What's wrong with the real estate sector in India

9 Jun, 2011, 01.11PM IST, John Samuel Raja D & Kausik Datta,ET Bureau

Paromita Banerjee is livid. Her builder has asked her to make illegal payments to seal her Rs 40 lakh flat purchase in Navi Mumbai. The 32-year-old IT professional, who has never given or taken a bribe, has to pay Rs 2 lakh for water and electricity connections, even though these are her entitlements. And an equal amount for a parking slot, even though the Bombay High Court disallows the sale of common area. All in cash.

All illegal. Her builder says he is helpless. He says he has to pay off officials in government agencies to finish the project and he has to stay on the right side of local politicians. He offers to help her save Rs 50,000 in stamp duty on registration by reducing Rs 6 lakh from her listed cost price. But then, Banerjee will have to pay Rs 6 lakh more in cash. Again illegal.

Banerjee represents a typical flat buyer in India. Her income is all 'white', but she is sucked into the 'black economy'. This has gone on for so long and it's ingrained so deep that it's become an accepted way of working for builders, brokers and even buyers. According to a survey by consultancy firm KPMG, 32% of respondents voted real estate as the most corrupt sector in India.

Niranjan Hiranandani, co-founder and managing director of the Hiranandani Group, agrees. " corruption is the highest in real estate and the government is aware of that," he says. "The process that asks a builder to take approvals from different agencies gives birth to corruption," adds Deepak Parekh, chairman of HDFC , the country's largest housing finance company. "Every stage involves malpractice."

The cycle of corruption

For instance, in Maharashtra, the country's largest real estate market, a builder needs about 60 approvals to construct a property. About 50 are from the municipal corporation. "These clearances should not take more than three months," says Kumar Gera, chairman and managing director of Pune-based Gera Developments. "But in most states, it takes anywhere between one year and four years.

And they add 20-30 % to a builder's project cost." Builders pass it on to consumers, and extend the circle of corruption and cash. "Builders don't just pass it on," says a regional MD of a real estate consultancy, not wanting to be identified. "They often add to it big time--for example, how they account for payments to suppliers-to dodge taxes and siphon off cash. Such payments and accounting tricks are a greater malaise." This intricate cycle has become the standard in the sector.

And it has spawned a way of doing business where everything is distorted : how builders price their projects, how they recognise revenues, how they pay their suppliers, how they value their land holdings, how they use their bank loans... Footprints of the sector participants can be found in indecorous places.




For example, in the 2G telecom case, real estate companies - Unitech and DB Realty - are alleged to be at the epicentre of both cases in which the accused are in jail. Similarly, most of the clients of Rajesh Sharma, the disgraced founder-chairman of Money Matters, a loan broker, were builders. In November 2010, Sharma was charged with bribing officials of public sector banks and financial companies to sanction loans for his clients. Other parts of the economy engage with the sector, but with fear and doubt.

Banks, for example, can't ignore it because of the sheer volume of capital it consumes-at Rs 468,000 crore, bank loans to real estate companies and housing loans accounted for 12.5% of bank credit outstanding on March 2011. It's why, in every credit policy in an expanding economy, the regulator asks banks to provide a greater buffer for their real estate loans. Despite such oversight, real estate has a tendency to over-borrow and put the economy at risk. It is prolific at extracting tax and accounting concessions.

It is not accountable to consumers-it still doesn't have a regulator. It is synonymous with black money. No other sector gets away with as much as real estate, simply because of the corruption that links every part of its chain.

The corruption in land

Corruption in real estate starts with land. "Land is abundant," says the 2010-11 Economic Survey. "It is accessible land that is scarce." Politicians are a big reason why urban land is scarce. "People with political connections hoard large tracts," says AN Sachithanandan, dean of the Chennai-based Measi Academy of Architecture. "Then, for example, they prevent the extension of city limits to push up prices."

"Once land is overpriced, it leads to all types of corruption," adds PA Ananthanarayanan, CEO of Universal Dwellings, a start-up realty firm with a focus on the entry segment in residential. Land overpricing begins at its very purchase. There are three ways to buy land: from a private party, or from the government through allotment and through auctions. At the time of purchase, corruption creeps into the second and third methods. Land comes under the purview of local authorities. Most of it adjoining urban centres comes under the village panchayat, which is controlled by local politicians.

And they have a deep interest in land affairs, as a Chennai-based marketing professional, who did not want to be named, found out. This professional wanted to develop a few flats on the outskirts of Chennai along the Old Mahabalipuram Road.

