Is Debt Good for Real Estate?

For any real estate project, from the time of inception of the project to its launch, execution and delivery, requires a lot of capital. This capital is sourced by various means such as the promoter’s own garnered or stockpiled funds (Equity), advances from the customers buying into the project and through debt. Notably debt plays a vital role by filling in the cash flow gap, which is created before the project reaches a self-sustainable level. Debt acts as a vital nutrition which keeps the project going as realisation of funds from buyers involves time and the execution of the project has to continue.

Debt though acts as a lifeline to the real estate industry, does come with its attendant complications. Effective management of debt along with ongoing project, requires an expert level of understanding of the real estate industry business.

The debt-to-equity ratio, determines the success of an organisation/project. Timely Debt repayment must be ensured with high visibility and predictability of the future cashflows. The ability to sustain in the real estate industry is dependent on various aspects, such as the degree of leverage (amount of debt), its utilisation for the intended purpose, its costs and tenor.

In the Indian real-estate market, the margin of safety is very important; it is possible to tap into the cash flow of the market by opting for a long tenured debt. If a borrowing is being availed for a short term with an intent of servicing only the interest part, and later getting the debt transferred to some other lender, this will land the project/organisation into financial trouble.

The Borrower has to be disciplined and conservative while availing debt to avoid getting into a bad debt trap. Defining the thin line between good and bad debt can ensure wise management of debt.

With the introduction of Real Estate (Regulation and Development) Act, 2016 (“RERA”), the real estate industry witnessed a paradigm change in its regime. The Act applies to the construction of buildings meant for both residential as well as commercial purposes, so long as they satisfy a minimum threshold of area of land and number of apartments proposed. The main objective of the Act is to regulate and promote the real estate sector, while ensuring efficiency and transparency in the system, especially in relation to the sale of plots, apartments, buildings, or the real estate project itself.

Overall, the Act seeks to protect the interest of consumers in the real estate sector and placed a number of oversight mechanisms to ensure greater accountability in the sector.

One of the major oversight mechanisms, is the Ring Fencing of the project receivables, wherein 70% of the amount received from customers is to be deposited in a separate account with a scheduled bank and the remaining 30% amount is available with the Developer for construction. The 70% amount is released to the Developer only to the extent of expense incurred on the project.

Another most common practice that plagues the real estate sector in India is delay in construction and completion of real estate projects. The RERA Act has sought to address this issue by imposing severe consequences, for delays or failures to complete construction and/or delivery of the apartments. Under the Act, the buyer has a number of safeguards, including cancellation of units and recovery of the amount invested along with interest. Continuing buyers are also entitled to charge interest on delayed delivery.

While this is a positive move, even from an investor’s perspective in that it incentivizes the promoter to stick to timelines, the down side is that the consequences of default may affect the investor’s ability to gain returns from his investment. Further, RERA reserves the power to revoke registration of the project.

In the present RERA scenario, Debt plays an important part in bridging the gaps of funds required during this phase, wherein 70% of the projects receivables are locked in, to complete the project within the committed timelines.

The views expressed herein are personal and do not represent the organisation’s view where the penman works.