Caveat Emptor

Let me share a recent case regarding illegal construction and sales. A close friend based in Mumbai bought an under construction apartment in Thane in 2010. It was one of those rare instances when he made a big decision in an instant. As soon as he saw that sample apartment, he fell in love with it. Immediately, he booked an apartment on the 22^nd floor; got a bank loan approved, paid the initial lump sum out of his hard earned savings and got the flat registered. He was happy; after all, registration meant that the paper work was properly done and with the property prices going up, he thought that he had made a wise decision.   

However, after a year or so, there was an article in the newspapers about the same builder having constructed some other project illegally and the local corporation body threatening to demolish it. Although, his specific project was not mentioned in the article, he decided to examine the approvals of his project in detail. Only then did he realize that his project did not have a CC (Commencement Certificate) beyond the 14th floor. In effect, he had bought an apartment that not only did not exist physically, but also did not exist in paper. The most shocking part was that the same had been registered as well!!

He was in such a hurry that he did not bother checking out whether the builder had proper commencement certificate or not. He skipped the necessary homework to close the deal quickly, a decision that gave him sleepless nights later! As a real estate investor, I am aware of many such cases. However, my intention is not to put off or scare buyers; rather the intention is to explain some of the process involved in construction approvals so that one is conscious about them while taking property decisions. 

Buying a property without ensuring that the developer has the necessary approvals is one of the most frequent mistakes that buyers make. Home buyers tend to let their emotions and dreams get the better of their senses, fall in love with a beautiful advertisement and make rushed decisions. Buying a property is perhaps the biggest investment that most people make and they should be extremely careful so as to not get duped by corrupt builders. Below, I am laying out a broad list of construction approvals that every buyer should be aware about before signing the dotted line. (Please note that these are construction approvals and have nothing to do with land; which is a separate subject altogether. For reference, I have used Mumbai as an example but it would be as applicable in any other city)

As far as the city of Mumbai is concerned, the Municipal Corporation of Greater Mumbai (MCGM), Mumbai Metropolitan Regional Development Authority (MMRDA), Slum Rehabilitation Authority (SRA) are the Planning Authorities under the Laws pertaining to the Town Planning. All the projects of construction whether residential or otherwise are required to be submitted to the concerned Authority and the plans are sanctioned by such Authorities.

Approved Plans   
First and foremost, please see the approved plans of the project. The local planning authority approves the plans of any development. The approved plans are issued in duplicate, i.e. copies to the owner & architect.

The approved plan bears signatures of owner, architect, municipal stamp of approval with case / file number, date of approval and is signed by the authorized officer of the Corporation. Validity of approved plan is one year and requires revalidation every year thereafter.

Intimation Of Disapproval (IOD)           
Along with approval of plans, the local corporation issues a letter of approval. In Mumbai it is popularly known as the IOD. (Intimation of Disapproval). People get confused with the term IOD. In fact even though it is termed as intimation of disapproval, it is to be read in its positive form; which means the IOD is a letter of approval subject to compliance of terms & conditions mentioned therein.  Validity of Letter of approval (IOD) is one year unless revalidated yearly.

The intimation of disapproval is issued with a list of NOC’s, which the applicant must obtain separately from various departments and government authorities. Final clearance to construct is given once the developer obtains all the NOC’s. The NOC’s assigned to the intimation of disapproval are case specific. However, it would generally include NOCs from the Tree Authority, Storm Water and Drain Department, Sewerage Department, Environmental Department (concerned with debris management), Traffic and Coordination Department, CFO (Chief Fire Officer - Fire clearance)         

Please note that only approval of plans and issue of IOD, is not a development permission unless it is clubbed with Commencement Certificate. However, most developers do start excavation work once they secure the IOD

Commencement Certificate                 
On submission of all required NOCs mentioned in the IOD and on compliance of the IOD conditions, the Commencement Certificate is approved. It is a development permission issued by the Local Planning authority. It is generally issued together with approved plans & letter of approval in other cities except in Mumbai. Validity of Commencement Certificate is typically one year from its date of issue. Only after obtaining the commencement certificate is a developer entitled to start the work.

High Rise Committee Approval

The High-rise committee was set up by the Maharashtra state government due to the surge in projects a few years ago and concerns about the effect it could have on the environment and infrastructure. It studies and clears every building being erected over 70 metres. According to the BMC's construction norms, a high-rise is any building more than 70 metres tall. Usually this means the building has at least 18 to 21 storeys, depending on the height of individual floors, which can vary from 3.2 to 4.2 metres in height.   