The charge for converting six grounds (14,400 sq ft) of agricultural land into commercial land was Rs 2 lakh. Local politicians asked for a bribe of Rs 6 lakh. He couldn't show the Rs 6 lakh in his costing for a bank loan, and abandoned the project. "Builders have inside information on critical infrastructure projects," says Sachithanandan. In Navi Mumbai, builders close to a heavyweight politician reportedly bought huge parcels from farmers before it was earmarked as the site for an international airport.




Some have since sold that land at a multiple or exchanged it for prime land in the city. Politicians also help builders obtain land and use their clout to convert farmlands for development. "Once conversion from agricultural to urban use is permitted-a difficult regulatory process - land prices can jump 20-fold," says the 2010-11 Economic Survey. A Pune-based developer, speaking on condition of anonymity, cites the example of a builder with strong political connections who bought land in a green zone in Pune at throwaway prices and has since built a five-star hotel there. "I have seen roads being realigned to suit a politician," he adds.

The influence of politicians even extends to auctions. For example, in several recent Mumbai auctions, the amount of construction allowed by the law did not justify the exorbitant bids. The probable justification came later, when the state government allowed the winning companies to construct more, which suggested buyers knew this approval would come.

The corruption in approvals

Builders would like to construct the maximum possible, especially if they have acquired land at high prices, which is mostly the case in urban areas. But the rules place limits on construction. The floor space index (FSI) is the measure of how much a builder can construct on a plot of land. For example, if the FSI is 2, on 2,000 sq ft of land, the developer can build only 4,000 sq ft. Many factors determine the FSI of a building, including its location, the infrastructure around it, and whether it is meant for residential or commercial use.

As a rule of thumb, the further a piece of land from the city airport, the better the infrastructure (roads, sewage, power and parking) around it, the greater the construction allowed. The definition is open to interpretation-and revision. "There is an opaque mechanism of awarding FSI to different parts of the same city, giving birth to corruption," says Raja Kaushal, managing director of BNP Paribas Real Estate and Infrastructure Advisory Services.

"It's absolutely flexible in Mumbai, depending on the clout of the developer," adds a merchant banker who has managed several share listings of large builders.

After FSI, a builder needs 50-60 approvals from various government authorities. Builders say corruption is rampant. "Each officer draws his own interpretation and it's a battle to get the file moving," says a Delhi-based real estate developer. "Corruption aside, the quality of people evaluating plans designed by professionals is very low," adds Vijay Sohani, president of the Council of Architecture. "It's like asking a fifth standard pass to evaluate a BCom paper." Even the regulations leave much to interpretation, leading to the strange situation of state agencies contradicting each other. In Bangalore, different local authorities use four definitions of built-up area. "They (local authorities ) know it well. It suits them to have confusion," adds Sachithanandan.

Continued in next post .....
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  • The corruption trickles down

    Sure, builders are victims of this anarchic system. But they also exploit this anarchic system while transacting with buyers, who neither know the rules well nor have the wherewithal to immerse themselves in such details. An example is the illegal sale of parking spaces. Another example is underreporting the sale price of a property. Because of the high tax rates-stamp duty of 5-14 %, longterm capital gains tax of 20%-both buyers and sellers tend to under-report the transaction value of a property and transact the differential in cash.

    "The increasing spread of home loans and corporatisation of big real estate companies has reduced such transactions in original purchases," says Ananthanarayanan. "But in resale, a cash component of 20% remains the norm," adds Sachithanandan. Such transactions put cash in the coffers of builders, which the promoters use to buy favours or generate more cash for themselves.

    "The expense side is a rich source for money laundering," says the regional MD of a consultancy quoted earlier. He says builders purchase many small items from the unorganised sector-for example, steel rods and sand-in cash. So, for example, a builder will show. 100 cash paid towards buying material. But as per an agreement with the supplier, only. 90 worth of material is delivered; the builder siphons off the remaining. 10, thus escaping tax. "Many realty firms indulge in 'creative accounting', which inflates sales and profits," says Jamil Khatri, executive director with KPMG, an audit and advisory firm



    Builders have even violated loan terms. With real estate emerging as an investment, builders exploit bank finance. They buy land, advertise a scheme and collect 20% of the booking amount from buyers. But instead of beginning construction, they use the loan to buy another plot for a new project. Banks are not allowed to fund land acquisition, but money is fungible.

