The Impact of Real Estate Bankruptcies

The past five years have been very difficult for the Indian real estate sector. The entire sector was coming from a very high point. The economy was booming, and sales would increase even as the prices went up year after year. However, after 2013, the Indian real estate market stagnated.

As prices did not increase, the speculators went out of the market. Given the already inflated prices of houses, genuine buyers have been priced out of the market. The present market can be described as a standoff between the builders and the home buyers.

Home buyers are willing for the housing prices to fall whereas builders are busy convincing them that prices aren’t going to fall in the near term.

It needs to be understood that many real estate developers in India were highly leveraged. Hence, since sales have died down over the years, they are facing imminent bankruptcy. In fact, the real estate sector has the highest number of applicants to India’s bankruptcy courts ever since they became functional from 2016!

There is no doubt about the fact that the entire industry is in dire straits. According to recent studies, the total amount of sales generated by the real estate sector in 2018 was less than 50% of the interest that builders need to pay as interest on outstanding loans! However, the effect of builder bankruptcies is not limited to builders only. There are a lot of parties that will be affected.

In this article, we will have a closer look at the possible impact of real estate bankruptcies:

Home Buyers: The most obvious group affected by real estate bankruptcies will be the home buyers. In the past few years, the Indian homebuyers have been at the mercy of the real estate developers. This is because, they were not given the status of financial creditors. Hence, their claim on the asset was inferior to the claim made by banks and other financial institutions. Therefore, in the event of a bankruptcy, the homebuyers were almost certain to lose their money. This has changed in the recent past.

The government has now passed an ordinance under which homebuyers will have the same right as financial creditors. This means that they will not only get the proceeds from the sale of any assets but will also have the required voting rights.

The bottom line is that the homebuyer of today is more protected by law. However, they still don’t have the time or resources to fight lengthy court battles.

NBFC’s: The Non-Banking Financial Corporations (NBFCs) will be one of the most obvious casualties of builder bankruptcies in India. As explained above, new government rules made lending to builders a non-viable business.

Banks understood the risks involved in lending to builders given the current situation. This is the reason why banks have only increased their exposure to the real estate sector by 4% in the past three years. On the other hand, NBFC’s have gone all out to give more and more loans to builders. Their exposures have been up by 46% during the same period!

To top it all, IL&FS which is one of the largest NBFCs in India came under financial scrutiny after it started defaulting on its loans. This effect soon spilled over to other NBFCs. Another possible scam was unearthed at DHFL. As a result, investors have become jittery of lending money to NBFC’s. The end result has been that these companies are now starved of more funds to lend. Most of their own loans are owed by builders who happen to be in precarious financial positions.

Mutual Funds: NBFCs have different sources for the funds that they generate. For instance, sometimes they take bank loans to lend further whereas on the other hand, sometimes they resort to capital markets.

In recent times, a lot of these loans which were given to builders were actually financed by yield-hungry debt based mutual funds. These funds would lend out money to NBFC’s who would then further give it to the builders. Hence if NBFC's go bankrupt, they will not be able to honour their debts, and mutual funds will be the next in the line of casualties.

Why Deleveraging Will Make Matters Worse?

The problem with the real estate sector is that it necessitates throwing good money after bad. Ideally, when lenders realise they have made bad loans, they stop making further loans. However, things are not so simple with real estate. This is because there are a lot of incomplete projects in the market.

In the absence of more funding, there perfectly viable projects will also become unviable and will lead to further bankruptcies and perpetuate the cycle further. Falling prices is not a solution either since it is rising prices which attracted buyers towards the real estate sector in the first place. Falling price will scare away any prospective buyers making matters worse.

Banks, mutual funds, homebuyers and NBFC’s will have to be careful with the manner in which they deal with real estate developers since bankruptcy wouldn’t really be beneficial to anybody.

The bottom line is that even though real estate bankruptcies are imminent given the current market conditions in India, it is essential that they be handled carefully.