Environmental Clearance

The principal Environmental Regulatory Agency in India is the Ministry of  Environment and Forests (MoEF).  MoEF formulates environmental policies and accords environmental clearance for the projects. Broadly, all projects have been been classified in two categories. Some projects require Environmental Clearance from the Central Level Impact Assessment Authority at MoEF, New Delhi whereas others require Enviornmental Clearance from state level Environmental Clearance authority i.e., State Environment Impact Assessment Authority (SEIAA).

Construction Projects for Environmental Clearance fall under two categories- Category 8(a) Building and Construction projects and Category 8(b) Townships and Area Development projects. No environmental clearance is required if Built-up area of the project is less than 20000 square meter (sq.m) for Category 8(a) and if project area is less than 50 hectare and/or built up area is less than 1,50,000 sq.m for Category-8(b).

Clearance from SEIAA is required for Category-8(a) projects if the built-up area is between 20,000-1,50,000 sq.m and if it exceeds 1,50,000 sq.m then clearance is required from MoEF.

Also, please remember that environmental clearance is required to be obtained before commencement of any construction activity.

NOC from Airport Authority of India

With a lot of construction coming around airport in many cities in India, this is increasingly becoming important. A NOC for height clearance is required for construction projects, such as high-rise buildings or communications masts, which fall within 20 km of an airport. As per norms, construction within a radius of 20 kms around airports is regulated by AAI which issues no objection clearances for the height of buildings. In the funnel area of runways, height restrictions are stricter. 

Plinth Completion Certificate

Once work commences on the site and is completed up to the plinth level, the developer has to submit a proposal for Plinth completion Certificate to the local corporation. The local corporation after verifying the construction work done on  site up  to the plinth level may either accords plinth completion certificate & permit to carry on further construction work as per approved plans  &  conditioned mentioned in CC or refuses to grant plinth completion certificate, if any  deviations found than the approved plan.  In such cases notice are given to stop further work and to get the revised plans approved.

Occupancy Certificate and Certificate of Completion                      

Occupancy Certificate evidences the completion of the building as per the approved plan and compliance of local laws.  Without the Occupancy Certificate, it is difficult to get the water and sanitary connection. The Occupancy Certificate allows the developer to occupy the building but is not considered a final document because it still requires the Certificate of Completion. The Completion Certificate is considered to be the final document to fully occupy the building and connect to utilities.                  

Shopping Centres

2010 - It was the best of times, it was the worst of times.. for the retail market in India.

India’s Retail story is one of long-term growth. According to a report by India Brand Equity Foundation, the Indian retail sector had an estimated total market size of USD 330 billion in 2007, which is expected to grow to USD 427 billion by 2010. This growth has been manifested not only in the growth of the organized retail trade, but also in the large scale construction of new retail environments - shopping centers. The growth of shopping center development in the country is visible from the significant increase in its volume.

While there were only a couple of built shopping centers covering around half a million sq ft in 1999, it has been projected that as of end-2009, more than 50 million sq ft of shopping centers would be operational throughout the country. The ownership of these shopping centres is distributed amongst 100s of local developers scattered through out the country. There are very very few developers who can claim to be pan India shopping centre players. Meanwhile, big shopping centers become even larger. One of the motivations of the expansion activities is that the inclusion of more entertainment and food courts should give shopping centers more retail traffic and increase the sales of other retail stores, though its effects are doubted by some researchers that consumers who are drawn by entertainments are less likely to visit shops rather than food courts.

However, by end-2008, shopping centres and their owners came face to face with increasing vacancy and falling footfalls. Getting the retailers to sign the dotted line, pushing them to start the fitouts and then chasing them for unpaid rents have since become a part of daily life for shopping centre owners. The harsh realities of global recession affected everyone in the Indian economy, including the retail sector and its physical construct - shopping centers.

Given this background, does it make sense for shopping centre owners to consolidate? For the shopping centre industry, does it make sense to have a few large national players rather than many many small local players? Lets examine the benefits of consolidation:

Bargaining power with retailers

Organized retail industry in India is largely an oligopsonic market. (An oligopsony is a market form in which the number of buyers is small while the number of sellers in theory could be large. It contrasts with an oligopoly, where there are many buyers but just a few sellers. An oligopsony is a form of imperfect competition. One example of an oligopsony in the world economy is cocoa, where three firms (Cargill, Archer Daniels Midland, and Callebaut) buy the vast majority of world cocoa bean production, mostly from small farmers in third-world countries.)

