Episode 54

The Bottom Line Blues: Understanding Real Estate Companies’ Financial Challenges

Category :  High Variability Operations

Delve into the dynamics of the real estate market with our latest Counterpoint Podcast episode. Understand the puzzling decline in Internal Rates of Return (IRR) despite a thriving demand. Tune in to this episode to access expert analyses and discover actionable strategies for enhanced profitability in real estate investment.

Shubham Agarwal : Hello and welcome to the Counterpoint Podcast. I am Shubham Agarwal, and today, we will discuss the real estate sector.

The real estate business in the country has always seen an upward curve, with the pandemic a small exception where the demand took a hit. But the market is back, and the sector looks at unprecedented growth rates. However, there is a specific metric that real estate companies look at internally as a measure of their profitability and growth – the Internal Rate of Return (IRR). Now, if you look at some ten years back, these IRRs are between 18% and 21%. However, it has decreased to about 13%-17% in the past few years, which concerns the sector. This is an interesting situation where the demand is high, yet the companies and real estate companies have their IRRs dropping.

Shantonu Ghosh, a senior partner of Vector Consulting Group, is with us today. He has helped many real estate companies overcome this dichotomous situation.

So, let’s welcome him and talk to him more about this.

Hi Shantanu, welcome to the Counterpoint Podcast. How are you?

Shantonu Ghosh : I’m fine. How are you?
Shubham Agarwal : I’m good, thank you. Shantonu, as I mentioned in the introduction, this situation is very interesting. With the demand on a high and the real estate sector growing at unprecedented levels in the past few years, the Internal Rate of Return (IRR), a measure of internal profitability and growth, is still decreasing. It’s on a downward trend.
Shantonu Ghosh : Yeah, true, Shubham; for that, we need to understand what IRR is. Right.
Shubham Agarwal : And what factors contribute to the IRR? How is that equation created, which contributes to IRR?
Shantonu Ghosh : So, IRR is typically a measure of the profitability of an investment. Okay. And if we want to look at what factors are affected, it is typically the investment we put in and the expected cash flows from that investment. Okay. And the timing of those cash flows, which is important. So, when you say the timing of the cash flows, does that relate to the efficiency, the time efficiency of the projects being delivered on time? Is that so? Yeah, true, because every real estate project generates cash flow as it goes on.

If you look at IRR, the earlier those cash flows are generated, the better the IRR because it is, after all, the measure of the present value of the cash flow.

Shubham Agarwal : So, you know, RERA was also introduced a few years back. And with RERA introduced, the timely efficiencies have, I’m given to understand with the data that we have that it has improved drastically. Right. So, that would have helped the IRR.
Shantonu Ghosh : That’s an extremely good question. And this is a paradox, right? On the one hand, the RERA ensures that timelines are met. Otherwise, builders get penalized, correct? On the other hand, we have IRRs that are going down. So, we need to understand this. What RERA has done is ensure that there is a deadline for a project, correct? The due date. Yeah. It has not given any guidelines on how that due date is set.
Shubham Agarwal : So, can you elaborate on this? When you say ‘how the due date is set’, there’s no guideline to that. But yet, the customers, whatever the end dates are given to the customers, they are being met, right?
Shantonu Ghosh : Yes. So, the RERA asks the real estate company or the builder to set a due date.

Then, they measure the builder for the completion of the project on that due date. Having seen this, the builders build a lot of time buffer in the estimates of due dates because they are safeguarding themselves against getting penalized, and the penalty is heavy on violating an RERA due date. So, when such a thing happens, they buffer their estimates, but internally, to calculate their profitability, they have a different due date set based on which they calculate their IRRs, based on which they calculate their return on investment. And when we look at these internal dates, they’re extremely tight. And the entire IRR calculation based on which they’re calculating their profitability is on these stringent timelines.

When you fail on these timelines, when you fail on these cash flows, because the cash flows are based on these timelines, so, when you fail on these cash flows, the IRR is the one which comes under pressure.

