Strategies & risks in real estate development in India
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2014
Strategies & risks in
real estate
development in India
[An approach paper]
This article starts with the different stages in real estate development. It
recommends strategy for a real estate development company and the
associated risks and concludes with ways to monetise the value created
Author: Sajeve Deora, FCA
[This document has been brought to you by eAuditor.in which runs an
online course on effective internal auditing at www.eAuditor.in]
2/11/2014STRATEGY & RISKS IN REAL ESTATE DEVELOPMENT IN INDIA By Sajeve Deora, FCA, Delhi, Feb 2014 CONTENTS A. Stages in real estate development in India…………………………………………… 3 B. Separate financing plan for each activity……………………………………………… 4 C. Risk minimization………………………………………………………………………………… 4 D. Branded development………………………………………………………………………….. 5 E. Documentation executed with property buyers……………………………………. 5 F. Accounting at each level……………………………………………………………………….. 6 G. Value monetization and long term funding…………………………………………… 6 Brought to you by www.eAuditor.in Read disclaimer on last page Page 2
STRATEGY & RISKS IN REAL ESTATE DEVELOPMENT IN INDIA
By Sajeve Deora, FCA, Delhi, Feb 2014
A. Stages in real estate development
Real Estate requires investment:
i. To acquire land,
ii. To take development risks,
iii. To deliver development, and
iv. To realize profits and exit from obligations.
The financing for acquisition of real estate is different from financing of
development.
The exit for real estate owner is possible at various points of time, from
sale of raw land to the time until development thereof is complete.
The exit for development of real estate is possible around or after the
time development is undertaken to the time development is complete
and delivered.
Each qualitative addition adds to realizable value, and while on one
hand an act of improvement takes out one or some classes of buyers and
brings new classes of buyers into the fold on the other hand it requires
marketing and sale of the asset to a dynamic target group.
In order to achieve growth on a long term basis, it is therefore necessary
that the business evolves into a form that segregates the ownership
risks of buying and owning land from the risks associated with
development (including construction) and sale of such land.
B. Separate financing plan for each activity
The plans for financing of acquisition of land and development thereof
should be independent of each other, drawn separately, so that plans for
activity based financing are implemented.
It is not unusual to run through mixed banking transactions as money is
fungible, and this results in loss of timely creation and monetization of
value of works on hand.
Loans for land acquisition are generally not available from banking
sector, and therefore, financing of land will have to be either from own
sources or non-banking sector or under development arrangements.
Loans for construction activity are available from the banking sector,
and additionally from non-banking sector, from private equity investors,
through rated instruments, developmental arrangements, advance
payment from retail / bulk buyers. The avenues for financing
Brought to you by www.eAuditor.in Read disclaimer on last page Page 3construction would be linked to the covenants of construction
agreement, which range could span over or anywhere between:
i. Cost plus basis, periodic / stage based running payments,
ii. Cost and interest plus basis, end of the contract payment,
iii. Fixed rate, periodic / stage based running payments,
iv. Fixed rate and interest, end of the contract payment,
v. Percentage of sale proceeds, periodic / stage based running
payments;
In all the above cases adjustment for significant increase in cost of high
value inputs could be provided.
The investment and borrowings for land acquisition should be
redeemable out of receipts from sale / disposal of development.
This will minimize the risk of finances getting stuck in project for long or
without there being a true and tangible assessment of performance of
investment.
This will also make funds deployed in land acquisition becoming free for
further rounds of similar activity or other uses.
C. Risk minimisation
Risks not mitigated or contained lead to, amongst others, losses, or loss
of profits, or damages, or loss of reputation, or erosion of goodwill.
Risks associated with an activity should remain integral to the activity,
and should not be capable of or in the alternate, prevented from
travelling to an associated or related activity.
Significantly, risks reside in the following activity segments:
i. Breach of confidentiality and secrecy,
ii. Approval and regulatory compliances (punitive damages – a new
class),
iii. Third party works, including contractors for construction in with or
without material situations (latter being preferred if solvency of
the contractor may be suspect),
iv. On-site events and accidents,
v. Lenders to property buyers having recourse to Developer,
vi. Continued obligations post delivery, and continuing obligations to
render warranty and guarantee,
vii. Holding and transfer of common areas and assets of public utility,
viii. Disposal of ‘No profit No loss’ or ‘low income developments’,
ix. Holding and transfer of land underlying development;
A significant risk that has shown up in the recent times is about
developer’s being made liable and responsible for borrowings of the
property buyers in the event of asset ownership not conveyed within
contracted time frame or if the project is abandoned for shortcomings in
due diligence on the part of the developer.
