Labourers work at a real-estate construction site in Mumbai. (Photographer: Dhiraj Singh/Bloomberg)

IIFL’s Nirmal Jain Sees No Systemic Risk In India’s ‘Fragile’ Real Estate Sector

The biggest risks to Indian realty might come from Mumbai, according to Nirmal Jain.

The founder and chairman of IIFL Holdings said the sector’s “fragility” was largely due to high-priced pockets in India’s financial capital, causing 80-90 percent of the problems. However, Jain said the sector doesn’t face a systemic risk.

“Many builders might lose their equity or a significant part of it,” he told BloombergQuint in an interaction. “Some lenders might have to take some haircut.”

The expensive real estate in Mumbai, according to Jain, is “the epicentre of all problems” due to sky-high prices and minimal end-user demand. “People are scared whether a builder will be able to sell,” he said, adding that the situation is vastly different in markets across the country.

“…the real estate markets in suburbs of Mumbai like Borivali, Thane, Virar, Kalyan and Panvel or in cities like Bengaluru, Pune, Lucknow and Jaipur, there isn’t much panic,” he said. He attributed this to the lower land and total costs in those markets.

On Prime Minister Narendra Modi’s ‘Housing For All’ scheme—which seeks to provide a house to over 20 million Indians by 2022—Jain said the sector needs to prioritise to whom it’s going to build for. “The developers have to be funded otherwise the whole industry will not take off.”

Watch the interview here

Below is an edited transcript of Jain’s interview.

A Care Ratings report suggested that bond issues stepped up in January 2019. A large portion would have been done by NBFCs in particular. Is it a sign that the industry is slowly limping back to normalcy or is it difficult to say that right now?

This is disintermediation. Investors invest in either mutual funds or banks. If they invest in debt mutual fund scheme or bank fixed deposit, and then banks in turn lend it to corporates or NBFCs included and similarly mutual funds can also lend it to NBFCs. Now, there is scare of about NBFC’s credit after the IL&FS fiasco that happened a few months ago. Many corporates invest in mutual credit and liquid funds. Companies like Sterlite, Tata and their finance departments might get hyper sensitive. They might start asking questions to mutual funds who’re the entities that they lend to. Many times, it happens that there could be one NBFC and they try to paint the entire NBFC sector with one brush. So, mutual funds are very hesitant to lend to many NBFCs. It’s a good thing because this is a disintermediation and disbursal of risk, in a way. Many investors can invest, take a credit call. Bond issuances started few years ago and they didn’t carry properly, or the trend didn’t become an established practice. So, it is coming back. It’s a long way to go. In India, the bond market is in a nascent stage. If you compare India with any other large market, then the corporate bond market is very small. Whatever issuance you have seen in January is the tip of the iceberg. In a way, it is a win-win because investors are investing directly. The cost of disintermediation goes away for the entities that are borrowing and in the longer term, it makes sure that the risk isn’t concentrated but disbursed.

The ability for NBFCs to raise money in January—is it a sign that there is acceptance of the NBFC paper?

No NBFC has defaulted in last four-five months despite media headlines every week and fuelling social media with rumours. The NBFCs are under attack from rumours but they have honoured all their commitments. So, credit goes to the regulator, too, as they created a robust framework after 1998 when many NBFCs went bust together. This is proof that the regulatory framework is working, and the risk disbursal and risk mitigation is working. In IL&FS, there is no lender which has a large exposure. There are exposures but are fragmented. Any system, out of its 100 entities, one-two can go bust. You can’t have any economy or any financial system, where you can say there will be no insolvency at all. The regulatory framework has been robust enough to make sure that no NBFC defaults, and the other is liquidity tightening. Many times, it may not be a solvency issue, but a liquidity issue. There also regulators have stepped in at the right time to make sure liquidity isn’t tightened because of fear factor.

Don’t you agree that fear factor was alive? We’ve gone over the crises as things stands right now but it could have worsened if some steps weren’t taken in time. Companies themselves said that this is a black swan event.

