‘Real estate needs a regulator urgently’

As chairman of HDFC, India's largest mortgage lender, Deepak Parekh has had an insider's view of the rise, fall and revival of the real estate sector. In a candid chat with Bhaskar Chakraborty and Avi Mehta of institutional brokerage IIFL, Parekh shared his views on what ails the sector and what should be done to ensure a sustainable and stable course of development for the real estate market. Excerpts:

What are the biggest mistakes that developers made to end up where they were six months ago?
Developers committed a number of mistakes. The first was that they increased prices too much, too soon. Since sales volumes were strong, all developers across the country felt prices should be increased, even though many of the projects were on legacy land parcels. Developers kept raising prices to a point that went out of reach of even the upper class. The second, and more damaging, mistake was that they committed to buy land at exorbitant prices. Developers rushed to buy land as if there is no tomorrow and land is in short supply. Without tying up the necessary funds, developers bought land at unbelievable prices at auctions across the country.

There was intense competition to buy land. The government was also increasing prices at each auction. Commercial plots of land in Bandra Kurla Complex went as high as Rs30,000-35,000 per sq ft. If you add on three years of interest (as buildings take that long for construction), it is just too high. The third mistake was that developers refused to sell stocks that they held as they thought prices will only go up.

All three factors were due to greed — aimed to make quick money and more money. All these could have been avoided if we had a real estate regulator, for which I have been asking the government for a while. We have a regulator for the petroleum ministry and for civil aviation. But we are reluctant to have a regulator for real estate. Agreed that it is a state subject, but the industry needs to be regulated — good times, you will notice that developers made a lot of money, but their balance sheets were still heavily leveraged.

When the Reserve Bank of India (RBI) prohibited banks and housing finance companies (HFCs) from lending against land, developers went overseas to borrow money. Most of the deals were structured as cumulative convertible preference shares (CCPF) and generally carried very high rates of interest. These were convertible into equity in 2-3 years, and developers intended to repay the face value before conversion. Since these structures were categorised as equity, they came under the automatic approval route. Developers utilised these borrowings to purchase land. So, real leverage on developers' balance sheet was very high.

Do you feel that the banks and the equity market bailed them out too quickly?
Well, the mood in the economy suddenly changed after the elections and equity markets started rising. Before that no equity or debt was placed for 5-6 months. The financial world had virtually come to a standstill in September-October 2008. The outcome of the general elections provided a window of opportunity that opened a door and everybody queued up. But how long are the good times going to last? I see the herd instinct playing out amongst developers as some of them have been successful in raising money.

However, appetite for real estate paper is not infinite. At some point, investors will cut back on further exposure.

Do you feel the high capital intensity of the industry implies that developers will continue to tap capital markets?
I think so. We are talking of urban areas in metros where land is a substantial component of the total cost. A developer needs money mainly to buy land because land costs are significantly higher than construction costs. Construction gets funded by pre-sales or through loans from HFCs and banks. Developers have also resorted to a new format of sales--they take 100% upfront from the customer on booking. The customer is offered some discounts, but no commitment is provided on delivery timelines.

Builders take money from customers to fund the approval process and construction without any work being commenced at the project site. In many cases, their development plans are not approved. Customers buy such projects and get finance from banks and HFCs. This is not healthy, as payments must be linked to progress in construction. That is the only way customers can mitigate risk with their life's savings.

Why are land prices so high in India?
The key reason is the faulty land policy. Land prices remain high on perceived scarcity value. A lot of politics is also involved. The lengthy approval process is another key reason why land prices remain so high. Multiplicity of approvals creates scarcity of supply, keeping prices elevated. Quick approvals will increase supply manifold, leading to lower prices. Land transactions have been made complicated to ensure that supply remains constrained and prices remain high.

How large is investor demand in the overall residential pie in Delhi and Mumbai?
No numbers are available. However, end-user demand in apartments priced in the Rs3m-5m range in Mumbai and Delhi and in the Rs1.5m-3m range in other metros is very high.

Rental yields on residential property are 3-4% while funding costs are 9-10%. Do you feel that the residential segment is mispriced and will correct substantially?
I am not so sure that a large correction can happen in a short time. Mumbai and Delhi are different markets. Delhi has adequate supply of residential units in various sizes and quality. Investors hold a large stock of supply. In Mumbai, availability is the key issue as landlords used to face problems in repossessing their rented apartments till not so long ago. Though the situation is better now, landlords insist that tenants have to pay 30-40% of the cost of the apartment as deposit.

