Wednesday, September 24, 2014

Real estate falls in a blind spot

There has been an increased focus on reforming the financial services over the last decade or so and improving its regulatory framework. At one level it is therefore somewhat inexplicable how similar approach has bypassed the real estate sector which accounts for single biggest investment in their lifetime for most people. Perhaps, the tangle is just too complex.

Recently, the competition commission has shown the resolve to pick up the threads in the interest of millions of customers who have invested heir lives savings in purchase of their homes.

Now, nearly all home purchase is financed from banks or finance companies. It is therefore important to examine the role of banks, financiers and the banking regulator. I believe RBI can take proactive steps which would be in the interest of customers and help de-risk the real estate sector. I have an article in Mint news paper today on this topic.

Real estate falls in a blind spot
Stronger regulation is required not just to protect consumers but also to de-risk the banking sector

Ashish Aggarwal

The Supreme Court’s recent order directing DLF to deposit Rs.630 crore as penalty has again put the spotlight on the lack of regulatory oversight in the real estate sector. Nearly all real estate is financed. It is therefore important that banks and the banking regulator, which seem to exacerbate the problem, examine their respective roles.

A key unfair term of the builder-buyer agreement is related to payments. In a construction-linked plan, builders require buyers to cough up 35-40% of the price at the start of construction. It is common to collect about 75% of the payment with only half the work being done. In other variations, buyers get an initial discount but end up paying 85-90% upfront with no serious commitment on the completion date. This encourages the builder to delay construction as he has realised bulk of the revenue.

The penalty for delay, if enforceable, kicks in after a grace period of six months and ranges from Rs.1-5 per sq. ft per month. If a buyer has paid Rs.50 lakh to the builder, at 10% interest, for a 1,500-1,800 sq. ft house, the cost of borrowing from the bank is much higher at Rs.23-27 per sq. ft per month. Moreover, many first time buyers also have to suffer the extra burden of rent due to the delay.

In effect, the buyer ends up paying for his home and also financing the builder’s working capital. If a three-year project is delivered in five, buyers—including the investor variety—might also not benefit from capital appreciation, as many of them might look for an exit. The investor variety also lose out on rental income for the period of delay. Now, all this cannot happen without the role of banks.

All builders have arrangements with banks. The banks review and approve the project as well as the buyer agreements before giving home loans. Perhaps it is convenient for banks to wink at the project and the one-sided agreement in favour of the builder as it allows them to disburse a much higher tranche initially and earn interest for the longest tenure.

Financiers also compete for business among themselves. With processes such as advance processing facility, the entire project is approved once and for all and the requisite due diligence by the financiers during construction is seldom maintained. To further cut short this process, financiers also approve projects based on approvals of other banks.

Builders also peddle a sense of assurance to the end consumer, making him a scapegoat. Many builders, after they have collected the full payment, get the buyers to move into apartments without an occupancy certificate (OC), and incomplete amenities. The OC is issued after the building has been completed as per the sanctioned plan. Banks know that OC is required but they release the final loan instalment based on the builder’s demand. However, the banks do penalize the buyer for any delay in repayment and not the builder for not completing the construction on time.

While builders play truant due to the regulatory blindspot in the sector, it should be possible for the banking regulator to monitor banks and housing finance companies and ensure the project approval and review is done based on objective scrutiny instead of short term commercial gains. The percentage of home loan disbursed by the bank should be directly in proportion to the work completed and not as per payment plan of the developer. The banks must effectively monitor this.

This would also make commercial sense to banks and the banking regulator in the medium to long term. A major risk in the real estate sector stems from builders taking bulk of the money from buyers early and diverting much of it elsewhere. This jeopardises the project’s cash flow, is expensive and harrowing for the buyer and can ensnare banks bearing the credit exposure. Overall, it exposes both real estate and banking to stress.

Builders need to mandatorily adhere to a model buyer agreement, which is approved by the Competition Commission of India (CCI). However, it might not be feasible for CCI to ensure compliance of its model agreement. With its order now being backed by the apex court, there is hope that builders might set their house in order.

However, it would not be advisable to rely on such hope alone. The Reserve Bank of India has in the past frowned upon subvention schemes of banks and builders, where the buyer suffers in case of delay in construction. RBI and the National Housing Bank should take proactive steps in ensuring that banks and housing finance companies play their role fairly and diligently.

This would be in the interest of customers and help de-risk the real estate and banking sector quickly.

Ashish Aggarwal is co-founder and executive director at Invest India Micro Pension Services.

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