Resolution of Jaypee Infratech Shows Path Forward in Residential Real Estate Crisis

Over 20000 homebuyers of Jaypee Infra now see the end of the road leading to their homes

Home buyers and the lenders overwhelmingly (over 97%) voted for NBCC Ltd to take over bankrupt, essentially a residential real estate company, Jaypee Infratech. The NBCC Ltd., a Government of India enterprise, will now complete the apartments, settle off the lenders and handover the flats to home-buyers, over a period of next four years.

Consistent with the murky ways in which residential real estate businesses and transactions have been conducted in India, there is no authentic count of how many homebuyers had actually booked flats in projects of this Company. At one stage, home-buyers group, speaking on behalf of “over 26,000 homebuyers” had alleged in their petition to the Government over Rs. 30,000 crore had been taken by the Company from the homebuyers and lenders. These homebuyers claimed to have booked flats in 2009/2010, taken loans of over Rs. 15000 crore from the Banks and paid to the company 90% of the purchase price of their flats to the Company.

21,781 homebuyers’ claims were actually admitted by the Resolution Professional. NBCC, acknowledging that there were large ‘ghost’ or ‘benami’ bookings, offered to handover 1500 flats to Banks in part settlement of their claims at one stage. Home buyers claims totaling to Rs. 13,364 crore were finally admitted. Lenders’ claim of Rs. 9,783 crore were also admitted, adding up to approximately Rs. 23,000 crore of admitted liabilities towards homebuyers and lenders.

NBCC will settle off lenders by transferring them large chunks of land, in total 1526 acres and also transfer rights in the Yamuna Expressway. Rest of the company would then essentially be a true real estate play. Homebuyers would be given flats booked by them ten years ago in next 3-4 years without any additional payment, except in case NBCC is required to pay additional compensation to farmers for the land earlier acquired. NBCC has also committed to pay small compensation in case there is further delay in delivery of flats.

It is hoped now that over 20,000 homebuyers will get the flats they booked after about 12-15 years, at original nominal prices, bearing all the financing and litigation cost additionally. This is certainly not what they had hoped when they booked flats but it certainly is a big consolation for them.

There are thousands of big and small residential real estate companies like Jaypee Infratechs in India

In the last three decades, most spectacularly after 2003, residential real estate markets and businesses in India have been built on steroids of large capital gains and black money. Between 2003-2013, stories of residential plot prices doubling every three-four years and residential houses / flats giving 20-30% returns per annum in most urban markets of India were very common. This bull market invited all kind of people- using own savings, borrowing funds from Banks and others, deploying proceeds of corruption and black income and diversion of funds from other legitimate businesses- to buy and book plots, houses and flats. Some of this demand was for real residential needs but a lot of it was purely for speculative gains. “Animal spirits” of the “builders” had got unleashed. They cared two hoots about the sustainable/reasonable price of lands. Lands were bought, many times even without caring for right title, at whatever prices available and houses and flats sold there on, many times in “pre-launch roadshows” even when the land was not in physical possession. All prices - land, houses, flats- were simply zooming without anybody worrying about the “bubble” which it was becoming. Prices of real estate in India, at many places, put the real estate prices in developed economies to shame.

Real estate prices have this bad habit of going out of sync with its fundamental value every now and then. Basic use of a house/flat is for living. Whether you live on rent or you live in your own house, as far as the basic service of living is concerned, you get the same economic value. Therefore, fundamental value of a house/flat can be determined with respect of capital value of rentals it earns. If you invest Rs. 1 crore in a house borrowing money at 10% and it yields you a rent of Rs. 4 lakhs a year, the fundamental value of the house is actually only 40 lakhs. Many people were investing in such houses hoping that the price would double to Rs. 2 crore in five years or give about 20% per annum of capital appreciation. If this capital appreciation materialised, it did not matter whether you keep the house empty for five years without earning rents. The moment this capital appreciation disappears, the house/flat you invested in becomes a “liability” rather than an “asset”.

