New act poses challenges for real estate project financing

By Rahul Sud and Aditya Vikram Dua, SNG & Partners
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The much awaited Real Estate (Regulation and Development) Act, 2016, is a reality now. Hundreds of thousands of prospective homebuyers, and those who are stuck in under-construction projects, were eagerly waiting for the act to come into force. The act aims to bring transparency and accountability to the real estate sector, which had lost credibility due to unending delays in completing projects.

Rahul Sud SNG & Partners
Rahul Sud
SNG & Partners

While the act is a welcome move from a buyer’s perspective, it got a mixed reaction from banks and financial institutions which used to lend to the real estate sector.

There is a lot of confusion about the act’s operational mechanism and the regulatory functions which are to be achieved through its implementation. Because of the lack of clarity lenders have become more cautious before they lend to this ailing industry.

Some of the challenges being faced by lenders are outlined below.

Charge on receivables:

The act requires promoters to register every real estate project with the state’s Real Estate Regulatory Authority (RERA). Promoters must also undertake to deposit 70% of the amount realized from the allottees in a separate account and to use this amount only for costs of the project.

Lenders usually lend to real estate companies on the security of project receivables. The act does not provide clarity on whether this separate account can be charged to a lender. Even if one assumes that it can, the charge may be subject to compliance with the act and rules made under it. Further, it is not clear if lenders would be able to enforce their charge on the separate account while the project is still incomplete.

While most states have not issued any clarification on this aspect, the Maharashtra RERA recently clarified that no lien can be created on this account. This may jeopardize the position of the lenders as they may not be able to control the cash flows arising from the project and may have to look for alternative security.

Lenders are also concerned about how this would impact existing loans which were granted against the security of the project and its receivables. There is an urgent need to review the escrow structures of existing loans to comply with this provision. Otherwise the promoters of real estate projects may be construed to be in default under the act.

Aditya Vikram Dua SNG & Partners
Aditya Vikram Dua
SNG & Partners

Deductions allowed:

The act also specifies that money in the separate account can be released proportionately to the percentage of completion of the project only towards land cost and construction cost. A question that arises is whether financing cost is covered under land cost and construction cost.

The Maharashtra RERA allows only interest on financing obtained for purchase of land to be deducted under land cost. Principal and interest in relation to financing towards construction cannot be deducted from construction cost. This came out by way of a clarification issued by the Maharashtra RERA recently. A lot of states remain silent on this. It would imply that only 30% of the project receivables are available for the lender to be set off against the accrued principal and interest. It has already led to lenders demanding additional security, including personal guarantees of promoters, for existing loans.

Enforcement of charge:

In the event of enforcement of charge, the lenders may want to take control of project. Section 15 of the act provides that “The promoter shall not transfer or assign his majority rights and liabilities in respect of a real estate project to a third party without obtaining prior written consent from two-third allottees, except the promoter, and without the prior written approval of the Authority”. This may leave the lenders without recourse to the project property at the time of enforcement.

No lender would want to face disgruntled allottees for a delayed project and moreover finding a replacement for the defaulting lender would be Herculean task for any lender, given the changed circumstances.

The act aims to improve transparency in the real estate sector and protect the interest of the homebuyer, however it needs some improvements and the legislators have to address the issues concerning financing of the projects. The lenders currently are worried that they may not be able to effectively enforce their security rights on the projects which are under the act, hence diluting the security cover. This may also lead to a situation where lenders inadvertently violate the provisioning norms set by the Reserve Bank of India.

SNG & Partners has offices in Delhi, Mumbai, Singapore and Doha. Rahul Sud is an of counsel and Aditya Vikram Dua is a senior associate.

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