Wednesday, November 27, 2013

Ten measures to mitigate valuation risks in real estate

Valuation Risks Need Recognition and Mitigation
Not a day passes without the realty sector hitting the headlines; and not always for right reasons. A realtor kills his mother in a car and also makes believe that he was dead and gone only to surface after two years – a case reported by the media extensively during the third week of November 2013 in Andhra Pradesh. Campa Cola Compound had to face demolition after the property owners were served notice of demolition for violation of FSI five years back just during the second week of November 2013. Hiranandini Construction Company received a Court verdict of Rs.76crores leading to liquidation while its prime properties in Chennai and Panvel are close to completion. Raheja Constructions received a huge penalty and punishment handed down by the Supreme Court in October 2013 for not handing over the promised flats to the investors. The Adarsh Housing Society of Mumbai is still under CBI investigation. Many more violations are awaiting court verdicts in different parts of the country. There is governance risk, reputation risk and market risk. One may ask: where is the valuation risk in all these deals? It is hiding deep in the skin of the sector. The reader may recall that the raison de ‘etre of recession was the subprime lending led by credit rating exuberance and inflated valuations. The resultant global recession is still staring at us.

Valuations are of different types depending on the purpose for which valuation is sought and there are varying valuations for the same asset and similar assets in dissimilar locations. They have time and space dimension. Depending on who asks for valuation the valuer gives the valuation report. These Reports have different formats for different institutions and individuals. The State and Central Governments periodically notify the market prices for purposes of stamp duty and registration. These are fiscal standards for valuation report. They invariably differ from the prevailing market value. One therefore notices these different value sets: Actual Value; Assessed Value; Assumed Value; Imputed Value; Book Value; Market Value; Registration Value; Insurance Value etc. Institute of Valuers consisting mostly of Engineers and Surveyors as its members, Institute of Chartered Accountants, Institute of Cost Accountants, Institute of Company Secretaries, Institute of Surveyors are in the game of valuation as certified or chartered valuers. Banks, Insurance Companies, Investors, Lease holders,

Tax Authorities, Courts, Builders, Housing Finance Companies and various other companies seek valuation for their own purposes. It is this nature of demand for valuation that kick starts the risks.
Most real estate companies do not have Boards and have no standards to follow. They do not have Enterprise Risk Management in place. The dynamics, distribution and development define the valuation risks across the verticals and product ranges. Companies that may be having some defective titles could also sell away their properties hot because of processes and systems that gave confidence to the buyer.

Today, after the new Land Acquisition Act 2013 came into effect the land titles have attracted new risks: the Government can resume the land earlier allotted if the purpose of allotment is either unfulfilled or partly-fulfilled as in the case of even SEZs.

Trend and Progress of Banking 2013 indicated that INR 16000cr are NPAs in realty sector. But mind you these are reported NPAs. Many may be hiding. Concealed risks are more than the revealed risks and these could arise from faulty valuation of the properties and could also be collusive faulty valuation reports. One Bank insisted on a valuer that he would give the valuation for insurance equal to the loan he sanctioned. He does not understand that the entire property is not insurable. The land value may not be insurable and even in the structure some would demand exclusion when it comes to the assessable value of the property. The Engineer may not have taken into consideration the property location in a potential seismic zone or surrounding the lake the property encroached upon. The insurance value when calculated could take such eventualities and earlier history of natural calamities or the bust cycles into account and reduce drastically the value for insurance. Or it can be the other way. These differences occur because of the absence of standards and risk assessment procedure across the verticals and within the verticals of the Real Estate Company set for valuation.
The Realty Sector is circumscribed by a number of regulators and each regulator has its own risk concerns around which the rules and regulations for compliance are framed. Right from local body to the metro corporation, different sets of regulations need compliance. Figuratively, risks can be explained as follows:

When the triggers for the sectors remain good with the Government allowing FDI in real estate sector to the extent of 100 percent and SEBI mulling over the guidelines for Real Estate Investment Trusts to emerge as new financial entities, the sector has tremendous opportunity for pushing the growth of the economy if it follows certain basic ethics in attacking these risks.

Formal funding mechanisms are scarce and most depend upon high cost informal costs that carry huge risks – one, in identifying these costs and two, in assimilating them into the cost structure for appropriate valuation. In fact, it is no exaggeration that there would be no real estate transaction without hidden costs being incurred by the buyer. This would mean that the recorded price is lower than the actual price. The financing institutions accommodate the hidden costs through equipments and internal structures when retail buyer seeks the loan. REITs are a significant capital and liquidity source for real estate industry globally and are making their entry, thanks to the SEBI’s recent draft proposal discussed earlier.

Risk Mitigation Measures
1. Risk culture needs to spread across all verticals in the sector by assiduously and consciously practicing it. Risk mitigation would start with an inclination to identify risks and actually identifying thereafter. The next step is educating the entire staff and administration as to where the risks are originating and fixing responsibilities and timelines to reduce or eliminate all together these risks. Therefore, fundamentally it devolves on sharing information across the organization.
2. We need a separate Regulator for the Realty sector that should be consisting of chartered engineers, experienced insurers and experienced financiers to put in place realistic regulations with implementation rigour.
3. Best practice manual for a variety of products where in the procedures and processes have to be clearly spelt out and the Builders’ Associations have to take on the responsibility.
4. Transparency in transfer pricing mechanisms.
5. Payment and settlement systems to integrate with the sector.
6. Defined products and processes matter most.
7. Corporate governance has to improve. McKinsey’s Global Institute in its latest study on the subject indicates that directors spend more time on strategy than any other area. 12 percent only is spent on risk management. The Study mentions that companies and boards are becoming more complacent about risks as the 2008 debacle becomes distant memory. Boards should insist on appointment of Chief Risk Officer to tackle both information asymmetry and adverse selection with oversight by the Board’s own arm of Risk Management Committee consisting of a CA, a competent legal Professional as important members. The line relationships should be clearly defined. Audit Committee should be set up for an ongoing internal audit or concurrent audit and for responsible external audit at the end of the year.
Corporate social responsibility assumes importance to enhance green field investments in real estate maintenance.
8. User association responsibilities to upfront the valuation mechanisms.
9. Each Realtor shall have mechanisms to oversee good governance, risk and compliance with clear cut responsibility for the Chief Risk Officer who shall be put in place mandatorily and who should be responsible to the Board.
10. Builders’ Associations should engineer specific studies to highlight how much of a percentage growth in the sector contributes to the growth in manufacturing and more particularly the SME sector as a building has over hundred MSMEs as vendors. The Corporate Social Responsibility of the sector can be moulded to enhance value to the vendor organizations in meeting the emerging standards in the components.

It is the systems and standard operating manuals, effective governance practices and the detailed risk management that hold the key for the healthy growth of the sector and the economy as well in its wake. The Institution of Valuers at its recent Mysore Conference (23-24 November, 2013) resolved to fight for their justifiable space in the realty sector on interactive platforms of the Government, Institutes of Cost Accountants, Institute of Chartered Accountants and Institute of Company Secretaries and Centre for Corporate Governance. They would like to disseminate knowledge on valuations and their varying dimensions. They are keen on setting up knowledge platforms driven by business ethics. One should only wish them good luck.
Published in Business Advisor, November 25, 2013.