Shubham Agarwal : So, Shantonu, you said that the RERA dates are the dates that are being given to the customers as a measure of timely delivery of the projects. And there are internal dates as well. How do the customers look at this date? I want to also look at how the customers look at this date. Do they think that the dates are good enough, or do they also feel that there are a lot of buffers and these are being stretched?
Shantonu Ghosh : Oh, the interesting thing here, Shubham, is that the customers are also given a date. Okay, and this date lies somewhere between the internal due date and the RERA date.

So, very interesting, you know, and the industry has a terminology for it. They call it the ‘soft possession date’. So, this date is typically four or five months ahead of the RERA date. It’s to pacify, so to speak, the customer because they’re concerned since the RERA dates are a little bit far off. And they say that we’ll complete it maybe five or six months earlier, we’ll give it to you for doing interiors or things like that. And ultimately, there is no legal binding to that soft possession date, but they give it to pacify customers.

Shubham Agarwal : It’s like, I am reminded of an analogy from the retail sector where you’re shown that this is the value, there’s a cut, and then this is the actual value, right? Right.

You said that the IRR is dependent on the timely completion of the project, and there’s an internal date. Now, obviously, the internal dates are not being met, and this is why the IRR is going down. How come that buffer is getting eaten so much that the IRRs are going down so significantly?

Shantanu Ghosh : So, if we have to look at that, we have to get a little deeper into how a real estate project is executed. Typically, the life cycle of a real estate project consists of three major stages.
Shubham Agarwal : What would be those stages?
Shantanu Ghosh : Yeah, so one would be what we call as the pre-construction stage where, you know, all the detail designing is done, and the code for construction drawings are given to the site.

We all know about show flats, right? So, show flats are built, and then you need a sales office to launch a project. So, the sales office is built, which is all part of pre-construction. Once this is done, the construction starts at the site, and then the first significant construction stage is called ‘the Core and Shell’. The ‘Core and Shell’ is the RCC structure of the building with all the wall partitions. Okay. And this constitutes, you know, what we also call as the gray casting of the building.

Shubham Agarwal : Okay, so it is the skeleton of the building.
Shantanu Ghosh : The skeleton of the building. Yeah. Very well put, the skeleton of the building and then once the skeleton is ready, comes what we call as the finishing stage. Now, what is the finishing stage? The finishing stage is something which starts after a skeleton and goes right up till handover to the final customer, which means it has everything from plastering to plumbing to electrical to tiling to painting. So, it’s a plethora of functions that start immediately after the core and shell are done.
Shubham Agarwal : So, if I were to ask you, you know, you define those three stages, is it a specific stage where the delays start to creep in, or is it that, you know, delays are across the stages and they add up and then.
Shantanu Ghosh : So, if you look at the project launch, which is the pre-construction phase, that is stringently adhered to because it is also communicated publicly.

Then the ‘Core and Shell’ is usually done by one agency. Okay. And it typically gets done without any delay. Some here and there, a little here and there, but more or less on time. Right. But it’s the finishing stage, which, you know, is where delay starts happening, and they keep on increasing as the project progresses. So, you can start with almost no delay to reach about 30%, 35%, or 40% delay by the time you end the project.

Shubham Agarwal : Okay. And what are these delays typically, as in what is the nature of these delays typically? Where does the time start getting compromised, and so on?
Shantonu Ghosh : Let me detail the finishing stage a little so you can better understand it. As I said, core and shell are done by one agency, right? But finishing involves many agencies, 9 or 10, which work in a very restricted area of the flat or a corridor. There are a lot of interdependent activities.

Handovers to be done of work front from one agency to another. And there is another important metric – the contractors are measured on volume. So, the contracts are volume-based, which means the more work they do, the more money they get. So, their money is linked to the volume of work done. Now, in this environment, when this is brought in, you look at it this way – I’m a contractor, I know that if I get in there with my people, the company is paying me for the volume of work, but I have to pay my people daily. So, I have to get the maximum out of them when they’re engaged.

Shubham Agarwal : He has to maximize the output.
Shantonu Ghosh : So, he maximizes what we call the billing or his invoicing. Now, to do that, he takes up all the easy work. Or he cherry-picks the work that he does, which means I do the high volume with no effort. I say, “I will go to the next work front and do the high volume rather than do the low volume in this work front,” I say, “I will come back and do it”. Yeah. When this happens, I’m handing it over to some other agency. When I hand over to another agency interested in engaging their labour force with the same metrics, I must keep them active. And they start to do whatever is available, wherever is available. And as they go along this journey, the work fronts keep opening without closing.

