Developer Due Diligence - a key part of

real estate investment process

RERA already influencing investor decision making
The Indian real estate sector is estimated to approach a market size of USD 200
billion by 2021. This sector has been witnessing continuous investments, especially
from global investors. According to recent data released by the Department of
Industrial Policy and Promotion (DIPP), during the period from April 2000-
December 2016, the construction development sector in India received equity
inflows of USD 24.28 billion through the Foreign Direct Investment (FDI) route. For
the same period, the total cumulative inflows in the sector accounted for 8.4 per
cent of total inflows into the country1. In 2016, the real estate sector in India also
witnessed private equity investments to the tune of INR 400 billion2 (USD 6.1
billion). While banks have shied away from this sector over the last 2-3 years,
NBFCs (Non-Bank Finance Companies) have been aggressively lending to the
developers and have built a sizable book.

Tarun Bhatia
Managing Director
Kroll Associates (India)
Pvt.Ltd.

While the pace and quantum of investment in this sector has been consistently rising, investors remain wary of the
risks. Real estate, even today, remains one of the least transparent sectors in India. While, RERA (Real Estate
Regulation Act) is expected to change the landscape, it is still early days and we are yet to see how this Act will
influence the operating style of the developers. Further, there continues to be muted demand. Demand for housing,
the largest component of the real estate sector, remains poor despite interest rates remaining low. Despite weakened
demand and a wide expectation that home prices will fall, they have largely held up (with some exceptions such as
Gurgaon where price have fallen). Other than some of the large and reputed names, most real estate developers
continue to struggle and have witnessed limited sales. Given the high leverage in the sector, developers that were
facing risk of default have been saved by the influx of funds. A recent report3 by CRISIL (India’s leading rating agency)
indicates that over the past few years, the residential real estate sector in India has been facing headwinds due to
weak demand. For four years in a row, the downgrades have outnumbered the upgrades in the real estate sector.
High liquidity has resulted in refinancing opportunities for developers who have been shifting from one lender to
the other. Also, with increased supply of funds, the yields available for the investors is constantly under pressure.
In this backdrop, institutional investors have become extremely careful and are extending funds only where they feel
comfortable with the developer and not just the project. Over the last 18-24 months, a large number of private equity
firms and NBFCs have introduced reputation and integrity due diligence on the developer as an integral part of their
assessment process. In Kroll’s experience, investors are keen to gain credible insights about the developers and
their governance, operations, quality and compliance.

Unique Challenges in India’s business environment

To realize value creation, investors need objective, credible information that can be used to support negotiation of
financial terms, identify areas of performance improvement and sometimes, aid in developing a clear strategy for
future exit. In the context of real estate, some of the critical aspects to look at are explained below.

1. The background, track record and reputation of the promoter/developer – can they be trusted?
The basic principles of knowing your investee or borrower is extremely critical and unfortunately is not generally
adequately reflected in the balance sheet of the company. Having a good understanding about the background
of the promoter upfront is critical and in many situations, can be a key differentiator. Getting a deeper perspective
about the intentions of the promoter and their operating style is also critical as it provides strong insights as to
how a promoter may act during a difficult period or at the time of exit. The due diligence exercise will also help
gain an understanding as to whether representations which may be made by the company are reliable and
accurate.

Further, a thorough due diligence should also include inputs from multiple stakeholders. Investors like to
understand what other investors, with current or past exposure to the developer, have to say about the operating
style of the promoter. Similarly, it is important to get views of other stakeholders such as contractors and
 architects and their experience with the developer. A potential risk in the real estate sector is the proximity of
the developer to its contractors. Validating key commercial relationships and uncovering potential conflicts of
interest helps to gain greater confidence that the invested funds will be used for the intended purpose and there
is no leakage. Promoters’ conduct with other stakeholders is an important signal of how much importance they
attach to a relationship and if they are likely to honour their commitments.

2. Source of funds
One of the biggest fears an investor may have in making a real estate investment is not knowing who they are
dealing with. Real estate transactions often tend to have complex ownership structures and involve multiple
middlemen. At times, the person at the forefront of the negotiations may not be the true owner of the business
and is just a representative used to hide the real beneficiaries. Politicians, who don’t like to be seen as people
with significant business interests or wealth, have used this approach to hide their identity. Further, the real
estate sector is well known to have a complex web of ownership weaved through multiple corporate entities,
many of which are Special Purpose Vehicles (SPVs) with no real business intent. Such structures also
potentially enable the laundering of money, as it can be difficult to trace both the origin and destination of funds.

A good quality due diligence enables the investors to decipher the ownership structure and gain further clarity
on the counter party. Knowing the ultimate owner also allows the investor to examine the source of funds and
verify its legitimacy. Understanding the origin and source of wealth enables an investor to take a more informed
decision and also potentially provides leverage during difficult times.