Brought to you by www.eAuditor.in Read disclaimer on last page Page 4Risks have potential to forfeit the asset and at times, the business.
While the effort should be eliminate Risk, they should be minimized and
as a fall back contained to the underlying asset.
D. Branded development
Land acquisition should remain an extremely confidential activity and
absolutely secretive. This activity should not be branded.
Development is an activity in public domain and should carry a brand,
with each brand representing parameters which convey attributes of
development.
The groups for land acquisition and development have diversity in work
culture and practices, and should operate as distinct set of work groups
comprising separate teams.
An alternate to mega development is to develop smaller parcels under
different brands to effect quicker development and delivery.
The smaller parcels for development will, nevertheless, remain a part of
larger contiguous / aligned development.
Multiple teams within the development group can be set up for each
brand, and the land group makes land available to a particular
development team basis approval of the plans to be submitted by each
of the development teams.
The role of a brand team should be allowed to grow over time from
mere conceptual designer and promoter of a brand to developer /
supervisor and seller of area, and therefore, vesting incremental
responsibility on the team with passage of time and its performance of
the team.
The team should ultimately be made responsible for profit and loss of
the development, including cost of land, which cost should be paid out to
the land group.
At the current stage it is envisaged that the teams are a division of land
owner group, except they operate as profit centres.
E. Documentation with property buyers
Aggressive posturing is visible amongst consumer groups, regulatory
bodies and judiciary in situations of delays on the part of developer in
delivering the asset and the consequential penalties (including
insulating the buyers from claims of their lenders).
Fulfillment of obligations in favor of the buyer should reside with
developer group and not the land owner group (real advantage will
accrue once the developer group is part of a separate legally constituted
entity).
Brought to you by www.eAuditor.in Read disclaimer on last page Page 5Documentation between land owner and developer on one side, and
developer and buyer on the other side, should be structured to keep the
land owner insulated.
Benchmarking of contractual covenants and business practices should
be done on decisions on the subject from CCI and NCDRC, and Supreme
Court.
Approvals of lenders and utilization of sale proceeds should be aligned
with lenders covenants.
Rating of Business Practices and Standards of Governance by an
International Agency be explored.
Transactions in digital space be promoted.
F. Accounting at each level
Revenue recognition as currently being followed needs to be examined.
Care be observed that no development contract should result in the land
owner becoming liable to account income unless stage of sale of
development, and those income tax authorities do not take advantage of
any statements or contractual conditions capable of being misconstrued.
Costs of stamp duty, wealth tax and lender / financier / co-investor
approvals need to be examined at each stage.
G. Value monetisation & long term funding
Monetisation should be positioned from a point of strength.
The realization of each stage of activity should be marked to a cost
centre, and be in the nature of cost of work-in-process which has to
absorbed at each successive activity. Ordinarily, loss if suffered in a
successive stage activity should be an outcome of a known decision, and
its financing plan should be in place ahead of time.
The cost centre concept has to integrate with timely cash outflow from a
successive stage to an earlier stage, which will help achieve redemption
of borrowings and computation and assessment of returns.
The brands within a Group should work as competitive units, and there
is an opportunity to monetize value of each brand if owned as a separate
company.
The value realization and monetisation thereof will be available in a
significantly greater measure after a reasonably acceptable framework
and underlying rules for REIT are announced.
REIT will offer an opportunity to hold assets either for sale (stock-in-
trade or investment) or let out of funds to be provided by investor
interest group (control remaining with land owner / developer /
promoter of REIT).
Brought to you by www.eAuditor.in Read disclaimer on last page Page 6A large part of the advantage for setting up of REIT can be gained if the
REIT is used for market making, whether the development is held for
sale or for let.
It will equally be possible to set up REIT at construction stage of
development so that contractor and developer payments take place on
self-redeeming basis.
Sajeve Deora FCA is a senior Chartered Accountant practicing in Delhi and is on the
Board of Directors of certain large companies in India including real estate. He can
be contacted on deora@vsnl.com.
Disclaimer
This article are the personal views of the author and contains general information intended purely for
increasing awareness and knowledge in governance, risk, compliance requirements & their practices in
India. The content of this article is neither to be used as an opinion or advice. Both eAuditor.in and the
author are not responsible for any action taken on the basis of this article. Before taking any action do
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