Yes, and no, because we can never have an alternate history to know what could have happened if we had done this or that. In India, the media and social media exaggerate the fear and something like a small issue looks like a big issue. IL&FS issue is a small issue from the economy’s point of view. IL&FS’ loss is not lost, nor a scam or fraud. It’s a situation where the total assets may not meet total liabilities and all the lenders may have to take some haircut. That situation is bound to happen in a large economy like India. IL&FS is neither the first nor the last. It got exaggerated and the entire NBFC sector started feeling choked in terms of liquidity. Panic, if taken beyond a point, can cause a real problem. Many NBFCs have met a call on them which were a very large part of their borrowing. In a financial world, any bank or large institution, if there is a crisis of confidence, then it’s difficult for anybody to meet it. That’s where the regulator and central bank have to step in and make sure this kind of crises don’t blow up into something more serious.

Are we behind that now? Is fresh credit getting created?

Few more things happened in the last few weeks. One was entire episode of loan against shares. Another one was the judgement on Jharkhand SPV (special purpose vehicle) of IL&FS. These things can create fresh panic and a different kind of panic. Supposing there is a secured asset in SPV and those cash flows are mortgage for a particular liability, the judgment of NCLT has questioned that. It can cause a fear factor because then nobody can do secured lending. If the secured is unsecured by some twist of interpretation, they come at par or come close, then it can be serious issue and it can cause a new wave of panic. The SPV of IL&FS, the cash flows have not gone to the lenders of that SPV but they might be. Many times, these kind of things in a democracy, if they work independently, it can happen, but they are all part of the game. They get resolved over a period of time, either by judgement of higher court, law or legal amendments. The trial by fire is behind us but there can be new one as you never know. For the time being, one should not panic. The kind of default you see in India, you take any developed market, the only difference is media will not highlight it as the front-page newspaper every day. In India, social media is very active.

If no other large incident happens, then what happens to growth? Last year, NBFCs took the space which were vacant as banks weren’t willing to do it. There was a belief when IL&FS happened, that banks will now come back and there will be re-balancing. Do you sense it?

NBFCs accounted for almost 33 percent of incremental credit. There are some people who feel that NBFC credit will go away and PSU banks will start lending and private sector banks will fill the gap. I find that difficult to believe. NBFCs have slowed disbursal in the last quarter and may be in this quarter, too, but they are limping back to normalcy. The demand for credit hasn’t reduced because the economy is doing well and the demand at all levels is still there. Public-sector bank credit has grown, and private sector bank credit is also growing. Can they fill the gap? Will the NBFC incremental growth always be slower? Most of the NBFCs fill the gap because they connect the last mile that banks will find difficult to do. If you are talking of small loan to a SME that doesn’t have income tax records and isn’t filing tax returns and the loan size be Rs 50,000-2 lakh. You require collection to be on time, too. You need to maintain collection discipline. Most of the PSU banks are large and average age of their staff is 52-53. You can’t imagine that they will disburse loans of Rs 2-3 lakh and collect with the efficiency that the NBFCs are doing. The complementary model is that the NBFCs do the credit, either in co-lending model but they take responsibility of collection, and they sell their assets to PSU banks or they do co-lending with new guidelines. I think that will work. In this crises, two categories of NBFCs have been clearly differentiated. The NBFC which lend retail, the small-ticket lending, they have specialised skill in a niche segment. Every niche segment you must have credit appraisal as well as collection skills. And the NBFCs who do the wholesale funding, it’s of two types—the real estate developer, and loan against shares. Wholesale funding NBFCs have seen increase in cost of funding much more than the retail funding NBFC. The NBFCs which do wholesale funding, must rely more on bonds and other sources of funding because they can’t secure the assets and get money from banks. Their cost of funds is higher, but they can charge higher, too, as it’s priced in when lending to large borrowers. That is happening in the industry and it is getting bifurcated. This is the way forward.