So, I have many work fronts on the project site, but they are still open. As we talked about, when we work like this, a lot of quality problems also come in. Since the quality problems are many, the work fronts are many. The supervisor of the real estate company really does not have the bandwidth to go and check every front. And hence, things need to be included.

Shubham Agarwal : But the project manager or supervisor does have the option of spacing the contractors out. Is he on purpose bringing them all together at the same point?
Shantonu Ghosh : It has to come back together because I hand over to someone, you know, like if I am a tiling contractor, if I am a plastering contractor, then the tiling work gets done, and I get come into the plastering. I do the plastering and then only hand it over to painting. Yeah. So, when I say I’m a plastering contractor, even the skirting has to be finished before I come in to finish the plastering. My doors and windows installation has to be done before I complete the plastering. So it is a lot of work. There’s a lot of intertwined work. I can only finish my work after with some other agency coming and doing some portion. And then I have to come back and finish it in a second pass.
Shubham Agarwal : All of this has to be done in that same space. You know, the house’s space is very small. So, that would create further confusion and challenges for the contractors as well as for the supervisor.
Shantonu Ghosh : Correct. There is a very limited workspace, and multiple agencies are operating there. So, it creates a lot of quality issues. When these quality issues come back to bite you at the end, when you know, there’s a huge snag list. Now, look at the interesting part of this snag list. This is a high-effort, low-volume job. Yeah. No contractor wants to do this. You have to give extra rates to get contractors to come in and finish your punch list. So this increases the elapsed time even further and also increases the cost of the real estate companies.

So this is how the entire delay happens in the finishing stage. And the longer it goes, the higher it is delayed.

Shubham Agarwal : So I think Shantonu, this is very clear as to, you know, the extent of the problems that exist. And I think you touched upon some of the issues as well, the reasons as well – why those problems start to happen, the length at which those problems are happening, and the problems that the supervisors end up with also, I think, very visible to us. However, you know, at Vector, we have this First Principle philosophy where we keep asking why and why and why until we reach that core issue or the core reason, which is, you know, building to all of these. If I were to ask you, what is that core issue, or where is it germinating from? What would that be?
Shantanu Ghosh : So, Shubham, if you see the experience of people in this industry, they have always experienced these delays. Right. Their entire thought process is that somewhere, this project will get delayed as heavily as we go along during the duration of the project. So, the tendency is not to delay, at least at the start. So what happens is that they try to start each work front as soon as possible.

As soon as it is made available, even to the extent of, you know, even if they have a partial material, partial kit to start, they will begin with whatever is available in the hope that they will get the balance as the project progresses. And if that doesn’t come, then that work front is delayed.

Shantanu Ghosh : And then this chain reaction sets in. It’s a vicious loop, you know, because you start with a partial kit, you stop somewhere, you open another work front, you go there, leave it, go to another, and then the entire thing spreads out. So the whole problem lies in the fact that you know, you start with a partial kit; you start as soon as possible, even without complete material, complete resources, complete approvals, all those you have to wait for.
Shubham Agarwal : That’s counterintuitive or counterpoint, as we call it, because typically, we are given to believe that if you can start early, why not? So Shantonu, I think what is very clearly coming out once again is that the core issue is not just starting early, but starting early with a partial kit or the partial full kit, not having all the resources that are required to complete that work front. Is that right?
Shantonu Ghosh : Yeah. That actually forms the crux of the problem. You know, I still need the complete kit. I start, I stop, I have interruptions, and it goes elsewhere. So everywhere, I have interruptions without completions, and that compounds the delay as you progress.
Shubham Agarwal : When you say it compounds delay, can you tell us the extent of these delays we have typically seen across the projects?
Shantonu Ghosh : Shubham, with the real estate projects that I have seen, the delay can be anywhere between, say, 30% and 40% of the project’s lead time, which is, you know, if I want to translate it into months, it can be anywhere between 9 and 12 months.
Shubham Agarwal : Oh, God. And this is people waiting for their homes.
Shantonu Ghosh : Yeah, people waiting for their homes. Actually, yes.
Shubham Agarwal : But no one would want to be in that situation. So, Shantonu, I think we have solved this issue for a lot of real estate companies in the past as well at Vector right.