3. Assessing developers true credit worthiness; access to unorganized financial market

As mentioned earlier, the credit quality in the real estate sector has traditionally been quite weak. However, the
heavy flow of funds into the sector has enabled developers to refinance their debt. In such an environment, it
becomes even more important to understand the credit worthiness of the borrower. Apart from looking at the
financials and project cash flows, it is important for an investor to also gain a better understanding of the standing
of the developer in the credit market, both organized and unorganized. When it comes to real estate, Indian
promoters are known to borrow actively from the unorganized market – money lenders (Hundis), High Net worth
Individuals (HNIs), etc. In addition, quite often borrowing is in a personal name of the developer and is unlikely
to be reflected in the balance sheet of the developer or the operating company. This mode of finance is largely
driven by relationships (and high interest rates) and provides relief to the developer in times of emergency or
distress. However, given the nature of such borrowing, the developer would always give it the highest priority
and service such debt ahead of institutional investors. In this backdrop, it becomes extremely critical for an
institutional investor to understand the extent of borrowing and the developer’s reliance, or potential for such
reliance, on this mode of finance.

Similarly, investors can also be exposed to hidden liabilities in connection with unresolved litigation and disputes.
It is important that potential investors understand how litigious the developer is and the potential liability in
connection with unresolved and ongoing disputes. This will ensure there are no unpleasant surprises post
investment.

4. Quality of delivery
For a long time, investors and lenders were only focused on sale of the project. For a majority of real estate
developers it was always about finding a buyer who is willing to pay upfront. Baring a few, there was little thought
put into the timeliness of delivery and providing the quality promised at the time of sale. This has been witnessed
more so in the Northern India, especially in NCR (National Capital Region). However, even before RERA came
into force, buyer/consumer forums (groups of aggrieved customers) had become very active in voicing their
concerns with the relevant authorities. Kroll is able to identify if a particular developer and their past or current
projects have been subject to such claims and the reasons behind the same. With the use of social media
analytics, we can also identify the extent of consumer activism as such groups often take to social media to
voice their concerns. The quantum and longevity of such complaints can be a good indicator of the real intent
of a developer.
 RERA
After years of prodding and pushing, India finally had regulations and regulator for its rapidly growing real estate
sector. The Real Estate Regulation Act, or RERA as it is commonly referred, came into force on 1st May 2017.
While initially only a handful states were ready for its implementation, one-by-one other states are also
implementing RERA. The regulation, which has been long time coming, is expected to bring transparency to the
real estate sector and is expected to boost the demand for home ownership.

The biggest impact of RERA is that it allows consumers to have more information about the developer and the
projects thereby helping them in the decision making process in one of the most important decisions of their life.
The act requires the developer to give information about themselves, their projects, agents, architect, contractors
and other stakeholders. Previously, in most projects, the buyers had limited or absolutely no information or no
way to verify that the information provided is accurate. Every project, whether new or ongoing, is required to be
registered with the Authorities with very little exceptions. If the project is not registered, the developer cannot
advertise, market, book or sell any plot, apartment or building under the project.

With introduction of RERA, consumers have become even more aware and the extent of activism has
significantly increased. In Kroll’s experience, PEs and NBFCs are today very keen to know the level of
compliance at the developers end, steps being taken and the potential risks that they can face due to breach
in RERA norms and dissatisfied customers. Few investment opportunities which were looking very strong on
paper have either been held up or let go due to developers lack of preparedness for RERA and the resultant
perceived risk in project delays.

In addition to the above areas of focus in a due diligence exercise, some of the other factors which are equally relevant
for the real estate sector include an understanding of the extent of political affiliations and the potential use of such
relationship in connection with the project. Similarly it is good to understand the land acquisition process of the
developer and if the same is at arm’s length basis. Indian reals estate players are known to be well connected in
the bureaucracy and seek benefits while acquiring land parcels and subsequently at approval stage.

Conclusion
Thorough due diligence on the reputation and integrity of the investee company and its promoters can help strengthen
a deal and have a positive impact on its success through the early identification of potential problems that may be
mitigated ahead of closing. The Indian real estate sector is witnessing significant investments and with the
introduction of new products such as REITs, the industry is likely to see increased participation of global investors.
In that context, local dynamics also should be factored into any due diligence. Segregated and regional markets,
coupled with the existence of different political structures and opaque regulatory frameworks, often pose challenges
to foreign investors. Similarly, local investors are also increasing their footprints from a few large cities to smaller
cities (Tier I and Tier II cities) and need to equip themselves with a better understanding of the regional dynamics
and the changing regulatory environment.
Kroll’s pre-transaction due diligence helps provide clients with important information and intelligence to drive
confident decision-making. When evaluating significant investments, acquisitions, transactions and IPOs, including
multi-jurisdictional deals, where risk levels can be elevated, decision-makers can benefit from Kroll’s investigative
due diligence services, a consultative-based offering that can be tailored to the level of risk and regulatory scrutiny
involved. Kroll delivers timely, critical intelligence regarding owners, board members, executive teams and their
related entities, providing robust and thoroughly researched information to aid its clients in carefully evaluating
business deals.
1
Source: Department of Industrial Policy and Promotion
2
Source: India Brand Equity foundation
3
https://www.crisil.com/pdf/ratings/CRISIL-Ratings-Round-up-REPORT-FY17-3Apr2017.pdf
Kroll Case Study
Client: Indian NBFC
Subject: A North India based Real Estate Company and its Promoter