The growth rate at which the NBFCs have grown, you believe that there may be a temporary mismatch but eventually they will get back there.

Most segments will get back.

What about the overhangs of a couple of business which may hamper this? How big is the overhang in the fragile real estate space right now?

Even for loan against shares, when promoters borrow, 20 percent or whatever is the minimum holding, the regulations should not allow that to be encumbered. Suppose I am promoter, there is a minimum stake that I should not be allowed to pledge or create an encumbrance. That kind of regulation could give stability to promoter lending or loan against shares because if 95-100 percent of companies pledge, it creates chaos. The developer space which is fragile. In India, the real estate is viewed as fragile. The 2 km radius from here is the epicenter of all problems since that is where the real estate prices are very high and end user demand is less and people are scared whether a builder will be able to sell. This is not for entire India. If you see the real estate markets in suburbs of Mumbai like Borivali, Thane, Virar, Kalyan, Panvel or Bangalore, Pune or Lucknow, Jaipur, there is not much panic, and industry works in different ways. The component of land cost and total cost is lesser there. You may incur cost of Rs 2,500 to construct and sell it at Rs 4000-4500. There you will not see price fall or risk of this magnitude. On one hand, if our government has a motto that you want to have housing for all by 2022, and with it giving so many incentives for affordable housing, the real estate needs to adjust as to who is going to construct. The developers have to be funded otherwise the whole industry will not take off. The industry is getting fear or bad name because of very large exposures in Mumbai market. That’s where there is risk. The risk is not as high as it appears from outside. In most cases, there is collateral. Most lenders would have done two times cover. There may be some haircut or losses. But it’s not a crisis where there is fraud. It is not a Ponzi scheme. The real estate is real, the prices might correct. The builder and developer may not have equity left when the price corrects. In most cases, lender might recover their dues. In some cases, lender may have to take some haircut, but it’s a part of the game. In 2008 in the U.S., the mortgage industry throughout the U.S. fell 40-50 percent. And the entire industry, lenders, banks, institutions went bust. I don’t foresee that kind of scenario in India. Many big developers are in concentrated regions of Mumbai, or few cases of Gurgaon or Noida, but 80-90 percent problem is in the high-priced areas of Mumbai. Many builders might lose their equity or significant part of their equity. In the worst-case scenario, some lender might have to take some haircut. I don’t see systemic risk in the real estate sector.

So, you are admitting that there is no exposure to a particular segment which could hamper the book in meaningful way?

At IIFL, we are very transparent. In our total book, we give you a complete break up. Our real estate or developer exposure, it is 10 percent of our AUM (assets under management). In the last quarter, our gross NPAs went up by almost by 9 percent. If you are 90-91 days, then you get classified as per RBI norms currently. Sales are slow because of fear factor. But in all cases, we have a collateral which is adequate. We are predominantly a retail company. 90 percent is retail in our book. Incrementally, we have to be entirely retail. In our group, in wealth we are subsidiary company in which we have alternate investment fund. So, we are raising fund. Recently, we had our India housing fund which will fund developers. We have six funds earlier in real estate out of which two were given complete exit with 17 percent IRR (internal rate of return) which is unique in industry. So, our track record of funding in real estate and collecting is very good. Going forward, that is the model. If you have 10-20 projects, one can get into liquidity and cash flow problems, but you pull in the risk and then people can get good return and the risk gets diffused.

In the past, your wealth business showed good ability to toggle between equity, real estate and structured debt. In FY19, the agency realisations are showing a sharp drop quarter after quarter. What is happening here? How long can this slightly moribund growth last?

There are two factors. The first is market conditions. If assets move fromequity to non-equity, then your average fee income might fall. Moreimportantly, we (IIFL) are the first wealth management company to make adecisive move from transaction or distribution-oriented model to a completelyadvisory or free model. When I say this is our preferred mode, and we areencouraging customers to sign up IIFL.