And I want first to understand the kind of impact that you’ve seen with the solutions that we’ve implemented.

Shantonu Ghosh : So, with the solutions, Shubham, that we have in place for this kind of industry, typically, we’ve seen a 25%- 30% reduction in lead times, which means somewhere between, say, a 4% %- 7% jump in IRR over the companies.
Shubham Agarwal : That’s incredible, in fact,
Shantonu Ghosh : So, typically, companies go above that 20%—21% IRR mark when operating under this kind of rule we implement.
Shubham Agarwal : We can’t wait to get the solution, either. Can you tell us what the components of the solution are? How do we break this conundrum? How do we break this vicious loop that you explained?
Shantonu Ghosh : The idea is to start with a full kit. But what do we base the full kit on? If I base it on the entire project, I will as it has been delayed.
Shubham Agarwal : Correct. Yeah. Finding the full kit for the entire project will be a gigantic task.
Shantonu Ghosh : Yeah. It will be too long actually to make it, plus the kind of working capital I’ll put in to store that kind of material. It’s a huge waste of resources. Now, if I go back and check the other extreme, if it becomes too small, you know, I cannot make it too big. Can I make it too small? But if I make it too small and my execution time is shorter than the time to make that kit. Then, I will go back to the situation I’m in today. So I have to find something that is more middle-path here. And for that, we have devised what we call a ‘work bundle’. A ‘work bundle’ is typically an entity based on the type of project, the type of technicalities, and the type of resourcing. And if I look at the project specs, the ‘work bundle’ gets designed according to that. Now, what does a work bundle do? It is an entity that is good enough for me to make it, which is timed enough for me to make it and is not too big, which means I can finish it quickly and hand it over to the next agency. And so, a work bundle is typically something which I make, and I give it to the next agency to start working. If I want to take an analogy, the analogy is something like you look at a manufacturing shop. There is an input of raw materials, a set of processes or machines work on that material, and the outcome is the finished goods. Now, if I look at a ‘work bundle, ‘it is something like that: a work bundle comes into the manufacturing shop, the agencies work on it, and then they push it out. So, every project is divided into multiple work bundles like this. And the full kit is maintained for each’ work bundle’; you cannot start, and then the full kit for the work bundle is complete. And when you start, you finish, and you hand over to the next agency.
Shubham Agarwal : So those handover criteria, closure criteria, it is very well defined
Shantonu Ghosh : So the entry criteria and the exit are very clearly defined. And only after they are met are they handed over to the next; this ensures clean hand overs and complete work fronts.
Shubham Agarwal : Right. But in that case, we’ll have to change a lot of metrics as well. You know, you said that the metrics of these contractors are based on the volume or, you know, the way they work.
Shantonu Ghosh : Correct. So, there is another place where we need to address this. You look at it: I talked about the interdependencies, and I talked about multiple agencies coming and working together . If I have work bundles like this going, multiple agencies may come in and disturb this entire thing. So, there is another set of execution rules that we put in place. Typically, any finishing work in a real estate project constitutes two types of functions. One is what we call a primary function, which has what we call a high touch time and fewer natural interruptions. Okay. When I say touch time, it means that if everything was available, the time I would take to complete that particular work front is the touch time to complete that work front. Natural interruptions are something that, if I’m working, I have to naturally now wait for something else to happen before I can start work.
Shubham Agarwal : It’s like saying that I want to paint, but I can’t do the next one until one coat of paint is dry.
Shantonu Ghosh : Right, right. Absolutely. Absolutely. So, these are natural interruptions. So, there is a function with a high touch time, okay, and low natural disruption, which we call the primary function. Then, there is a secondary function, which is the exact opposite: low touch time but very high interruptions.
Shubham Agarwal : And this is not the natural time, but the interruptions that I’m wearing
Shantonu Ghosh : It will have low natural interruptions. So, you know, I have, say, a tiling person who is doing skirting; I have to do this skirting here, then wait for the next set of functions to be done before I come back and do it again. So, in an area, there is a combination of primary and secondary functions, which we term a ‘cluster’. So now, what are we saying is that a cluster is formed, and a cluster is a sequence of events which will happen in the real estate budget based on the technical dependencies of these clusters. These clusters will work according to the work bundles. Now, what am I ensuring here? I’m ensuring full kit. I’m ensuring entry and closure criteria. I’m also ensuring that only a particular set of people are working and handing over to each other; wherever interdependencies are within the cluster, they cannot cross the clusters. So, the cluster also has an exit criteria; I finish that and then go to the next cluster.

