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29th November 2023 (Version 4)
PREAMBLE
The real estate sector comprises entities engaged in the construction and development of residential/ commercial real estate. Acuité understands that the entities engaged in real estate activities have to be assessed on a framework, which differs from the conventional framework applicable to manufacturing entities primarily on account of the following reasons:
Firstly, there exists significant time lag between revenues and cash inflows from a project. Typically, in a residential project, advances from customers are received at the inception of a project whereas in case of a commercial project, revenues may be recognised at a later point after the project is sufficiently advanced. Hence, profit for a given period may diverge significantly from cash flows. Since timely servicing of debt obligations depends on adequacy of cash flows rather than profitability, it becomes necessary to focus on cash flow adequacy for real estate projects.
Secondly, real estate activity is project-based. Each project is unique in terms of size, profitability, time requirements, among others. Since, a real estate developer may be executing more than one project at a time, revenues will depend on the stage of completion of the project and sales effected. Resultantly, the revenue profile of a real estate developer may fluctuate widely from one period to another unlike that of manufacturing units, wherein revenues will typically exhibit a steady pattern. Hence, the operational and financial parameters applicable to manufacturing entities, cannot capture the nuances of that of real estate projects.
In view of the above differences, Acuité considers certain parameters specifically for the construction sector in its Risk Assessment Framework. The overall framework is based on Business Risk, Financial Risk and Management Risk assessment of the entity whose facilities are being rated.
I. BUSINESS RISK ASSESSMENT
MARKET POSITION
Geographical and Segmental Diversity
Higher the geographical diversity in operations, lower is the risk inherent in the business model. Since, demand supply dynamics of each region is different, geographical spread in operations imparts resilience to the revenue profile. Apart from geographical diversity, Acuité also examines the segmental diversity in the business of a real estate developer. The demand drivers for residential and commercial segments vary. While residential real estate growth is influenced by factors such as increased affordability, demographic profile of the region/city, the large number of people in the employable segment and higher preference for nuclear families, residential projects by established developers attract advances from customers which provide a major part of the initial funding. Hence, residential projects are generally funded through a mix of customer advances and promoter funding. Again, in case of customer interest, the actual user's interest is protected than that of the investor, since actual user’s demand is usually backed by housing loans that implies a steady flow of advances as construction progresses. As against this, in case of high investor interest, the flow of advances is linked to market conditions.
Commercial realty demand is influenced by demand from sectors such as Information Technology, retail and services. Commercial projects generally attract customer interest as they approach the completion stage. Hence, cash flows from clients are usually back ended. It has been observed that residential real estate is generally sold off and hence has limited potential to generate recurring revenue streams for a developer. Commercial real estate segment, on the other hand, has the potential to generate recurring streams of revenue such as lease rentals wherever the property is given out on lease rather than an outright sale. In case the developer opts for a lease model, the developer may choose LRD (Lease Rental Discounting) loan, which is used to replace the construction loan.
The advantage of the leasing option is that it allows the developer to generate liquidity at regular intervals by discounting the future receivables from time to time and also gain from any upside in property prices.
In case of assessment of real estate cases under the LRD model, certain other risks such as counter party credit risk, early exit risk, interest rate risk are also examined while conducting credit assessment. Please refer to Acuite’s criteria on ‘Lease Rental Discounting’ for more details.
Track Record
Longer the track record, better will be the score on the market position since prospective buyers are keen about an established track record of execution of projects. A developer who is compliant with regulations and has an established track record of timely delivery is likely to fare better.
Brand Equity of Real Estate Developer
The brand equity of a real estate developer is critical from a customer acquisition perspective and also from the stand point of attracting funding to support the project.
OPERATING EFFICIENCY
Status of major projects
Entities with major projects in the initial stages of construction will score low on this parameter primarily because the likelihood of high time and cost overruns is very high. Hence, cash flow forecasting becomes difficult. Delays in receipt of approvals from government authorities are common, thereby translating to cost and time overruns.
Nature of Projects undertaken
While conventionally, real estate developers own land parcels and develop projects on these land sites, more efficient models are also in vogue such as joint development projects/ redevelopment projects. Models such as redevelopment projects/ joint development projects are asset light in nature and reduce capital requirements of the developer.
Again, projects with inherent modularity will score higher on this parameter. For instance, a developer developing independent villas on plots of land will have the flexibility to align the level of progress of construction undertaken to cash flows from clients. However, in case of multi storeyed structures, the builder has limited flexibility to slow down construction even in case of low demand owing to commitments made to buyers for handover of the possession by specific dates. The enactment of legislation such as RERA, which stipulates penalties for non-adherence to commitments made to buyers of flats, adds to the risk.
