The Kathmandu Terai/Madhesh Fast Track Road – A possible financial disaster in the making and need for further critical analysis

Recently there has been a lot of activity with regards to Kathmandu Terai/Madhesh Fast Track Road (KTMFT).  DPR was awarded to IL&FS consortium in March and now there is talk in the media for the same consortium to take on the project on a BOT basis which part of the growing popularity of the PPP (public private partnership) movement in the award of infrastructure projects.  Any PPP is a sharing of risk and return between the private and the public parties and this sharing should be based on who is able to take on the risk properly and how the cost of those risks are borne by the parties.  The distribution of risk and return should be balanced between the parties.

With what little information that is out in the public domain, one gets the feeling that in the KTMFT case proper due diligence and balancing of risk and return on the project between the parties have not been done.  There also appears to be a fundamental flaw in the overall analysis upon which certain terms and conditions have been defined for the project.  I just want to focus on two issues that seems to make this project very one-sided and to the detriment of the Nepali taxpayers.

Table 1: Minimum PCU and MRG as per LOI to award dated Feb 6, 2015

The LOI (http://www.mopit.gov.np/files/download/LOI%20Notice.pdf) intent published in the MOPIT (Minsitry of Physical Infrastructure and Transport) web site mentions that it expects to award the IL&FS consortium the project based on the numbers they have provided with respect to the cumulative passenger carrying units (or vehicles) of 558,356,865 and the present value of the minimum revenue guarantee (MRG) of NPR 317,040,820,961.09 over the 25 year operations period.

First let us dissect what the cumulative PCU implies.  Essentially, GON will be guaranteeing that the concessionaire will get 559,365,865 million vehicles using the road over the 25 year concession period.  This translates into 22,334,275 (559,365,865 / 25) vehicles per year or 61,190 vehicles per day (22,334,275 / 365) or 2,550 (61,190 / 24) per hour or 43 per minute (2,550/60) over the entire operations period.  Anybody who has driven from Kathmandu to Mugling (the busiest section of Nepali highways) knows that is nowhere the case and it will take decades to reach that level.  An article in Kantipur on 2014-03-11 states that a survey revised down the expected traffic on this road to 3,000 per day from the ADB estimate of 7,000 per day.  (http://www.ekantipur.com/2014/03/11/business/study-downgrades-expected-traffic-on-planned-fast-track/386571.html)

Table 2: MRG based on Minimum PCU and impact of 10% shortfall in Minimum PCU

The minimum revenue guarantee is based on this figure.  If you assume monthly payments over a 25 year period, to get the minimum revenue from the implied PCU, the toll fees have to average 1,550 per vehicle or 20 rupees per kilometer. (In Excel use the PV function with the rate set as 10%/12, Term as 25 x 12, PMT as 22,334,275/12 x 1,550.  You will get a PV very close to the PV of given MRG.)  In India for cars and jeeps, toll fees are usually less than 1 Indian Rupee per kilometer.  There is even talk about exempting the fees to private cars and jeeps. (http://www.hindustantimes.com/india-news/highway-toll-may-be-exempt-for-private-vehicles-levies-kick-in/article1-1298953.aspx)  The implied toll fees in the MRG will make this one of the most expensive toll fees in the world.  Therefore the willingness to pay for the use of the toll road by non-commercial users may not be there. According to media reports, toll fees for KTMFT road is expected to be 800 rupees for two wheelers and 1,600 rupees for cars and jeeps. For a person earning 30,000 rupees per month a two-wheeler round-trip on the KTMFT will cost him 5.2% of his monthly salary

Add to this, the fact that an alternative route to the Terai, the Kathmandu Hetauda Tunnel Road, has also been awarded to a different group of investors.  If this gets off the ground and completed, most of the container/commercial traffic from Birgunj making the trip to Kathmandu will prefer this shorter route which means that the average implied daily PCU will be even more difficult to achieve. Planners should also realize that for traffic to and from the west and far west, both of these roads do not necessarily lead to significant savings in fuel costs and only marginal savings in terms of time.  Existing highways are being broadened which means that the diversion of central and east bound traffic to these planned toll roads will make them less congested.  West and far west bound traffic might find that the benefit of using the toll roads are not as compelling for them.

It is therefore very certain at the outset that the Nepali taxpayers will be paying IL&FS consortium compensation fees as a result of this MRG.  We will be entering this agreement knowing very well that the MRG will start clicking from the very first year and most likely will continue for the entire 25 years.  A 10% missed target over the 25 years implies a pay out to the concessionaire of 31.7 billion rupees or approximately 317 million USD at todays current FX rates in present value terms.  Clearly the risk and return associated with this project has not been thought through properly. 

It appears that the GON has a clause that assures that it will get 80% of revenue for vehicle traffic above the PCU.  But if the minimum PCU is itself unachievable this benefit-sharing term is meaningless.