Rising plot/flat prices brought a lot of people in the real estate business. “Builders” mushroomed. These people smelt large profits in real estate projects. Building real estate projects does not require any complex technological knowledge, except for possibly the high-rise buildings. It does not require large amount of legitimate capital- financing it from the home-buyers deposits and bank/ NBFC loans, if you hope to complete a project in 3 years period with ‘investment’ earning large returns. Even for the large projects, real estate companies could raise most of the funds needed from the homebuyers against their bookings and from the Banks/Non-Banks for project finance. Thousands of small ‘builders” entered the arena. Many large real estate companies undertook hundreds of projects across the country with small and weak foundation of low equity capital and high leverage of loan financing.

Following global financial crisis, which also had its origin in real estate, Indian real estate prices stated stabilising/ correcting somewhere around 2011-12. Since then, there has been no significant increase in plot/house/flat prices in most places in India. Once real estate prices stopped growing at high rates, the speculative interest flagged. This brought down the demand for residential real estate materially. The builders treated this as short term, hoping the boom to come back soon. It did not. Demonetisation delivered the final blow. It took away the major driver of the speculative demand. Deprived of the possibility of huge capital gains and removal of the support of unaccounted funds, the residential real estate industry virtually became insolvent in 2017. For some inexplicable reasons, the NBFCs and HFCs, decided to throw a life line to this beleaguered industry, by lending to these projects. Excessive borrowing and stalled off-take of constructed houses made the residential real estate builders and companies what they are today. Resulting in many of these builders having their loan liabilities towards Banks and Homebuyers far in excess of the value of residential assets they hold making them insolvent. As most of the houses are not complete, they have lost liquidity as well.

There are no reliable estimates available of the residential real estate projects which are stalled and incomplete, the extent of real gap between their liabilities and assets and how much more money is required to complete the projects. No public agencies collect these data and place in the public domain. IBBI’s newsletter on insolvency and bankruptcy says that there were 115 real estate companies under corporate insolvency resolution process (CIRP) at the end of September 2019. Some newspapers have reported, citing surveys of private real estate consultants that amount involved in these proceedings is $66 billion (Rs. 4,50,000 crore). Total NPAs in the banking system were about 10 lakh crore. Real estate sector NPAs are as high as 50% of banking system’s peak NPAs. Banking sector NPAs brought down investment in the economy. Liabilities of bankrupt real estate companies has the potential of taking the bottom out of the economy. In fact, this has already done so.

Today lakhs of completed units have no buyers. Lakhs of incomplete units are not getting completed on account of these projects having become insolvent.

A major Housing Finance Company DHFL with assets exceeding 1 lakh crore has been admitted under CIRP recently. It has loans in excess of Rs. 40,000 Crores outstanding from real estate developers. If these developers are sick and bankrupt, there is no likelihood of DHFL getting anything substantial recovery from these borrowers. This will not allow resolution of DHFL to be completed. In any case, IBC process is entirely unsuitable for resolution of financial entities like DHFL.

Will the 25000 crore AIF work?

The Government is rightly concerned about the state of residential real estate in the country. The Government is also fully aware of the backward and forward linkages of real estate sector with the economic growth, employment and wages and health of core industries like steel and cement. The Government announced its intent to infuse funds of Rs. 25,000 crore to provide a fighting chance to the stressed real estate developers, which satisfy criterion laid down, to get funds to complete their stalled projects. The Government decided to adopt Alternative Investment Fund (AIF) route to deliver these funds to the industry and committed to invest Rs. 10,000 crore from its budget for raising the AIF of Rs. 25,000 crore.

This AIF is registered with SEBI, SBI Caps has been appointed its Investment Manager and as reported in the newspaper, citing MD of SBI Caps, total commitments of Rs. 10,500 crore have been secured from 12 institutions, including Rs. 10000 crore from Government. It does not inspire much confidence as all the remaining 11 institutions have committed only Rs. 500 crore.

More fundamental design problem seems to be the financing model of the AIF. This Fund will provide debt to the stalled real estate projects provided its repayment and interest payment gets escrow security. Burdening with more debt to already over leveraged residential real estate developers does not make right financial prescription. It does not solve the basic unviability of the stalled real estate projects. Further, the AIF Investment Manager is duty bound to look at the financial viability of the project and adequacy and safety of funds to be invested before lending from the AIF. As this would be a very difficult call to take, there is little chance of much money being lent. If, ignoring the financial viability and returns metric, the AIF lends to unviable projects, taking comfort from securing its finance with some escrow, it will pit the existing lenders against the AIF, leading to stalling of financing. If, it is unlikely, but the AIF lends without ensuring viability and without obtaining escrow, it is simply throwing good money after bad.

