Thursday, May 10, 2012

Construction/Real Estate Sector: Why it looks Attractive!!
India is on the verge of witnessing a sustained growth in infrastructure build up. The construction industry has been witness to a strong growth wave powered by large spends on housing, road, ports, water supply and airport development. The construction sector has registered double digit growth during the last few years and its share as a percentage of GDP has increased considerably as compared to the last decade. The Planning Commission of India has proposed an investment of around US$ 1 trillion in the Twelfth five-year plan (2012-2017), which is double of that in the Eleventh five-year plan.
From a policy perspective, there has been a growing consensus that a private-public partnership is required to remove difficulties concerning the development of infrastructure in the country. During the twelfth five-year plan, the contribution of private sector in total infrastructure investment is expected to increase to 50%. The balance will be borne by the public sector.
The real estate industry comprising of construction and development of properties has grown from family based entities with focus on single products and having one market presence into corporate entities with multi-city presence having differentiated products. The industry has witnessed considerable shift from traditional financing methods and limited debt support to an era of structured finance, private equity and public offering.
The construction sector is a major employment driver, being the second largest employer in the country, next only to agriculture. This is because of the chain of backward and forward linkages that the sector has with other sectors of the economy. About 250 ancillary industries such as cement, steel, brick, timber and building material are dependent on the construction industry. A unit increase in expenditure in this sector has a multiplier effect and the capacity to generate income as high as five times.
Key Highlights
  • Supply:  Past 4-5 years have seen a substantial increase in the number of contractors and builders, especially in the housing and road construction segment.
  • Demand: Demand exceeds supply by a large margin. Demand for quality infrastructure construction is mainly emanating from the housing, transportation and urban development segments..
  • Barriers to entry: Low for road and housing construction. However, high working capital requirements can create growth problems for companies with weak financial muscle.
  • Bargaining power of suppliers: Low, due to the rapid increase in the number of contractors and construction service providers, margins have been stagnant despite strong growth in volumes.
  • Bargaining power of customers: Low. The country still lacks adequate infrastructure facilities and citizens have to pay for using public services.
  • Competition: Very high across segments like road construction, housing and urban infrastructure development. Relatively less in airport and port development.
After a slow growth in the last fiscal, due to interest rate fiasco, the sector is expected to do well in FY13, as the RBI goes in for the cut in the Repo/Reverse Repo rates.  Considering the strong order backlog, the this fiscal could be promising provided execution remains on track.
Infrastructure remains a vital sector for India's growth story--lack of adequate infrastructure is a major constraint in India’s growth. Infrastructure, which was the golden sector a few years ago, is battling regulatory bottlenecks, land acquisition delays and credit crunch. Without any dichotomy - the future growth prospects of the Indian economy lingers primarily on the infrastructure investment and timely execution of the projects. 

The infrastructure sector was one of the thrust areas in Union Budget 2012-13 as a string of measures were announced in the budget.The measures are expected to propel the economy to a healthy growth trajectory in the coming years. 
Concrete measures for  the growth of infrastructure in India have been taken as part of budget 2012-13 by creating adequate funding mechanisms. Tax-free infrastructure bonds doubled to Rs.60,000 crore, which is a welcome move in creating access to funds for infrastructure projects. Power plants will benefit significantly from access to ECBs, tax holiday for power plants that commence generation by March 31, 2013. Cascading effect of DDT (Dividend Distribution Tax) has been eliminated which will benefit infra companies that typically operate with an SPV model.
As stated by the Finance Minister, infrastructure will require Rs.50 lakh crore in 12th Plan, half of this from the private sector. Besides this, the announcement on development of urban infrastructure including metro rail projects, road building, comprehensive water management and sewage treatment plants in various cities in country, introduction of much awaited implementation of GST and the reduction on withholding tax on external commercial borrowings, airlines, roads, bridges, affordable houses and fertilizer sectors would foster the sector’s growth. The full exemption from basic customs duty to coal mining project imports and LNG would show signs of recovery in various sectors.