So, people come in, finish their work, and come out. So the entire.

Shubham Agarwal : That will also make the work for the supervisor very convenient or, you know, much more accessible to be tracked because now he has those work bundles defined. He can simply go back and understand if the bundle was defined well and executed well or not until it was moved to the next.
Shantonu Ghosh : Correct, correct. We also call it ‘management by exits’.
Shubham Agarwal : So interesting
Shantonu Ghosh : Yeah. So why we call it management by exits is that a contractor, when he goes into a certain cluster, finishes work and comes back, never goes there again.

Right. Now look what it is ensuring that the entire billing entity for that contractor is ensured, and he’s come out. So, his need for invoicing is also met by that, right?

Shubham Agarwal : So, it makes the line better for the contractors because I’m sure they would also be created and confused about the entire thing in the current situation.
Shantonu Ghosh : Correct. So they go and finish the part of the cluster. Because they have a full kit, they can do it at a very fast rate. They finish it quickly, and then they come out, and they get paid for it. So, it becomes a win-win situation for the real estate company and the contractor. And that ensures that work is happening at the fastest possible pace. There is only one more element.
Shubham Agarwal : Is there any element that is missed out? Yeah.
Shantonu Ghosh : So, one more element can actually derail this entire concept.
Shubham Agarwal : Even after doing all of this.
Shantonu Ghosh : Even after doing all of this, okay? See, this is, after all, a project. Right? I cannot accurately predict what issues will happen in the project before I even start doing or executing it.
Shubham Agarwal : Murphy will definitely hit,
Shantonu Ghosh : Murphy will hit; issues and problems will definitely come. Now the, the problem comes when these issues, these problems take time to be addressed. If there is a delay in addressing issues, and my contractor needs to get their work front, their idle, their labour is idle, they will naturally shift it to someplace else. Then, all the good work that has been done is broken. And we go back slowly to the old way of working. So, we have a process called ‘high-frequency management’, which addresses this particular
Shubham Agarwal : quick decision-making
Shantonu Ghosh : Yeah, it’s quick decision-making. So, we set up flow meetings at various levels of the organization, where every problem encountered is addressed in the most aggressive way; we call it Aggressive Issue Resolution. It is addressed in the most aggressive way. And if a lower level cannot address it, it is automatically discussed at a higher level. These meetings are set at pre-defined frequencies. Which means all calendars are matched. And you know, typically to get somebody to come to a meeting, it’s a challenge, right. Yeah. Even four people coming together can solve an issue in 15 minutes, but getting those four people may take 3 to 4 days. So, these meetings are at pre-defined frequencies and calendars are set. And every issue at any level is resolved or escalated to the next level immediately. So Aggressive Issue Resolution ensures that my problems are resolved and you operate during execution. And the rest of the processes ensure that all this makes the project happen as soon as possible.
Shubham Agarwal : Perfect. I think, Shantonu, when we have a win-win solution in place and when we have also looked at what problem that solution could create, we have targeted that as well. That is the recipe for, you know, true success in our parlance.. And we’ve reached that level. So, thanks a lot for this discussion once again.
Shantonu Ghosh : Thank you, Shubham.
Shubham Agarwal : It’s really helpful.
Shantonu Ghosh : Yeah. Thank you for having me. Thanks.
Shubham Agarwal : And thanks for all the listeners. You would have gotten a very detailed view of the entire sector and the problems that happen, and if you are from that sector, you would have actually witnessed at some level as well. And we also spoke about the solution in detail. We’ll keep coming back with more discussion on the podcast and keep discussing more interesting topics. Until then, this is Shubham signing off. Bye bye.

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