Then to Now – whats causing the NBFC crisis in real estate?

NBFCs are in the eye of storm. And its still unclear whether the crisis is real or mere panic reaction. The key reason pinned is asset-liability mismatches in select NBFCs, although that leads to a question on how A-M mismatch get so severely out of control in regulated and audited entities, and not be anticipated on a timely basis. And so, does that make it a mismatch or mismanagement?

In context of the real estate industry specifically, it helps to look back on the turn of past events that have led up to the current scenario. The real estate industry post the global financial crisis (GFC) of 2008 witnessed a trend reversal in capital funding of projects.

Equity for housing projects completely vanished from the market and most funders thought it fit to shift to debt that completely protected their downside with approx. 2X security covers. Interest rates were as high as equity and ranged between 18-24%.

It seemed like a good deal for lenders; the industry did not have too many options and lapped up financing with the hope of pre-paying through project collections.

While sales haven’t really moved from slack to buoyant, we witnessed a lot of optimism amongst NBFCs that went aggressive on deployments. Typical of herd mentality, several NBFCs entered the market, looking to finance projects that were at early stage / high risk, or refinance existing projects extending moratoriums to developers. Some projects are now in their third rounds of refinancing.  

With refinancing typically taking place post approvals, risks were perceived to be lower and this entailed better interest rates. However, the moot point here is that if a project is in need of an extension in moratorium, it signals a certain stress on account of sales velocities.  This questions the risk underwriting philosophy of NBFCs in not being able to assess risks and diagnose the financial health of a project that in fact needs several rounds of refinancing.

This is typical of the ‘frog-in-boiling-water’ phenomenon, where one’s risk appetite can increase, when exposures to risks are gradually and periodically increased, thus stunting the ability to view risks as a whole.

Having said that, unlike investors pre-GFC, NBFCs have been more cautious on their partner selection. ‘Intent to pay’ has been placed topmost by all NBFCs in the list of risk measures, to augment the concerns of fly-by-night operators that existed pre-2008.  This however, led to more capital chasing select developers.  Many developers, especially the Tier 1 and 2 developers, also had the benefit of getting maximum debt with narrow margins, against low-quality collaterals, thus having limited skin in the game.  

With the Supertech default, NBFCs have now pulled back on fresh disbursals and started relooking at their portfolio more holistically.  Looking forward, there are certain ramifications of the current events that the already battered real estate industry should brace for –

• Financing avenues will dry up – With sales already sluggish, project execution and completions could get hindered. This could lead to more stress and defaults, with price correction and offloading of inventory seeming the only possible respite to generate liquidity. Refinancing will cease altogether and the last NBFC standing in this round of musical chair could bear the brunt of the liquidity crisis.
• Project costs will shoot up - Cost of borrowings for NBFCs are likely to shoot up in the short term. This will raise interest rates to real estate projects reducing asset covers and squeezing margins further, thus making projects even more unviable unless sales improve.
• Action on new land acquisition and launches will slow down - With developers being cash-strapped, focus will now be purely on execution and completion of current projects rather than taking up new projects.  New launches will significantly drop.  Having said that, this may not result in any price appreciation over the short to medium term, as many projects could be under default / near default lines, requiring price corrections to trigger sales.
• Closures and consolidation - With limited resources for funding, developers may find it difficult to sustain ongoing employee and other costs. We could witness closures and lay-offs which in turn could have a domino effect and create a vicious circle of dragging down sentiments further. Unless there is more strategic consolidation, which in turn needs liquidity and capital support, there could be a significant funding gap in facilitating smooth takeovers and continuity / completion of projects.

Way forward

While the NBFC crisis does not seem to be too pronounced at the current time, but a few more defaults and delayed repayments, could put a real strain on liquidity, accentuating the current crisis and leading to some tough times for the real estate industry over the short term. 

The current turmoil will once again reflect the importance of corporate governance and only NBFCs that have strong governance and internal risk controls will survive. The liquidity constraint faced by NBFCs is a short-term one albeit could get deeper if developers do not see a turn-around in demand.

This remains a function of pricing and affordability. One could also witness return of equity financing over the medium term, and fund managers that have demonstrated track record over the last decade will stand to benefit out of this crisis.

Given the cyclical nature of the industry, the current lackluster demand situation is sure to reverse in future. The comforting factor though is that the current liquidity crisis has largely been caused by market forces (delay in approvals, slow sales, etc.) rather than fund mismanagement by developers (barring few exceptions).  

It remains to be seen how long and many developers / lenders are able to withstand the pressures of depressed markets until such a turn-around takes place.