Real Estate Best Practices for Financial Institutions
When it’s come to Real Estate, Financial institutions (FI) play the role of creating a pool of fund from investors – institutions, taking the responsibility of management of funds viz lending and receiving thereby creating wealth for the investor – institutions and in return charge a fee for this whole operation.
The Govt & The Policyholders set the compliance structure to be followed by the FI so that the operation of lending and receiving funds do go with the right flow.
Study shows that the worst financial crisis across the globe, all started from the default of a financial institution. Therefore, it is very important to understand what practices they follow and from where the default happened.
Let’s understand how these institutions started formulating their process, The Financial Institutions (Banks/PE/NBFCs) primarily work in the below manner.
• The bank creates a fund from individuals and corporates at a fixed price (rate of interest) and can further lend at price-controlled by RBI. The PE funds, VCs and some other institutions have a little more liberty to negotiate with the investor for borrowing at a higher price and lending to an organization(developer) raising debt at a reasonably higher price.
• Fundraising by banks by small savings like FDs is a little simple because the investor has faith in the system and the regulator (RBI) however fundraising by Mutual Funds, Private Equity is mostly through the HNI investors – Institutions and hence requires considerable deliberation and confidence.
• Lending is an operation that makes revenue for financial institutions. The lending rates of the banks are less as compared to Private Equity.
•The banks have strict compliance while lending to the Real Estate sector, since the banks are not allowed to fund developers for purchase of land, here the Private equity comes into action.
The difference between the rate at which money is raised and subsequently the rate at which money is lent is the margin financial institution makes after taking into the account of operational cost.
BEST BUSINESS PRACTICES FOR FINANCIAL INSTITUTIONS:
1.Feasibility Study based on Realistic Profit Margins
The financial institutions do a project feasibility study while lending to a project – a study that puts down the Profit & Loss possibility. The FI should lend to projects with realistic profit margins. 8-12 % is a reasonable profit margin to invest in. we being an emerging economy and having a consumption that outpaces demand can look at up to 15% profit margin.
However, if a project shows more than a 20% profit margin then the FI should be a little careful while lending. Too much greed has pitfalls.
2. Review the SPV structure and bring in more auditable structure
Initially, the developers had a holding company and all projects were undertaken in the same financial structure so it was easy to monitor the health of the company.
Then came the new structure namely SPV: Special Purpose Vehicle. The SPV had a great benefit because it brought in a discipline in the cash flow management leading to the timely execution of the project. The problem is that when a developer takes multiple projects and is not able to sell – raise revenue as per requirement in any of the SPV then the stress of one SPV brings in strain for the other. This leads to default in the repayment of funds to FI.
A better review system needs to be in place to avoid such situations.
3. Feasibility study for the size of the project
The NBFCs provide funding on land parcels of 10 acres, 20 acres ….50 or 100 acres. The FI should fund-land parcels that the developer can monetize within a stipulated period in one go.
The FI should also assess the demand-supply of the region, the social and physical infrastructure before funding to the developer.
FI need to work on a tracking mechanism
RBI – The central bank has a strict compliance structure for FI. Like-wise the listed developer companies like TATA, GODREJ have to publish the quarterly performance of the project viz Sales, Construction, etc.
The FI should make a process where the unlisted developer has to produce quarterly data so that the FI can keep track of the performance of their fund deployed.
4. A complete Audit mechanism needs to be in place
The FI release fund to the developer based on the stage of construction. In RERA the developer cannot withdraw money from the account in which he collects money from the customer by sales until it is audited by engineer, FI and by RERA. However, this is not full proof. The FI must create a complete audit system, where an audit for the payment of the material used in construction is also made to the vendor, likewise, the broker who facilitated sale has been paid, the media and marketing agency is paid and above all the employee gets salary in time, any of the due could lead to stress in the system.
Simply releasing funds based on the structure can at times be deceiving. FIs must be alert in the revision of auditing on all aspects.
5. Fund on the already mortgaged property
FIs must also look into the arrangement of funding the purchase of the land (where land is mortgaged) and then funding the customer for purchasing an apartment on the mortgaged land, which is not an appropriate flow of the transaction.
The lending system needs to be reviewed and recalibrated so that neither the customer nor the FI is put at risk.
6. Work as a financial partner, not as a lender
FIs should partner the developer and not just be a credit
lending machine – a partnership from the start of the project to completion of the project.
The above best practices are carrying the intent of formalizing the complete process in a way so the financial institutions could minimize the chances of default.
We do not want any defaults of Financial Institutions; this breaks the credit movement and all industry gets affected.
Writer: Mr. Sanjeev Kathuria Real Estate Speaker and COO CRC Group