Rating criteria for real estate developers. December 2016

Transcription

1 Rating criteria for real estate developers December 2016

2 Criteria contacts Pawan Agrawal Chief Analytical Officer CRISIL Ratings Sameer Charania Director Rating Criteria and Product Development Somasekhar Vemuri Senior Director Rating Criteria and Product Development Ankit Dhawan Senior Rating Analyst Rating Criteria and Product Development In case of any feedback or queries, you may write to us at 1

3 Executive summary CRISIL has ratings outstanding on more than 600 real estate firms. These firms can be broadly classified as special purpose vehicles (SPVs), or firms incorporated to execute a single project or a few projects with ring fenced cash flows, or as developers 1 or firms that execute several projects. The projects that are executed by a developer may be housed under one firm or different firms, but they have some degree of cash flow fungibility between themselves. This criteria article explains the methodology adopted to assess credit quality of developers. For ratings of real estate SPVs, please refer Rating Criteria for Real Estate SPVs which is available on CRISIL s assessment of credit quality of real estate developers focuses on three key areas business risk, financial risk and management risk. While the overall risk assessment framework is similar to that of manufacturing entities, the factors that are analysed as part of this risk assessment differ, given the nuances of the real estate sector. Business risk comprises an analysis of the market position and operating efficiency of the developer. Market position determines the ability of the developer to sustain its competitive advantage and is assessed through the development track record, extent of diversification, and brand equity and market share of the developer. Operating efficiency indicates the developer s ability to execute projects in a timely and cost-effective manner. CRISIL evaluates operating efficiency by analysing the progress in ongoing projects, the extent to which these projects are sold and whether the firm s portfolio has a healthy mixture of projects at different stages of completion. For commercial projects, CRISIL also evaluates the vacancy rates, tenant profile and customer concentration. CRISIL evaluates financial risk by assessing the cash flow position and liquidity of the developer. Cash flows in residential real estate projects are generated through sale of units of the project during the project implementation stage. This stands in contrast to the typical manufacturing/ EPC projects where cash flows are generated after project completion through asset utilisation. Hence, in order to capture these nuances, CRISIL uses the Cash Buffer Ratio (CBR) a modified version of the Debt Service Coverage Ratio (DSCR) across projects to evaluate the financial position of the developer. However, for commercial real estate projects, where a substantial portion of debt is backed by lease rentals, the regular DSCR methodology is used. For liquidity assessment, CRISIL evaluates different sources of liquidity available to the firm such as cash, unutilised bank lines, ability to raise additional debt and refinance the existing debt. Management risk evaluation is very important in case of developers. It is the reputation of the management that plays a key role in ensuring business stability. In this regard, CRISIL evaluates the competence, integrity and risk appetite of the management. The three ratings business risk, financial risk and management risk are combined to arrive at the standalone rating of the developer. This rating can be notched up in the case of external support by a stronger parent or group. 1 The term developers and real estate developers are used interchangeably in this document

4 Scope This article discusses the typical risks that real estate developers are exposed to, and the rating methodology CRISIL adopts to assess their credit quality. The criteria is applicable to real estate developers that are engaged in execution of multiple real estate projects, which may be housed in different legal entities, but have a some degree of cash flow fungibility amongst themselves. This stands in contrast to the single project real estate SPVs where there is limited cash flow fungibility due to ring-fencing of cash flows. For assessing the credit quality of such entities, where there is limited fungibility please refer to the Rating criteria for real estate SPVs available at The impact of Real Estate (Regulation and Development) Act 2016 on fungibility of cash flows is highlighted in the box below: Box 1: Real Estate (Regulation and Development) Act 2016 Indian real estate sector is marked with information asymmetry and limited bargaining power of customers. With a view to resolve these issues, the Real Estate Act has been ratified by the Parliament. The major provisions of this Act are: 1. Mandatory registration of projects with Real Estate Regulatory Authority (RERA), prior to which the developer cannot market the project 2. Developers are required to declare details about the project and submit relevant documents on RERA portal. 3. Developer is required to deposit 70% of customer advances in an escrow account, proceeds of which can be used only for the project for which advances were sought 4. Adherence to the project plan and compensation to customers in case of any delays This act is expected to boost transparency in the sector and empower customers. However, it may impact the financial risk profile of developers and restrict fungibility of cash flows between projects as developers are required to deposit significant chunk of customer advances in an escrow account. This is likely to impact cash flow fungibility between projects. These factors are expected to put pressure on the liquidity of developers. To overcome liquidity issues, developers are expected to tap alternate sources such as non-convertible debentures (NCDs), private equity (PE) and real estate investment trusts (ReIT). But this funding is expected to come at a significantly higher cost than customer advances, which are practically interest free. 1