Developers have revised prices upwards by 20-25% already from the bottom seen in November-December 2008. Do you feel the volume revival will sustain?
I am very unhappy and disappointed. Just because there has been a revival in residential sales, some spurt in the stock market, some improvement in liquidity flows, prices have gone up. But builders who continue to sell the largest volumes are the ones who have offered lower prices compared to competitors. There are quite a few examples in western and central suburbs of Mumbai where developers have priced 30% below competition and sold very well. By the way, all of these are genuine sales, as developers have collected 20-25% on booking. We have funded many of these transactions. If prices continue to go up, transactions could cool off.

In a lot of developed countries, the builder does not collect progress payments and gets money when they receive the completion certificate. Given the high cost of capital and the huge delays, can a similar regulation be implemented in India?
I don't see it happening in India unless it is regulated.

There are not many countries where the difference between the carpet and built-up area is so huge. Are there any steps being taken by the government to protect the interests of the consumers?
I feel things are getting from bad to worse. The difference in many new projects is 40%. It is shocking and unacceptable. Consumers are getting the raw end of the stick. This is another reason why we need a regulator. For a long time, I have been propagating that all flats should be sold on the basis of carpet area. The buyer should be able to get the flat measured by an architect and pay for the actual liveable space he is getting. If quoted rates go higher, it's fine--at least the buyer knows what he is paying for.

An average development in India takes 4-5 years to deliver, while larger projects in Singapore and Hong Kong are delivered in two years. Is it because the land acquisition and approval process is cumbersome or that Indian developers do not focus on constructions like their overseas counterparts?
The approval process is only one of the reasons; other reasons are that the builder takes on too many projects simultaneously, stretching his bandwidth, and the pace of construction is slow. We have not learnt how to do faster construction. Builders need to introduce better technology, spend more money, and ensure construction at the sites happens round the clock. In Singapore, construction happens round the clock without inconveniencing anyone. Pace of construction is fast, which allows the developer to recover the money he has invested in land quickly and reinvest it in the next project.

In India, there is a disincentive to build fast--as the builder holds on to inventory, prices go up and so do profits. In my 32 years in housing, prices have actually fallen only twice. Since prices keep going up, developers hold inventory and go slow on construction.

How many approvals are needed to launch a residential project in Mumbai? How can this be simplified, in your view? As one of the biggest and oldest lenders to this industry, what suggestion would you make to the government to improve the system?
I wish I was positive, but I do not foresee any change in the current process. There has been no progress with one-stop approvals, easier approvals, or rationalisation of the number of approvals. The central government is pushing some reforms through the Jawaharlal Nehru National Urban Renewal Mission (JNNURM) scheme. It allocates money for urban development through the scheme. The amount of allocation has increased significantly as the government has realised that cities are the engines of growth.

The centre laid a pre-condition that the Urban Land Ceiling Act has to be removed for a state to receive funds under the scheme. Faced with this predicament, the Maharashtra government finally repealed the Act in late 2007.

Can developers make the 'affordable' housing model work in the current environment of high land costs? What changes need to happen for affordable housing to be a reality?
Affordable housing is more topical. If land prices are so high, how can one make affordable housing work? Either affordability has to increase, or land prices have to fall. So, the way things stand now, affordable housing projects will be in distant suburbs only. The best way to do it is to mandate the developer that a portion of any development has to be kept aside for small affordable units. The developer can sell the balance at any price. A typical example is the slum rehabilitation scheme in Mumbai--developers have to rehabilitate slum-dwellers in proper homes to then exploit the available FSI. Without cross-subsidisation, affordable housing will not happen in cities.

In your opinion, which markets look the strongest and which the weakest over the next 1-2 years?
Demand in residential markets where prices are affordable looks strong. Commercial space is surplus and will take longer to recover.

In your opinion, which are the three best developers/companies in India to play the property sector? Which companies would you be concerned about and for what specific reasons?
I would not like to pinpoint any. Certain developers have better quality of construction and they charge a higher price for it. The entry of corporate groups like Tatas, Mahindras, Godrej, Great Eastern Shipping and Bombay Dyeing are a key positive. It brings order and sanity to the industry and the level of governance improves. IPO listings are also positive. Once companies list, reporting requirements go up, improving transparency and governance.

Finally, what are the lessons learned in the US property market crash and how should India as a country guard itself from such a crisis?
The main reason for the crash was over-leveraging by end-consumers. Liabilities ballooned on poorly-designed products that were beyond the means of the borrowers. Finally, the house of cards fell apart. Over-leveraging magnified their profits on the upcycle, but wiped them out when property prices started falling.