    A slowdown in loans can snap this chain. The credit crisis of 2008-09 threatened this chain. But PSU banks were coaxed by their political masters to provide loan support to builders on the pretext that defaults could put the economy under stress. Even as the BSE Real Estate Index tumbled 80%, real estate prices fell just 15%. Thanks to the generosity of bankers, and the interest of politicians, builders have consistently defied a basic principle of economics : prices should fall if supply exceeds demand.

    In 2010, the number of unsold flats in the Mumbai Metropolitan Region (Mumbai, Thane and Navi Mumbai) stood at 28 times normal monthly sales, according to research outfit Liases Foras. Yet, in the past year, house prices in the region are up 36%. "That's because Indian builders can access alternate finance channels," says Kaushal of BNP Paribas. It's an intricate chain of corruption, controlled by the rich and the powerful. And the losers in this cosy, connected web of relationships are honest, powerless buyers like Paromita Banerjee.

    Accounting Conditions Apply

    Even in how it does it accounting, sharp practices are endemic to the sector, which is partly the reason why the stock market perpetually discounts its stated value. As these five examples show, one just can't take a builder's word at face value.

    PERCENTAGE COMPLETION METHOD

    When a builder recognises revenues is divorced from when it delivers a property to a buyer. Most builders follow the 'percentage completion method'. This lets builders recognise revenues from a project on an ongoing basis, based on how much work they have done on it. Say, if in a financial year, a residential building is 40% complete, the builder can recognise 40% of the revenues. The next year, it is 70% complete; the builder recognises 30% that year. And so on. Since this method does not differentiate between finished projects and work in progress, it does not incentivise builders to deliver on commitments.

    In developed markets, the rule is to recognise revenues only on delivery. It could have become the rule in India too, but builders lobbied successfully against it earlier this year when the government was drawing up its plan to align with International Financial Reporting Standards (IFRS)-a global accounting framework. Builders were "pretty organised", says a member of the committee overseeing this convergence. "They marshalled key accounting professionals to present their point of view."

    And they had it their way: the percentage completion method stays. The current rule has the rider that builders can recognise partial revenues only from sold properties. "One on three companies add revenues from unsold flats too," says Jamal Khatri, executive director, KPMG. In 2009-10, DLF had an innocuous item in its balance sheet: unbilled receivables, worth Rs 1,443 crore. The interpretation: these properties are unsold but their revenues accounted for. DLF did not respond to queries on this practice.

    UNDERSTATING CURRENT EXPENSES

    There are expenses specific to a project. Then, there are indirect expenses, spread over many projects. For example, sales and marketing expenses, or headoffice expenses. Builders often bundle these into the project cost. It helps builders in two ways. One, they have to provide lower expenditure in the current year, which increases their profits. Two, the project is written over several years and it gets a tax cover too. By deferring expenses, it will account for lower expenses than incurred.

    SHADOW WORKERS

    This is a money-laundering trick. Builders show fictitious payments to labour. This is easily done because labourers are mostly paid in cash. Cash is sid out, which can be used to oil the corruption chain, or spent or deployed elsewhere.

    DEBT STRUCTURED AS EQUITY

    In March 2009, a foreign developer invested $50 million each for an equity stake in two real estate subsidiaries of its Indian joint venture. The foreign company is assured a 'minimum guaranteed return' of 10% a year, which is compounded and is payable at the end of five years; 15% if the JV fails to bring in two more investors in six months, with invetsments of at least $5 million each. Is this debt or equity?

    The question acquires significance since foreign debt is not allowed in real estate companies and the accounting of such a transaction inflates profits of the Indian firm. At the time of investment, the Indian company books a profit equivalent to the difference between its cost of investment and the price paid by the investor. But if the buyback arrangement is effected, on exit, the same transaction is treated as redemption of debt.

    Continued in next post .....
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  • UNDERREPORTING DEBT

    Another opaque practice is that of floating a special purpose vehicle to acquire land. A person close to the builder's promoters will float a company with a small capital of, say, Rs 5 lakh to acquire land. To avoid land prices from going up, this company's name will be such that it doesn't establish its connection with the builder. The builder lends money to the company. Say, the cost of acquiring the land isRs 100 crore. The builder transfers Rs 20 crore and the rest is borrowed from banks, with a corporate guarantee from the builder.

    "As of now, the debt in the books of land-buying company is not reflected in the builder's balance sheet, leading to underreporting of debt," says Khatri. Such practices mask the quantum of debt being carried by a real estate firm. At a later stage, the loan is converted into equity.
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  • ET articles :) :)
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  • Originally Posted by kingmanish
    ET articles :) :)


    True, when did I say it is my article :D.
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