Why private equity cannot rescue real estate

3D chrome Dollar symbolRegular readers of The Daily Reckoning would know that I have been bearish on the real estate sector for a while now. There is no way that the current price level in real estate is sustainable. It has gone way beyond what most people can afford and hence needs to fall. That’s the basic logic I offer in almost all the columns that I write on real estate.

In response to these columns I get different kind of feedback. Some people agree with me totally. Some grudgingly. Some are coming around to the idea. And some don’t agree at all and ask me to revisit everything that I have been saying on real estate up until now.

The latest reason offered to me on why real estate prices will not crash is that the private equity firms are now investing in real estate. This will help real estate companies get the money they need. And in the process they won’t cut prices.

This logic doesn’t hold on multiple counts. But before I get into explaining why, let me first talk about a term called “availability heuristic” from behavioural economics. As Jason Zweig writes in The Devil’s Finance Dictionary: “Availability [is] essentially a mental shortcut, or HEURISTIC, that leads people to judge the frequency or probability of events by how easily examples spring to mind. The vividness of rare events can make them seem more common and likely to recur than they are.”

Initial public offerings of companies in stock markets are a good example. As Zweig writes: “The vast majority of initial public offerings (IPOs) fail to outperform the market, but it takes only a few spectacular successes like Google to create the illusion that investing in IPOs is the road to riches.”

Further, the availability heuristic leads to people making confident conclusions. As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why We Believe Them Anyway: “The availability heuristic is a tool of the unconscious mind. It churns out conclusions automatically, without conscious effort. We experience these conclusions as intuitions. We don’t know where they come from and we don’t know how they are produced, they just feel right. Whether they are right is another matter.”

Hence, how did the availability heuristic evolve is a question worth asking? As Gardner writes: “The availability heuristic is the product of the ancient environment in which our brains evolved. It worked well there. When your ancestor approached the watering hole, he may have thought, “Should I worry about crocodiles? Without any conscious effort, he would search his memory for examples of crocodiles eating people. If one came to mind easily, it made sense to conclude that, yes, he should watch out for crocodiles.

Nevertheless, the world has changed since then. But looks like our minds haven’t and the availability heuristic instead of helping us, continues to trick us.
Getting back to the topic at hand, people who believe that the private equity money coming into real estate will lead to real estate prices not falling, have essentially become victims of the availability heuristic. These people, the smart lot, read business newspapers religiously every day. And in these newspapers they read that a lot of private equity money is being invested in Indian real estate companies. This leads them to conclude that the money problems of all Indian real estate companies are over and hence, real estate prices will not fall. Their “unconscious mind churns out conclusions automatically, without conscious effort.”

Those who believe real estate prices will not fall because of private equity money can easily recall examples of private equity investment in real estate companies. These examples are very easy to recall given that the smart lot reads business newspapers regularly. But the business newspapers only report the news of real estate companies getting investment from private equity firms.

No newspaper talks about those real estate companies which have not received any private equity money and the situation that they are in. And that’s simply because there is no news in it for them. The situation is similar to newspapers and the media talking about airplane crashes though no newspaper or media talks about the thousands of safe airplane landings that happen all over the world every day. This leads people to conclude that airplane travel is unsafe, though it is not.

Along similar lines, the examples of real estate companies getting investment from private equity firms are fairly easy to recall. The opposite is not. The availability heuristic is at work. Hence, the idea that private equity firms are investing in real estate companies seems more common than it actually is.

Now the question is how many Indian real estate companies have actually seen investments from private equity firms? The real estate lobby the Confederation of Real Estate Developers’ Associations of India (CREDAI) claims to have 11,500 real estate developers from 156 cities across 23 states as its members. Only a very small portion of these real estate companies have seen private equity investment.  And those that have seen investments operate largely in the bigger cities.

So that was one part of the analysis. Now let’s get to the second part with some numbers. Crisil has carried out an analysis of India’s top 25 listed real estate companies which make up for 95% of the market capitalization of India’s real estate sector. The analysis is titled The realty reality.

In this analysis Crisil points out that “Rs.35,000 crores or 50 per cent of their residential debt will continue to remain at high refinancing risk.” “With the demand pick-up expected to remain tepid in the near term, developers are heavily dependent on refinancing their existing debt given their highly leveraged balance sheets.”

What does this mean? It means that real estate companies that Crisil studied need to repay Rs 35,000 crore to banks soon. With real estate companies not being able to sell enough homes they are not earning enough to be able to repay these loans. Hence, they need to refinance these loans i.e. borrow more to repay these loans.