Seven key interventions deserve highlighting. First, increase in scope of viability gap funding in new areas like irrigation, oil & gas pipelines, market terminals etc. Second, significant increase in limits to raise tax free infra bonds by PSUs like NHAI, HUDCO, SIDBI, IIFCL, NHB, Indian Railways. The space goes up from Rs.30,000 crore to Rs.60,000 crore. Third, opening up the ECB window across a wide range of  infra sectors. Fourth, creating a new PSU, namely, the Water Resources and Irrigation Company. Hopefully, this will re-energize action in  inland water, irrigation, river-linking and similar large programmatic initiatives Fifth, high focus on rural infrastructure like drinking water, sanitation, warehousing etc. Sixth, import duty exemption for imported fuels for power sector and finally, a slew of import duty exemptions for equipment imports in solar power, safety equipment for railways, aircraft maintenance equipment, road construction equipment in urban areas etc. All these bodes well for the construction sector. 
Also, the proposed investments in health and education sectors will further boost the country’s infrastructure to a large extent. Moreover, steps to control imports of HR and CR coils and low quality CRGO will help to boost domestic steel industry. Initiatives taken to reduce duties on equipment for setting up or expansion of iron ore beneficiation and iron ore pellet plants will provide incentive to use iron ore fines which are at present not being utilized fully. Exemption of duties on steam coal, and coal mining project equipment will also benefit the related industries
Country needs infrastructure growth and the Union Budget, 2012-13, has not disappointed on this front as well. The doubling of allocation in infrastructure debt fund through allocation to NHDP, IIFCL, NHB and SIDBI coupled with full exemption from basic customs duty for equipment for road and highway construction are likely to boost infrastructure and construction sectors. Further measures such as credit guarantee & direct transfer of subsidy likely to change growth environment. One year extension of sun set clause on tax incentives for infra projects under 80 IA is also a welcome step. While construction sector will benefit from higher allocation in infrastructure and investment linked deductions, the increase in excise duty will result in cement prices going up by Rs.4-5 per bag, which could be easily passed on to the customers.
One good development is allowing of ECB in sectors like road construction and the target for highways development in FY13. This coupled with increase in the tax free infrastructure bond allocation to Rs.60,000 crore will definitely help in spurring some growth in the infrastructure sector
If we can recollect then we will find that the last year's (2011-12) Budget also saw a massive increase in allocation towards various infrastructure development schemes. The government at that time earmarked Rs.2 trillion for infrastructure development as a whole. This is an increase of 23.3% over 2010-11.  Thus, backed by government's sustained focus on housing, road, port and airport development, infrastructure sector in India is poised to grow rapidly in the coming days.
It is to be understood that in the soft interest rate regime, Infrastructure/Real Estate sectors, could be key areas to watch out for by the marketmen. Also, the global economy is slowly improving (though a mild-slowdown still exists in the Euro Zone), bringing back financial confidence to the home buyers along with low interest rates could augur well for the sector. As demand for houses mounted, developers increased the prices. Prices went up to pre-2008 levels and in some cases beyond that.  We have seen even in the High interest regime, the prices for property remained firm, at least in the Metros and Tier--I & II cities, though there were some demand destruction. 

The real estate companies which are reeling under heavy debt and rising costs (both operating expenses and interest costs) are expected to get benefited from the ECBs and fall in the interest rates (when the high cost loans can be replaced with the low cost ones). Nevertheless, as genuine demand exists for good quality homes, long-term fundamentals for real estate sector remains strong.
India is on the verge of witnessing a sustained growth in infrastructure buildup. Infrastructure investments continue to be the most important growth driver for construction companies. The proposed increase in allocation in the twelfth five-year plan (2012-2017) will translate into a healthy business for construction companies.
