Economic slowdown: Stress points in real estate limited, but financial sector needs to be watchful

Against the background of a slowdown in the economy and the myriad problems in the financial sector which have not yet settled, any signs of adversity can result in panic reaction. A concern today is about the real estate sector being a possible area of stress for the financial sector.

Following a series of reforms which came in the form of demonetisation, Goods and Services Tax (GST) and Real Estate (Regulation and Development) Act (RERA), the real state sector has faced headwinds with the financial side being affected quite perceptibly.

The sector works on high-cost borrowing and the formal sector which gets involved are banks and non-banking finance companies (NBFCs). The former has inherent restrictions on lending to real estate as it gets classified as a sensitive sector. NBFCs, on the other hand, tend to be preferred for access and have done fairly good job in providing the necessary funding.

Representational image. Reuters

Developers have traditionally been using informal sources along with credit from the NBFCs for financing property development. Funds from individual home owner’s installments are used to meet the phased requirements of construction. However, with formalisation of the economy and RERA there have been several regulatory measures that have brought in discipline but also put pressure on their finances.

Post-demonetisation, the NBFCs took over with some aggressive lending which was also seen in the growth in credit to this sector which reached around Rs 1.25 lkh crore by March 2018.

Bank exposure to real estate as of March 2019 was Rs 2.2 lakh crore, but overall credit to the NBFCs stood at Rs 6.8 lakh crore. Hence there was a re-routing of some credit from banks to the NBFCs to real estate. However, real estate exposure to NBFCs was not really high at 6 percent of the outstanding credit.

Two factors have affected the real estate sector of late. The first is the economic slowdown which has affected the corporate sector performance which in turn has affected demand for property. Several companies have deferred their expansion plans as economies have been evoked to maintain profit lines in the last couple of years. Hence this has led to the build-up of inventory that has been funded through loans by the financial sector which is primarily banks and the NBFCs.

Simultaneously there has been an over-estimation of the retail boom which had led to the development of property which has not been sold as plans have been altered over time. One reason for the same is the expansion of e-commerce business which has made the brick and mortar showrooms/spaces less relevant. The focus now has shifted to the Tier 2 cities where chances of expansion are better.

The second relates to the NBFC crisis that began in July last year and led to a contagion which has only of late been brought under control. Funding has gotten constricted as NBFCs’ ability to lend has been curtailed given the challenges in raising funds. It may be pointed out that the NBFCs typically used short-term funding for long-term lending which led to a mismatch. When the commercial paper market dried up for them, they have been forced to source funds from the bond market where costs are typically higher.

Both of these factors have meant that this sector has been under pressure. However, the performance of residential property has been better and made up for the loss of business on the commercial side.

The modified credit ratio (defined as the number of upgrades plus reaffirmations divided by the number of downgrades plus reaffirmations) of CARE portfolio was 0.87 for H1-FY20 and has been in the range of 0.85 for the last three years. Therefore, this is something to take note of by the lending agencies as it requires closer monitoring.

There are hence three distinct pictures on the real estate sector today. First, for the first quarter of the year, the performance has been impressive. Second, from the ratings perspective, there have been more downgrades (which is not default but a change in rating to a lower level) than upgrades, which is indicative of signs of stress. Third, there is the physical market which does not look good on the commercial side especially given the inventory build-up and limited demand for new property.

Presently, the non-performing asset (NPA) ratio for NBFCs is 6.6 percent (RBI: FSR, June 2019) which is manageable though there has been a call to revisit these numbers in the face of the crisis. Bank NPAs to the service sector (which include NBFCs) was 5.7 percent.

Given the relatively low share of real-estate in overall loans for banks (2.5 percent) and NBFCs (7 percent), there does not appear to be any imminent problem for the system as such. However, given the rather vulnerable state of the NBFCs, stricter vigil would be required to be invoked on such loans as any slippage on this front would give feedback to the banking system as they have a share of almost 8 percent in total bank credit.

The future course of the performance of the real estate sector would be dependent on how the economy fares and how soon the recovery sets in. The present focus on housing – both affordable and regular — has provided succor to the sector and brought about some buoyancy which would otherwise not have been there. Both corporate expansion and retail growth would hold the clue to commercial real estate prospects.

(The writer is chief economist, CARE Ratings)