One which is our advisory service. Also, we havemade some changes in accounting to make this accrual basis. We have Rs 1.60 lakhcrore of assets and the incremental flows can be Rs 20,000-25,000 crore every year. When we make a transition where we say we’re going to do this on accrual basis only, then your income might drop when you do the transition but over a longer time period, it makes it a very sticky business model. At IIFL, we charge you 50-60 bps on investment, but we don’t charge anything for transaction. Even for close-ended products, either from mutual fund or AIF (alternative investment fund), we give you a separate series where the distribution fee or commission is waived. From a client’s point of view, it becomes very transparent. Although the fee is coming in an accrual basis, it becomes a win-win. If otherwise, we’re taking upfront, I’m taking a discounted value of it. If I take it over every year, the aggregate may still be more. The change in business model has also resulted in drop in the reported income. When capital markets face headwinds, you will see some drop in that income. The beauty of that business model is whether equity markets are doing well or not,the clients are with us and we can toggle their allocation from equity to fixed income. But that is what our customers expect us to do. That is why our advisory is for.

Do you scale down business at the risk of missing out when the cycle turns back to normalcy?

This is a business where you can’t have quarterly numbers based view of how the business is doing. As an entrepreneur or owner, I look at the flow of assets. I look at assets under management. If there is net flow of money, then I am happy because I am getting new customers and new money. Suppose this is a private business and I am not doing it from a quarterly point of view, you will look at whether I am getting more money to manage or if I add clients. From that perspective, we’re very happy the business is progressing. There can be cycles when you get slightly lesser fee or cycles where you get a higher fee. As long you are getting new money and new customers, business is doing very well.

Would you believe that the book and quality of the book from where it’s right now to three years further, it will be substantially higher and better? Or is it difficult to say?

There’s a one-year loan book which we have in our balance sheet. There’s retail which is very good, and we maintain the quality of those assets carefully. Then there are customer assets which we advise and service. There is wealth that is with customers. There are three components where we have a distribution relationship for every transaction, we take customers approval and make investment. There is an advisory where we advise but it is non-discretionary, and then there is discretionary. Among these three components, we are very happy with the way customer assets are. They can move from equity to debt but there is no problem with quality or if customers have lost money because of reckless investment; all our customers are happy. When you are a market leader, you may be subject to rumours and can be frustrated with competition or a rumour can go anywhere. They can talk about your book, customers, compliance, regulations. I want to assure that there is no problem and IIFL One is in the pink of health in terms of quality of assets, books, strength of relationship with customer or the fiduciary responsibility which we have delivering to our customers, it is in good shape.

Will the business continue to earn same kind of IRRs as consolidated business as you had in past? You have raised money and it is arguably at a much higher rate than you would have raised 6-9 months ago. Is this the new normal and therefore will the margins come off?

Cost of borrowing had gone up in the wake of liquidity crises. It is stabilising and showing signs of coming off. Our weighted average cost of funds in last quarter went up by 40-50 bps. The advantage of business model is, when I am talking about affordable housing or gold loan or SME loan, I can pass on cost increase very well. The book growth will come back in this or the next quarter. I don’t see any significant challenge in maintaining the ROE (return on equity) over medium to long term. The cost of borrowing which had gone up for us had increased lesser as compared to peers. If it had gone 40-50 bps for me, then for my peer may have had a 70-80 bps increase. So, it is comfortably placed in terms of how lenders perceive me. As we’re seeing rate cut and the inflation is low, next three-five years my view is that interest rate in India has to come down significantly. They have been maintained at high level artificially for too long. In the last 200 years of history, nobody can afford real interest rate of more than 1.5-2 percent. In India, real interest rates have been high at 4-5 percent for too long and it is impacting growth of economy and industry. It is true about any market or economy for the last 300 years. If inflation remains low, given the crude oil prices, food inflation, then interest rates have to be brought down. If the systemic interest comes down, it will come down for us too.