The question is with their highly stretched balance sheets will the banks be interested in lending more to developers? The monthly sectoral deployment of credit data released by the Reserve Bank of India (RBI) points out that the total bank lending to commercial real estate grew by a minuscule 2% between September 19, 2014 and September 18, 2015. This, when the overall lending by banks grew by 8.4%.

Now compare this to how things were in September 2014. Bank lending to commercial real estate between September 20, 2013 and September 19, 2014, had grown by a massive 20%. The overall bank lending by banks had grown by a similar 8.6%.

This clearly shows that the lending by banks to real estate companies has slowed down dramatically. Between September 2013 and September 2014 banks lent Rs 26,958 crore to real estate companies. This has crashed to Rs 3,157 crore between September 2014 and September 2015.

In fact, the overall lending to real estate companies by banks is down by 1% during the course of this financial year (actually between March 20, 2015 and September 2015, to be very precise).

And this is clearly reason for worry for real estate companies. As Crisil points out: “Traditionally, bank loans have been the primary source of funding, meeting ~90% of the requirements of India’s top 25 developers. The net exposure of banks to the real estate sector declined 1% in the first half of the current fiscal…However, going forward, incremental bank funding is expected to decline ~5%.”

What this clearly tells us is the banks are not really gung-ho about lending to real estate companies anymore. (As can be seen from the accompanying table).

So what happens from here on? The slowdown in lending from banks explains why real estate companies have been looking at alternative sources of finance through non-convertible debentures and private equity. Data from Crisil points out that the issuances of non-convertible debentures have grown at the rate of 68% per year over the last four years and reached Rs 8,500 crore in 2014-2015. The private equity investments in real estate have also jumped at a very fast rate of 32% per year from Rs 6,600 crore in 2012 to Rs 15,600 crore in 2015.

Over and above this, the recent government moves on foreign direct investment in real estate is also expected to help bring in money into the sector. Earlier foreign direct investment could come into real estate only if the project size was a minimum 20,000 square meters with a minimum capital of $5million.

Further, it was required that foreign investors bring in money within six months. This requirement has also been done away with.

All this is good news for some cash-strapped real estate companies. But can we conclude from all this that with the money flowing back into the sector again, real-estate companies will not cut prices? The first point I would like to make here is that only a small portion of the builders have received money from the alternative routes. The second point is that the alternative routes of raising money come with a very high cost of funding.

As Crisil points out: “The cost of alternative funding has increased over the last two years as pressure on developers financial position intensified. About one-third of the non-convertible debentures issuances last fiscal yielded an internal rate of return of more than 20%, compared with no issuances of similar yields in 2012.”

The same stands true for private equity firms as well. As Crisil points out: “As for private equity [firms], the higher return expectation will increase the refinancing risk for the realtors over the longer term, unless the demand picks up substantially. CRISIL estimates payout for private equity funds for the sector as a whole at Rs 85,000 crore, assuming a return of 20% over a 5 year period. Hence, alternative funding sources such as non-convertible debentures and private equity [firms] are expected to continue providing some respite in the short term only.

What does this mean in simple English? The real estate companies are essentially kicking the can down the road. The money being brought in through the alternative route will also have to be returned. And where will that money come from is a question worth asking?

My guess here is that the money being brought in through non-convertible debentures and private equity firms is being used to pay-off the bank loans of real estate companies that are falling due (It would be great if any Daily Reckoning readers in know of this trend can confirm it by commenting on this column or writing to me at [email protected]). This has allowed the real estate companies to not cut prices. If this money hadn’t come in then the real estate companies would have had to cut prices in order to sell unsold homes to repay their bank loans.

Nevertheless, the non-convertible debentures as well as private equity firms will also have to be repaid in the years to come. As mentioned earlier the returns expected by those providing the alternative sources of finances are very high. They will also have to be eventually be repaid.

And how will that happen? The only way real estate companies can do that is by selling homes. Homes will only sell if they are reasonably priced. At current prices the demand will continue to remain muted. As a recent 99acres’ Insite report points out in the context of the Mumbai real estate market:The market is witnessing demand in the affordable and mid-range segments (Rs 25 lakh to Rs 60 lakh), while supply is in the bracket of Rs 1 crore or more.” So there is clearly good demand at lower prices.

Further, as Crisil puts it: “demand recovery and deleveraging are the only sustainable solutions to the problems staring at the real estate developer community.”

And that ain’t happening without prices falling.

The column originally appeared on The Daily Reckoning on November 20, 2015