The second question I want to tackle is the value transferred by the subsidized financing provided by the government.  The government has two subsidized financing schemes.  A grant not exceeding 15 billion rupees.  If this is part of the equity and the government is going to share in the profits proportionately, I may have very little to say about it.  But if this is a grant and the concessionaire does not have to pay it back with the relevant return then this is 15 billion of value transferred to the concessionaire from the Nepali taxpayers so obviously not in Nepal’s interest.

The other subsidized financing is with regards to 75 billion rupees in long term low interest loans at 3%.  In an article in Kantipur IL&FS consortium says that it could build the road with a commercial loan at 13%.  (http://www.ekantipur.com/2015/07/22/business/hopeful-fast-track-builder-asks-for-help-with-funding/408256.html) Let us use this to determine the value GON is transferring to the concessionaire on the 75 billion at these rates.  Let us assume that payment will be made in equal quarterly installments.  So all you have to do is determine the quarterly payment under the two different interest rates and then calculate the present value of the different in payment.   

Table 3: Estimate of value of interest rate savings given as per LOI.
Payments are equal quarterly payments so Loan is paid off at the end of 25 years.

Let us use the 10% that MOPIT mentions in its various documents when calling for RFP for the project to calculate the present value.  How they came up with this number is in itself a big question but we will not discuss that here.  The difference in payments will be 1.47 billion per quarter whose PV will be 53.91 billion or 72% of the face value of the loan. We have not taken into account the grossing up of interest payments that are done during the construction period.  This is in essence the value that GON is transferring to the concessionaire relative to the market.  The question is what is the GON or Nepali taxpayers getting in return?   

The above analysis is based on the fact that the loan will be in NPR.  If the loan is in USD, then 3% rate is just 0.14% over the 30 year USD treasury rate.  Obviously this does not reflect the risk of the project.  Similarly, let us hope that this is not a fixed rate loan because it is evidently clear that interest rates in the US will be rising.  Let us also hope that the government has not provided an FX rate guarantee. This has its own implications.

From what I have read in the media and the information that is available on MOPIT’s website, I find that the anticipated award to IL&FS consortium is very one sided primarily to the benefit of the concessionaire.  The concessionaire is not even bringing financing to the deal but instead is getting significant subsidized financing and also ensured a minimum return that is not feasible at all from the anticipated vehicle flow dynamics.  I have no arguments with the PPP model as long as proper due diligence has been done and we have taken balanced approach to the distribution of risk and return between the parties involved. 

As is, this project is a disaster in the making and going to be an embarrassment to the GON and the Nepalese taxpayers in the future.  As a concerned Nepali citizen, I would like the responsible authorities to undertake a proper analysis to ensure that the award of this contract is done only after ensuring a proper risk return analysis to all stake holders involved.  

Finally if the government is going to arrange all the financing then why not use the Build, Operate and Maintain model where the concessionaire gets a fixed percentage of the total construction cost as fee during the construction phase and a fixed percentage of annual gross profit during the operation and maintenance phase.

It is clear that GON/MOPIT has not done a proper due diligence regarding the risk and returns associated with this project. They should either get the IBN (Investment Board of Nepal) or an independent financial team to review the terms and conditions and ensure that all parties share in the risk and return in a proportionate manner before the contract is actually awarded.

Note:  I have also read in some media reports that the operation period will be for 30 years and certain terms and conditions with regards to PCU and MRG have changed.  It is therefore possible that certain issues I have mentioned in this blog may not reflect the current status of the project.  Regardless, it is very important to take stock of how realistic the assumptions going into the analysis are since they will drive the risk and returns of the project which will be shared by the parties involved, in this case GON and the IL&FS consortium.

Rental Guarantee – Understand before you invest

Recently, housing developers have come with interesting ways to market their properties.  One recent example in the papers is the rental guarantee offered by the developer CD Developers for investors in Grande Towers, Dhapasi for a limited number of units. Figure 1 shows the ad that appeared in the Kantipur daily of September 11, 2014.  The guarantee is for five years and ranges from USD250 per month for a one BHK apartment to USD1,500 for a 4 bedroom Duplex.  This is an ingenious method of trying to instill a false sense of rental security to potential investors. The real estate market in Nepal is a buyer beware market. 

Figure 1: Advertised in Kantipur daily of 2014/09/11 for Grande Towers

 

What are some of the questions you might want to ask before investing in one of the apartments at Grande Towers?

First you might want to find out the specifics of the guarantee and how it works.  What does the fine print say? When can you make claims and get recompensed? Can you immediately exchange the guarantee for a five year lease to the developer so you do not have to worry about looking for tenants?

Second will the developer live up to its guarantee?  Once you have handed your money, there is very little you can do but rely on the developer’s goodwill to fulfil its end of the guarantee. Of course, you have the legal route but that has its own issues and challenges in Nepal.

Third you might want to know value of the guarantee you are receiving?  Mathematically, you can calculate this as the present value of an annuity that pays the guaranteed monthly rent for five years discounted at your expected return rate. We will look at an example later.

