MUMBAI: One of the worst-hit industries in the past three years has been real estate. Land prices have stagnated, housing demand has stagnated, commercial demand has shrunk, interest rates have gone up. The Reserve Bank of India has also implemented measures restricting access to capital for real estate firms and, at the same time, limited housing mortgage exposure for banks by assigning high risk-weights.
Several banks, including large public sector banks, do have dodgy mortgage portfolios. Banks also have exposure to real estate projects in trouble. Given weak sales, the industry's ability to service massive outstanding debt is questionable. Fitch Ratings reckons that debt as a proportion of earnings before interest, taxes, depreciation and amortisation (the Debt:Ebitda ratio) is now at a six-year high.
DLF has been forced to sell off assets at discounts to deleverage debt. LIC Housing Finance has taken over property developed by Unitech and Orbit Corp, after the two real estate developers defaulted.
Real estate firms need to find sources of funding not only to retire debt, but simply to complete projects. Overseas allocation to Indian real estate is minuscule. In calendar year 2013, global investors allocated over $130 billion to Asian real estate. Yet, only $1 billion or so came to India. Improving demand on the retail or commercial side would be useful, but booking amounts may not be enough to rescue real estate.
The industry is desperately hoping that the general elections will be a game-changer. First, that a new government will be able to inject enthusiasm, or "animal spirits", and thus improve demand. Second, a new government may finally clear REITs (Real Estate Investment Trusts).
REITs are somewhat like mutual funds in that REITs parcel out real estate related investments into small units, which can be sold to individual investors. This allows wider participation in the real estate market because it breaks up lumpy large real estate deals into smaller commitments. Giving real estate developers the chance to tap new funding sources would obviously help these cash-strapped businesses.
However, within the broad definition of an REIT, there can be enormous variations. Some REITs speculate on developing projects, looking to capture land-related capital appreciation. Others look to manage rentals for stable income yields and there are hybrids, etc. The tax treatment of REITs is tricky and depends on what exactly a given REIT does.
The concept of Indian REITs was mooted in 2008 at a time when there was a knee-jerk negative reaction due to the US sub-prime crisis. Since then, there have been at least four proposed tax treatments, which have been drafted and redrafted. There is some hope that a new government may finally freeze a given tax treatment and allow REITs to be floated quickly.
I would actually be somewhat pessimistic about this and assume it might take several years and a few more drafts, regardless of the shape of the next government. However, this is an important perception since it could bring in speculative funding.
Cost of funding is another issue that the real estate industry seems to be approaching with some optimism. Right now the cost of debt is very high - close to 20 per cent on average, if one goes by anecdote. If interest rates fall, the industry will receive relief even if it is still paying a major premium over prevailing prime rates. REITs could ease this situation, of course. So could a revival of the stock market , which allows real estate firms to make follow-on public offers.
The industry has underperformed the overall market for the past five years. The returns in the past 12 months are revealing. While the Nifty has gained about 18 per cent since April 2013, the realty index, which tracks 10 listed real estate firms, has lost 24 per cent. Delta Corp and HDIL were the only gainers over the past 12 months. The other eight companies (DLF, Unitech, IBRE, Sobha, Godrej, etc,) all lost ground in terms of share prices.
However, the change in perceptions showed up in the last month, when the real estate index went up 7 per cent. It would have been even more positive except for DLF's performance (down 11 per cent). The other nine firms delivered positive returns, but DLF has the highest index weight.
This recent outperformance is in line with the high-beta nature of the industry. If the stock market continues its surge, the real estate sector could well be a segment which outperforms the broad market. However, given the sector's risky profile, it could also collapse spectacularly again if the right ingredients for a bull run don't exist.