5 Methodology CRISIL uses the framework highlighted in the diagram below for assessing the credit quality of real estate developers Chart 1: Framework for rating real estate developers Business risk assessment Business risk assessment entails evaluation of risks associated in the environment where the firm operates. The real estate sector is marked by high degree of fragmentation, given a large number of small regional players with small market share. In such an environment, the assessment of a firm s ability to sell profitably and in a sustainable manner becomes crucial. This is captured in the market position of developers through factors such as track record, extent of diversification, brand equity, market share and land acquisition policy of the developer. Additionally, real estate cash flows are generated through sales proceeds and lease rentals. Sales proceeds are released based on milestones, and lease rentals start flowing in only when the project is completed. Hence, timely completion of project within budgeted costs and healthy balance between projects in the under-construction stage as well as cash flow generating stage are critical indicators of overall operating efficiency of developers. When assessing commercial real estate developers, parameters such as vacancy rates, tenant profile and customer concentration are also considered. The components of business risk are described in greater detail below:

6 Market position Market position captures the ability of a firm to maintain competitive advantage i.e. to sell 2 real estate units profitably in a sustainable manner. It indicates the ability of the developer to sell the real estate inventory over time and commands a premium in the respective market segments. These factors are captured through the following: 1. Development track record: Real estate projects carry significant implementation risk as they involve coordination with several stakeholders and require liaising with multiple government authorities to successfully execute the project. Chart 2 and 3 below indicate the diversity of stakeholders and breadth of approvals required to execute a real estate project. Chart 2: Real estate value chain 2 The term Sell should be read as Lease for commercial projects which are usually leased out 3

7 Chart 3: Regulatory regime for real estate projects Given these complexities, real estate projects are prone to delays. Hence, the past development track record of the real estate developer, including timely completion of projects, would instill confidence in buyers that the project will be handed over in a timely manner. This is an important factor in ensuring the salability of projects during the construction stage. For assessing development track record, CRISIL takes into account factors such as: Years of experience in the given micro-market, as it indicates the reputation of developer and the fact that developer has experienced multiple business cycles Projects executed till date in terms of type (commercial or residential), area developed (in sq ft), time or cost over-runs in these projects. This highlights the project execution skills such as whether the developer has capabilities to execute projects of varying complexity Project pipeline in the medium term, evaluated in conjunction with the projects that developer has executed in past. An aggressive expansion plan would require commensurate scale up in execution capabilities, too 2. Extent of diversification: Developers with a well-diversified portfolio of projects are viewed favourably compared with those having significant exposure to one or two projects. CRISIL evaluates diversification in terms of Type of projects (residential or commercial) Stage of projects (new or in advanced stage) Geography Commercial real estate projects have a consistent revenue stream in lease rentals, whereas revenues from residential real estate projects tend to be lumpy. However, this advantage is partially offset by the timing of cash flows. Commercial projects generate cash flows after project completion, whereas sales proceeds from residential projects start pouring in even during the construction phase. Hence,

8 developers with well-diversified mix of projects across residential and commercial space are likely to have higher stability in cash flows, allowing them to withstand downturn in a particular segment. CRISIL also analyses developer portfolios to determine at what stage projects are in. If most projects are nearing completion with too few projects planned or initiated, it reflects poorly on future cash flows. Conversely, if most projects are in initial stages, with only a few projects having been completed or nearing completion, it will adversely impact firms financial risk, since projects in the initial stages lack funding tie-ups. Therefore, a healthy balance between the two is required to balance the existing and future profitability. Geographical diversity becomes important as demand-supply dynamics in real estate tend to be local in nature. A developer with presence in multiple geographies will therefore be better protected against slumps than the one with entire exposure in a single geography, irrespective of type of properties. 3. Brand perception: Developers with strong market reputation tend to have better capability to withstand cyclical downturns and ensure higher degree of business stability. This allows them to sell projects or lease inventory even when the industry outlook is tepid. 4. Market share: Significant market share in a fragmented market is an indicator of reputation of the developer and the ability to manage the demand-supply dynamics of a particular micro-market. Operating efficiency Operating efficiency captures the developer s ability to execute projects in timely manner at competitive cost and manage project level cash flows. This is important because it not only impacts the existing profitability of the developer, but for a developer facing time and cost overruns in several projects, it impacts reputation and consequently the future salability. This can spiral into weakening profitability as highlighted in the chart below: Chart 4: Impact of time and cost overruns on profitability Time and cost overruns in ongoing projects Time and cost overruns in future projects Heightened Funding risk in ongoing projects Heightened funding risk for future projects Sustainability of profitability impacted High reputational risk Market position negatively impacted 5