Shopping centres in India have well defined product categories. These including the multiplex, the food court, the hypermarkets, the departmental stores (loosely referred to as anchors) and then the vanilla stores. In each of the anchor product categories, there are virtually 4-5 established players that all the retailers have to go to. This gives rise to an oligopsonic market with the retailers having the relationship power balance tilted in their favour. Also, with shopping centres being capital intensive (with large amount of debts) and the retailers working on negative working capital, the cash flow pressures are that much more on the shopping centre owners than the retailers. It gives retailers much more time to play hardball in their negotiations with the shopping centre owners.

If shopping centres in India could consolidate into 4-5 pan India players (rather than the 100 local players), the power balance could be restored and would provide shopping centre owners with a good amount of bargaining power vis a vis retailers. With a few buyers (shopping centre owners) and few sellers (retailers), one can expect a fair power balance in the industry.

Economies of Scale

For shopping centres, expenses can be saved from efficient operations.

CAM is the largest operating expense and is customarily recovered by tenants, but these expenses are not simply a pass-through, it requires the shopping center owners to control CAM and utility expenses that are also reimbursed by retailers to make a win-win situation. A stronger bargain power of a larger shopping center to negotiate better deals in procurement such as cleaning service could lead to scale economies. If the CAM expense elasticity with respect to gross revenues is lower than one, shopping centers could achieve benefits by efficient CAM and utility management.

General &Adminsitration expenses are likely to follow a stepwise increasing pattern as shopping centers expand and there are certain economies of scale expected to be achieved there. Insurance expenses are very likely to be the source of economies of scale for big shopping centers. Generally speaking, a larger shopping center is better placed to negotiate for favorable insurance contracts, and thus it will take benefits as the center size increase. Marketing expenses are certain to exhibit strong economies of scale.

Externalities

Externalities may have be huge source of competitive advantage to a shopping mall owner. Because of its large presence, it may attract retailers looking for quick expansion and because of the large amount of leasing available, the shopping centre might expand further. Large scale also give an organization the ability to invest in high quality personnel, which results from of its size; and implies that larger shopping centres, with higher quality management, will be better positioned to acquire properties and position them for rent growth.

So, how is this consolidation possible? REITs seem to be the only solution.

Reference:
Economies of Scale in Shopping Center Industry, Qiong Wang

Retail Asset Management – Empowering Indian Shopping Centres, JLLM

Real Estate Accounting

Real-estate accounting is a complicated business! It is difficult to comprehend and understand. Needless to say, real estate companies in India have been criticized by analysts for a lack of transparency in their property dealings and in how they account for projects.


As the industry struggles, investors are scrutinizing companies' accounting methods and transparency. The Institute of Chartered Accountants of India (ICAI) has, in the meantime, issued a Guidance note on Recognition of Revenue by Real Estate Developers. It has suggested that companies recognise revenues for real estate sales on the basis of the percentage of completion of the project at the time of reporting. In residential real estate projects, apartments/units are typically sold before they are constructed. A significant amount of money could also have been received even though construction might not have even commenced.

Under the percentage completion method, companies do not recognise revenues until a certain minimum cost threshold is reached, which can vary from 5-10% of total budgeted costs to as much as 25% being followed by some real estate companies. Some companies include the cost of land in estimating the progress achieved, whereas other companies do not take this cost into account in determining the percentage of work done or progress made. A change in these variables can have a significant impact on the revenues and profits reported by various real estate companies that follow the percentage completion method.

At a recent real estate seminar, I met the CFO of a large real estate company and we were discussing the intricacies of the interpretation and implementation of the percentage completion method. He gave me an interesting example. Suppose you have a project with a total size of 1,000,000 sq ft out of which 200,000 sq ft has been launched and about 50,000 sq ft has been sold. Assume that the land cost is Rs 500 sq ft, estimated construction cost is Rs 1500 sq ft and the actual cost incurred till date is Rs 200 sq ft (on the 200,000 sq ft). Now, suppose you had to compute the percentage completion, the logical way would be to compute the land cost of 200,000 sqf (Rs 100 million) add the cost incurred ( Rs 40 million) and divided it by the total estimated cost (Rs 100 million land plus Rs 300 million). This comes to approximately 35% (140/400). However, there is an another method. Since you have already paid for the 1 million sq ft of land, you can essentially include the entire land cost of 1 million (Rs 500 million) in the percentage completion computation. This means the ratio becomes (Rs 500 million + Rs 40 million)/ (Rs 500 million + Rs 300 million), ie 68% instead of 35%. Essentially, you can frontload the entire land cost on a smaller phase of the project to boost up the percentage completion ratio. This enables companies to book a higher revenue since revenue booking is directly dependent on the percentage completed. Such accounting policies are technically not incorrect and have been approved by the auditors of the company !