Fourth and probably the most important part of your analysis will be to get an idea of the rental ability or salability of the apartment after the guarantee is over.  This will depend on the state of your apartment, the state of the apartment complex, the availability and demand of apartments in Kathmandu.  Unless your apartment is in an ideal location, people who rent will always prefer newer apartments for the same rental rate.  As I have written in my previous articles related to the real estate market in Nepal, the pool of clients who can afford these upper-end rental units is very limited.  The same is true of the salability of apartments. Unless the location is such that it will always be in demand, the price of most apartment units will decline over time.  Investors will also tend to prefer new apartments for the same price in similar locations.  My personal view is that rentability and salability of upper-end apartments in Kathmandu is very uncertain.

Let us now do an exercise to get an idea of the value of one these apartments from an investor’s perspective and also from a developer’s perspective.

The value of the apartment from an investor’s perspective is basically the sum of three components: (a) the value of rental income during the guarantee period, (b) the value of the rental income during the non-guarantee period and up to the time of the sale of the apartment, and (c) the sale value of the apartment at time of sale.  For now let us ignore recurring expenses such as taxes, and maintenance which can sometimes be pretty large.   

For this exercise let us assume that you can immediately exercise the guarantee that is give the developer the apartment on lease in exchange for the monthly rental guarantee. When you do this, you will have given the right of the use of the apartment for five years.  Let us also assume that your target rate of return is 10% and that exchange rate will be fixed at 96 Nepalese rupee per US dollar.  With these assumptions we can calculate the value of the guarantee. 

Table 1: Valuing rental guarantee offered for units in Grande Towers

The table below lists three apartments from the “Sun” Tower in the Grande Towers Complex.  The data has been taken from the developer’s web site. I have taken the smallest units of 1BHK and 2BHK apartments and applied the lowest guarantee from the range provided in the advertisement given in Figure 1.   What this analysis shows is that the value of the guarantee is not proportionate with your investment. Value per square feet of investment declines significantly as you move up the value amount of the investments.  The guarantee for the most expensive apartment is only 39% in per square feet terms of the guarantee of the least expensive apartment.  This is primarily because the rate of return of your investment during the guarantee period declines from 8.31% for the 1BHK apartment to 5.90% for the most expensive apartment. So what this is telling is that if you want to invest in Grande Towers and take advantage of the guarantee, you want to look at the smaller units. For the 1BHK apartment in our analysis, you might also be better off paying only 23.2 lakhs and giving a lease for the developer for five years at the guaranteed rent.

 

Of three components mentioned above, we have calculated only on the first.  How do we go about calculating the expected cash flows and the resulting valuation of the other two components?  This is where all the risk of the potential investor lies.  As I mentioned above your expected rentals after the guarantee is over will depend on a variety of factors but most likely due to competitive pressures it will be less than what the guarantee is offering you now.  Keep in mind that the rentals envisioned for these apartments means that your target pool of potential renters is very small. Similarly the sale price will also depend on a variety of factors and as I mentioned earlier, unless the property is in a location or becomes a branded property such that there will always excess demand over supply, the sale value for old apartments will decline again due to competitive pressures.  You also need to take into account of the fact that the apartments will be vacant for some portion of your holding period.  Furthermore, we have not even looked at taxes, other charges and maintenance costs that you might have to pay during the holding period.  Keep in mind also that the present value of cash flows decline significantly as you move into the future. So the same one year rental income received say ten years from now will be much lower than the rental income received in the first year.

We will not go into this exercise but what I would like to point out is that the basic decision you will be making is whether the present value of your rental income and sale of property after the completion of the guarantee period will be in excess of your net investment with exercise of the guarantee given in column 5 for these three units.   Let me emphasize that I have assumed that you can immediately exercise the guarantee and give the developer the unit on lease for five years on payment of the net price.   If the fine print does not permit this then that brings additional uncertainty.

So how can developers afford to give these guarantees?  To get an idea of this let us look at the valuation from a developer’s perspective.  For the developer also the value of the sale of apartment again consists of three components: (a) the initial sale price (column 3), (b) the value of the guarantee it is offering (column 5) and the expected rental income during the guarantee period.  For the developer there is less uncertainty relative to the investor.  The minimum value is the net price with exercise of guarantee (column 5).  This occurs only if the developer is not able to rent out the apartment at all during the guarantee period which is hardly going to be the case.  The developer can rent at half the guarantee price and still recover 50% of the guarantee value that it has offered.

For a developer who has already priced in a high margin in the initial sale price, the guarantee will make a partial recoverable dent on the initial expected margin.  If the initial margin was say 50%, then the developer is still better off.   For the developer who is being financed by a bank loan, it is in its interest to quickly offload the apartment and pay back the debt even if it means getting a lower rate of return.  The consequences of not paying debt on time is much larger than stalling for a higher margin on the sale of apartments.

My advice to potential investors is to do your proper due diligence before purchasing any real estate units especially apartments before putting your hard earned money into one of them.  The last thing you want is to be an owner of a white elephant:  a high priced-apartment that you can neither rent nor sell and whose value will decline over time.