Regulatory Framework
The enactment of RERA (Real Estate Regulatory Authority) is a major step by the government in enforcing basic discipline among real estate players. RERA stipulates registration of existing/ proposed projects on the website of the real estate regulator, restrictions on diversion of funds received as advances for a specific project, penalties for non-adherence to commitments, among others.
Each state will have its own RERA, which would be broadly based on the lines of the Central RERA. Other than legislations such as RERA, the real estate sector will also be influenced by interest rates and policies of the banks/financial institutions in lending to real estate.
The changes in the regulatory environment will also have an impact on the business risk profile of real estate players. Acuité factors in the regulatory environment while assessing the real estate player.
II. FINANCIAL RISK PROFILE
Acuité seeks data from the client in terms of project cost, funding mix, bookings and advances received, construction work in progress till date and expected date of completion.
The projected cash flow statement is constructed and the Cash Flow Coverage Indicator is examined in this regard. The analyst may look at the base case scenario and also examine movements in the ratio under various scenarios.
Importance of Cashflow projections Lumpiness of cashflow is an inherent characteristic of business
for real estate developer. A developer earns healthy profits once the project
is sold, however the cashflow is not uniform throughout the project development
phase and therefore in order assess potential liquidity mismatches project
cashflows are drawn on quarterly/annual basis. Project cashflows provide a view
of the surplus or deficit that a project may have over the near to medium term,
for which a funding support may be required. Limitation
of using cashflow analysis: While cashflows
provide a view on potential liquidity mismatch that may arise on the basis of
construction schedule provided by the real estate developer. These cashflows
are drawn on the basis of existing sales velocity and the assumption that the
committed receivables are received as envisaged. Capital Structure: As a measure of capital structure Acuite uses the following
ratio. Leverage = Total Debt
Outstanding / (Work in progress – Advances received from customers) This indicator when used in conjunction with Debt to Equity
ratio can provide an understanding of sales velocity experienced by the
project. A project experiencing healthy sales will depict a higher leverage
ratio compared to the project debt to equity and vice versa.
Distance to Completion = (Receivables from sold units + undrawn limits) / (Pending Cost + Debt
outstanding + Undrawn Limits) This ratio provides an understanding on the breakeven level of sales
required for a project to complete the construction. A ratio less than 1.0
shall require funding support from promoters. A project which has already
achieved unity, is not required to reduce rates/offer discounts or resort to
promotional offers to achieve incremental cashflow to complete the project. Cash flow coverage Indicator = (Cash
inflows from customers on sold units + Infusion
of additional promoter funds+ Fresh term loan/undrawn limit drawdowns) ÷ (Cash outflows for construction+ Taxes+
Interest+ Principal repayment) This ratio is calculated for every year across
the life of the project. Acuité examines the minimum and maximum ratio across
the tenure of the loan. If the ratio is likely to go below unity for any given
period, Acuité examines the refinancing ability/ additional fund infusion to
support the operational and financial commitments. The refinancing ability has
to be examined in the context of the prevailing operating environment.
Typically, NBFCs are the key lenders to real estate sector, the occurrence of
events which impedes the lending ability of the NBFCs will impact the financial
flexibility of the lenders. The presence of marquee real estate focused private
equity players as majority shareholders tends to be viewed positively from a
financial flexibility standpoint especially if such players are able to
demonstrate the willingness to support the ventures. Acuité also considers
liquidity support like unencumbered cash balances and cash equivalents while
formulating an opinion on the cash flow adequacy of the entity. The emergence
of REITs (Real Estate Investment Trust) as an investment option provides the
real estate developers an avenue to raise fresh resources by transferring
certain income yielding assets to the trust.
III. MANAGEMENT RISK ASSESSMENT
The key parameters of integrity, risk appetite and competence are evaluated based on the following:
Integrity: Past credit history, instances of delinquencies, market perception as evidenced by articles in the print and electronic media.
Risk Appetite: Propensity to launch several projects over a short period which is likely to expose the balance sheet to considerable stress, excessive reliance on debt funding.
Competence: Demonstrated ability to execute projects across cycles, geographies and segments.
Assessment of Environmental, Social and Governance (ESG) Risks
In addition to the above mentioned Rating Framework, Acuité also comments on the ESG parameters in case of certain listed entities in its Rating Rationale.
The primary goal of any commercial entity is to maximize the value for its owners/ shareholders through profit maximization. However, it has to be recognised that besides profit maximization any business entity has certain responsibilities towards the society in which it is operating and towards the environment. Hence, an ESG assessment of a business entity assumes importance. ESG is a framework for measuring the performance of the company across three specific categories: Environmental, Social and Governance.
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