9 CRISIL assesses the operating efficiency of a developer based on the following factors: 1. Construction progress: Real estate projects tend to have higher implementation risk during the initial stages, and this risk reduces as it nears completion. This is for two reasons: customer advances (which may constitute 50% - 70% of project cost) being linked to project milestones; and, significant number of approvals required for project execution. As the project progresses, more customer advances are released, which provides funds for the project. In the absence of sales traction, developers have to rely on bank funding, which puts pressure on margins, adversely impacting operating efficiency. These factors necessitate a detailed analysis of portfolio construction progress and whether it is in line with the estimates. Any cost or time over-runs impact the operating efficiency negatively. In this regard, CRISIL evaluates the following: Construction progress in ongoing projects Sales booking progress in ongoing projects Proportion of projects for which funding has been completely tied up, i.e. construction cost is completely covered by means of available funding 2. Status of operational projects: In addition to monitoring construction progress for projects in construction stage, CRISIL evaluates tenant profile for commercial projects dependent on rental cash flows. As operating efficiency is linked to stability of cash flows, factors such as vacancy rate, tenant diversity, daily footfall and profile of anchor tenant become important. An anchor tenant occupies the largest area in the mall and witnesses the heaviest footfall. Such a tenant has a positive rub-off on footfalls for other tenants, too. Therefore, if a developer is dependent on a few anchor tenants across its properties, sudden vacation of even one anchor tenant can adversely impact lease rentals. Financial risk assessment CRISIL evaluates the financial risk associated with the developer in two broad areas cash flow analysis (captures the debt paying ability) and liquidity (captures the financial flexibility of the firm). These areas are discussed in detail below: Cash flow analysis CRISIL uses cash buffer ratio (CBR) to evaluate financial position of properties where loan repayment is through sale of units and debt service coverage ratio (DSCR) for projects where lease rentals are the primary source for debt repayment CRISIL evaluates these ratios at an overall portfolio level to assess the financial position of the developer. A typical residential real estate project generates cash flows through sale of real estate units, which begins well before project completion. Therefore, it is the debt which is used to fund deficit of construction over advances thereby acting as inventory funding mechanism. CRISIL s cash buffer ratio addresses this very aspect of debt. It factors debt contracted during the construction phase as source of inflow (like promoter s equity and promoter s funds) and calculates CBR as (Cash surplus before debt servicing)/ (Debt and interest obligations maturing during the year). This is illustrated in the diagram below:

10 Chart 5: Sample CBR calculation FY 2016 (Actual) FY 2017 (Projections) FY 2018 (Projections) FY 2019 (Projections) Net cash flow from operations (A) Debt service obligations (B) Cash flow from external sources promoter s funds and release of bank debt (C) Cash surplus before debt servicing (A+C) Cash buffer ratio for the year (A+C)/B For commercial real estate projects, where there are no cash flows during construction phase and significant proportion of debt is backed by steady stream of lease rentals, CRISIL s uses DSCR based approach. This is illustrated in the chart below: Chart 6: Sample DSCR calculation FY 2016 (Actual) FY 2017 (Projections) FY 2018 (Projections) FY 2019 (Projections) Rental income + Common area maintenance (CAM) income (A) Operating and maintenance expenses (B) Net cash flows from operations (C = A B) Debt service obligations (D) Debt service coverage ratio (C/D) CRISIL considers both the average and minimum CBR and DSCR ratios at portfolio level during the tenure of the project as part of its financial risk assessment. It also assesses the sensitivity of these ratios to external events such as unanticipated downturn, delays in receiving customer advances, etc. For commercial properties, CRISIL also assesses the proportion of non-lease rental discounting debt (LRD debt) as that of project cost. Commercial properties usually depend entirely on construction debt for funding. This debt is partly or fully converted into LRD debt after construction. LRD debt is relatively safe as it is against the cash flows from lease rentals. However, if significant proportion of property is still vacant, not all debt will be LRD backed and will carry higher risk. Further, if the repayment has a large bullet component, CRISIL also evaluates the flexibility of the developer to refinance the debt through various means. Liquidity analysis CRISIL evaluates the various internal and external liquidity sources available with the developer, as against the cash outflows expected to be incurred over the near-to-medium term. These sources include: Cash, unutilised bank lines etc. Ability to raise additional debt as evaluated through loan to value (LTV) of the commercial projects Potential cash flows expected from existing under construction projects 7

11 Management risk assessment CRISIL s evaluation involves assessment of the management in three broad categories: integrity, risk appetite and competence. In real estate projects, management evaluation further assumes importance on account of the opacity in the sector. CRISIL evaluates competence in executing similar sized real estate projects and whether sufficient project execution capabilities exist if the developer is scaling up in the medium term. The risk appetite of management is assessed through aggression in land bank acquisition and pricing policy. While history of litigation or regulatory action reflects negatively on management integrity, presence of professional management, management information system (MIS) and transparent disclosure practices are given due credit. Conclusion CRISIL s methodology for assessing credit quality associated with the real estate developers takes into account business strengths and weaknesses, reflected in market position and operating efficiency. These factors impact the financial position of the developer, which is assessed through analysis of cash flows and overall assessment of liquidity position. These risks, combined with the management risk, are evaluated to arrive at the standalone rating of the developer. In addition, CRISIL may also factor in parent support or external credit enhancements in form of guarantees. The criteria for parent/ group support and for evaluating guarantee instruments are covered under the other articles available on CRISIL s website.

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