Source: The Economic Times.
Investors and customers need to be wary of the real estate risks, and should factor them in their decisions.
The real estate sector is booming and everyone is euphoric on the economic returns, given the buoyant property and share prices of real estate companies. But this should not make us believe that the risks are low, given the risk return trade-offs in any financial investment. Ignorance of risks will enhance the vulnerability of the investments, and can precipitate losses and shake-outs. The real estate development inherently involves various risks, and the insufficient recognition of these can adversely affect the customers and investors. CRISIL believes that these risks not only need to be recognised, but also need to be evaluated well, incorporated in valuations, and continuously monitored. The customers need to factor these risks in their purchase decision and property values, equity investors needs to value these risks in their share pricing and the lenders need to incorporate these risks in assessing the project's credit-worthiness.
The key risks in the real estate sector, alongwith their implications, are discussed below:
Investors and customers need to be wary of the real estate risks, and should factor them in their decisions.
The real estate sector is booming and everyone is euphoric on the economic returns, given the buoyant property and share prices of real estate companies. But this should not make us believe that the risks are low, given the risk return trade-offs in any financial investment. Ignorance of risks will enhance the vulnerability of the investments, and can precipitate losses and shake-outs. The real estate development inherently involves various risks, and the insufficient recognition of these can adversely affect the customers and investors. CRISIL believes that these risks not only need to be recognised, but also need to be evaluated well, incorporated in valuations, and continuously monitored. The customers need to factor these risks in their purchase decision and property values, equity investors needs to value these risks in their share pricing and the lenders need to incorporate these risks in assessing the project's credit-worthiness.
The key risks in the real estate sector, alongwith their implications, are discussed below:
- Construction risk: The construction risk involves the design, structural quality, infrastructure, project location, soil quality, costs and quality of input materials (primarily steel and cement), technology etc. These factors could not only affect the quality of construction, but could also result in cost overruns. Poor quality, substandard structure can not only result in problems like leaky, damp roof, uneven flooring, jammed doors/windows, leakage in toilets, water stagnation, but can also affect the safety of the inhabitants. The customer should evaluate the construction quality of a developer, based on its track record, quality policy and quality control tests. The pre-construction tests will include - soil test, water test and pest control. The construction quality tests will be undertaken during RCC structure (concrete cube test), plumbing (pressure testing in sanitary pipes) and material tests.
- Legal risk: This involves the establishment of clear title to land through title investigation, ensuring nil encumbrances on the right of the developer to develop land, incorporation of key equitable covenants in the sales agreement to protect the interests of the customer, and obtaining various regulatory approvals such as the commencement certificate, environmental clearances, and occupancy certificate. The presence of any of the legal risks can potentially lead to the disputes between customers and developers, defective land titles and legal hurdles in title transfers. CRISIL experience shows that at a time when the land prices are on the upswing, the legal risks increase tremendously. The quality and value of the land bank is directly correlated to the legal risks involved in the land purchased. Hence, the customer/ investor should evaluate key legal documents, mainly sales agreement, closely.
- Management risk: This is based on the developer's track record in executing the type and scale of projects being undertaken, its long-term commitment to quality and the business, its integrity in honouring its commitments to various stakeholders, and its attitude towards risk as reflected in undertaking projects beyond its proven competence. In a boom, the management's attitude towards increasing scale of development can have a major impact on the resource availability for a specific project. CRISIL assessment shows that while management risk has improved for the real estate developers and is low for the majority of rated developers, it varies between moderate and high for the sector as a whole.
- Financial risk: This is reflected in the developer company's financial policy, accounting policy, gearing of the company/ project, cash flows of the project/developer, break-even level of area to be sold, proportion of land cost in the project cost, and the ability of the project to raise financing. Over-dependence on external funds can be costly and risky. A judicious mix of residential and commercial projects, combined with a fair mix of debt and own funds, can help a developer to reduce the financial risks.
- Organisational risk: This reflects the robustness of systems and processes followed by the company, its land acquisition strategy, its marketing strategy, the standardisation of workflow processes, computerisation levels, and extent to which modern techniques are deployed in project conceptualisation, design, planning, and execution. Overall, the monitoring and control mechanisms deployed by the developer for ensuring adherence to time schedules and cost estimates reflect the organisational risk.
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