 Real estate investments account for majority of the total construction investments. Demand-supply gap for residential housing, favourable demographics, rising affordability levels, availability of financing options as well as fiscal benefits available on availing of home loan are the key drivers supporting the demand for residential construction. According to the Technical Group on Estimation of Housing Shortage estimates, the shortage of housing will continue even in 12th Five Year Plan (20012-17), which provides a big investment opportunity. In addition to this, demand for office space from IT/KPO segment is expected to continue due to emergence of India as a preferred outsourcing destination. Also, boom in organized retail is expected to result in huge demand for real estate construction.
While long-term factors are likely to work in favour of the real estate developers, the outlook for the short term remains status-quo, with inflation becoming the joker in the pack. The double whammy of plunging sales and rising costs have taken their toll on the profitability of real estate majors, but the situation is expected to improve in the coming days, as the interest rate slowly comes down. Also, banks turned cautious towards rescheduling debt or issuing fresh loans to real estate companies, as an aftermath of the bribe-for-loan scam. Prices of steel, cement and labor, which together make for almost 75% of overall construction cost, have some-what stabilized after it rose by over 30% since 2009. Upward spiraling cost of construction materials has has also abated, with the commodity prices crashing in the international, market. Now with the fall in the crude oil prices, due to sluggish demand, in India, China and Eurozone, economies, we could see, a sharp fall in the inflation and Indian CAD. 
The services sector has played a paramount role in driving growth of the Indian economy for more than a decade. The economy has successfully navigated the turbulent years of the recent financial crisis due to the vitality of this sector in the domestic economy and its prominent role in India’s external economic interactions. The services sector incorporates trade, hotels, and restaurants; transport, storage and communication; financing, insurance, real estate, and business services; and community, social, and personal services.
The Real Estate & Construction sector is an important component of the Service Sector. During Twelfth Plan period, investment in infrastructure to go up to INR 50,000 billion with half of this, expected from private sector which will increase opportunities for the construction companies in the coming days. Budget 2012 has provided the much needed “fiscal” impetus to affordable housing by allowing ECBs and reducing tax withholding from interest on such ECBs from existing 20 percent to 5 percent for 3 years. The Rural Housing Fund has been enhanced to Rs 40 billion from 30 billion. All these measures will support affordable housing projects.
Enhancement of investment linked incentive for affordable housing to 150 percent of capex from current 100 percent and extension of 1 percent interest subvention scheme for housing loans upto Rs.15 lakh where cost of house does not exceed Rs.25 lakh by another year, are welcome moves. Also, a couple of days back, during the passage of the Finance Bill, the Finance Minister, spoke of removal of the clause of Tax Deduction at Source (TDS) at 1 percent of consideration for transfer of immovable property, which is also positive for the sector. The restriction on Venture Capital Funds (VCC) to invest only in nine specified sectors is removed and consequently, investment in real estate sector is eligible for pass through tax treatment for VCFs/VCCs. Removal of cascading effect of Dividend Distribution Tax (‘DDT’) in multi layer corporate structure – if dividend distributed by a subsidiary company has been subject to DDT, there will be no further DDT in the hands of holding company while further distributing the said dividend in the same year. Service tax exemption for construction service related to specified infrastructure, canals, irrigation works, post-harvest infrastructure, residential dwelling and low cost mass housing up to an area of 60 sq mtr. under the scheme of affordable housing is already providing relief to the sector.
Full exemption from basic customs duty, CVD and SAD is being extended to equipment imported for road construction projects awarded by Metropolitan Development Authorities.
Full exemption from basic customs duty and CVD at present available to tunnel boring machines for hydel and road projects is being extended to all infrastructure projects. The exemption shall also be available for parts required for assembly of such machines. Overall, the Budget provides the much needed impetus to the Affordable Housing segment to achieve the Government’s vision of “Housing for All” and this will have a positive impact on the sector. Further, the enhancement of the spending on the infrastructure sector will generate opportunities for the construction sector.
In such a scenario, I think it is time to think, on investing in the REAL ESTATE/CONSTRUCTION counters. 

(iv) KPMG Research Report. 
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