindling sales volume have put further pressure on their capability to raise funds through this route. Even promoters who had pledged their shares in lieu of funds have already breached the comfort levels of investors and this may result into losing control over their company to lenders.
In order to overcome these challenges, developers have resorted to the last option available to them which is sell-off of assets in terms of land, Transfer of Development Rights (TDR), leased properties, SEZ land and others. Over the last couple of quarters many developers have either diluted their stake or completely sold off some of their assets in order to raise funds. We believe that till the time real estate players are able to raise additional long term funds in order to meet their short term obligations, residential prices will remain steady.
However, there is always the possibility of some players who are not able to raise fresh funds through any of the above mentioned sources and this will force them to reduce prices in their projects in order to meet the short term cash flow requirement. Going forward, although real estate market will not witness a significant fall in prices, there will be isolated pockets wherein developers may offer huge discount to existing prices in their projects for the purpose of improving their cash flow position.