Will a “Bad Bank” work?

A “Bank” to warehouse all the “bad” assets of the public sector banks for “resolution” with the help of better professional management was suggested as a solution for non-performing assets of the public sector banks (PSBs). Now, the same solution has been suggested for the non performing real estate loans of the NBFCs and HFCs. PSBs have not lent to real estate developers directly, but they have indirect exposure as they have lent to the NBFCs and HFCs which have funded these non-performing loans. Instead of a ‘Bank”, it can be a “Non-Bank” or a “HFC”.

The idea is simply unworkable. Which Bank or Non-Bank or HFC in the private sector would take over the non-performing real estate developers loans and who would provide capital for it? If it is to be set up in public sector, it would amount to socialisation of private losses. The PSB or public sector NBFCs have no expertise in resolving real estate non-performing loans.

At more fundamental level, the “Bad Bank or Non Bank” does not address the basic unviability of non-performing developer. It will have to do it either by selling it to ARCs or taking it to IBC? If resolution is ultimately to be done by the ARC or the IBC, why do round tripping through a “Bad Bank”.

What is the real solution?

The residential estate business would have to be fundamentally restructured and existing insolvent developers resolved, like their counterparts in other businesses by being ousted from their projects and lenders taking required haircuts to make the projects financially viable.

We have in our country an individual ownership model of housing real estate. All our incentives, tax and non-tax, are also designed to basically serve this model. At the same time, we have totally irrational rent control laws, which discourage Corporates and Non-Corporates to build and manage houses/ apartments for rent. As capital gains have disappeared, individual ownership model has become quite unattractive to even individuals. Corporates have not gone into residential housing with leasing as business model deterred by rent control laws and lack of tax and non-tax incentives to them.

The solution is therefore quite clear. It is built around following reforms.

First, simply abolish rent control laws. Vested interests have thwarted this for so long. They need to be told to stay out. Owners, Corporates or Individuals, should have all rights to repossess their property on the date of conclusion of contract or on default of payment of rent. No court intervention should be needed.

Second, seed the Corporate Residential Housing business in the country. Corporates have carried on very successfully commercial real estate business. Millions of square feet of commercial real estate have got constructed in the country and numerous projects are currently going on. A great majority of these projects are doing financially very well, earning decent returns to service their lenders. These corporates have also been able to monetise their investments by setting up Real Estate Investment Trusts (RIETs) to release their capital to invest in next projects. The Corporates, especially large established players, need to be encouraged to now take up residential real estate projects for being managed on leasing basis, not selling to individual owners. This also jells with the requirement of housing by the millennials and also many workers who change their jobs or move to different cities following their jobs and increasingly find owned house in one city a liability rather than an asset. As the economic model is still not very established, these projects need to be provided tax incentives. There is no harm if such projects are given income tax exemption for 10-15 years and receive full GST refunds for all the taxes paid on inputs, including on capital machinery. Simultaneously, liberal tax incentives should be provided to households and individuals renting these houses, much like individual house owners are provided. If entire rent paid is allowed as deduction from salary, it would provide quite a good fillip to corporate residential real estate projects.

Third, land owners should be encouraged to provide their land, at least a good part of it, to the Corporate developers as equity to the project. This will help the land owner get steady returns over a period of time rather than getting bulk of it upfront. This will also reduce the borrowing requirements for undertaking such projects. This has started happening. This need to be scaled up.

Fourth, all the stressed real estate projects should be put on an expedious resolution path in the IBC process. The failed owners should be thrown out and replaced with good and established ones and the lenders should take due hair-cuts. The resolved entities would then fast-track investment and complete the projects. This will kick-start the stalled economy.

Fundamental restructuring of residential real estate business is the need of the day and if this is done, economy would see higher growth path again and people would be able to live their lives better.

Subhash Chandra Garg

New Delhi 20/12/2019