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Jatin Khemani
Whether it is real estate as physical assets or as stocks, there has been a lull for many years now. Will the two always move in tandem? Can real estate stocks do well even without real estate assets picking up?
Before that, let’s understand why the real estate business and stocks are so out of favour.
How real estate went out of favour
– It is an extremely asset-heavy business with significant upfront investments needed for buying land and for project development, necessitating the use of borrowed money or settling for a lower return on equity. Further, each project has a long gestation period of 7-10 years.
– To make economic sense, the project size has to be meaningful, in which case even one or two projects going wrong on location/timing/pricing can push the company behind by a few years with significant resources getting stuck.
– It takes decades to build credibility in one geography. However, the moment a company enters a new geography, it has to start all over again in terms of building customer trust and working with the local ecosystem. For instance, the brand and operations of a successful Mumbai-based developer cannot be leveraged greatly in Pune. You don’t believe me? What else explains the largest developer in the country, a so called ‘national’ brand, deciding to restrict itself to only five cities?
– So, to keep the growth momentum going, a company has to keep capturing higher market share in its existing geography or geographies, but it can hit a ceiling when it becomes too large – think DLF in Gurgaon – and this also adds to the risk of geographic concentration.
– Thanks to multi-year projects, the accounting has been too complex – revenue booking as well as cost assumptions are at the discretion of the management. Difficult for even a seasoned investor to judge if reported financials of developers depict the true and fair picture of the underlying operations. This makes valuing a real estate company a speculative task – you can’t use any P&L metric such as operating profit or earnings and valuing based on net present value of on-going projects, land bank etc. involve a whole host of assumptions around volumes, realisation, cost, and timing.
– Long-term investors struggle to see too far into the future as a project’s life is typically about seven years and life beyond that would depend on new projects, which you may not know about right now, and these may or may not work in the same way. It’s like being on a treadmill – you got to constantly run even to stay at the same place, unlike a Nestle or a 3M which add growth on top of a sticky base business.
– It’s a sector marred with corruption & red-tape; there are 50-plus approvals a developer needs from different government authorities before he could commence a project. It is not easy to find clean promoters operating in a sector in which being clean is a disadvantage.
– An apartment is a capital good and the biggest investment in a customer’s lifetime; typically, he/she will be your customer just once or twice in his/her lifetime, no matter how happy he/she is with your product, unlike companies selling consumables where customers keep coming back for repeat purchases.
– Among buyers of real estate, there are home buyers and there are investors. The latter come in herds and only in a good cycle, adding fuel to fire, which leads to asset prices gaining further momentum.
– All these factors make it a classic cyclical industry, which does well for a few years, with higher volumes, higher pricing, higher margins leading to higher market valuation, followed by a bad cycle, resulting in lower volumes, lower prices, lower margins and thus lower market valuation. In a good cycle lasting 3-5 years, the price-to-book multiple for a respectable developer could move from near book value to 3-5 times book, while the book value itself could double in that period, leading to phenomenal gains for shareholders who catch the cycle right, ride along and make a timely exit (even if it’s 15-20 per cent below the top).
A vicious cycle
So, where are we in the cycle? While it is impossible to point that out with any precision, when one sees the data over the last 5-6 years with real estate transaction volumes being weak, flattish to negative pricing trend being prevalent across key cities and dismal performance of large real estate stocks, it becomes pretty apparent that we have been in a negative cycle for a while now. This vicious cycle has been further exacerbated by path-breaking (& back-breaking for real estate) policy actions such as demonetization, GST and RERA, all happening in the last couple of years.
Mind you, the sector remains extremely important for the enormous employment it generates, the linkages it has to core economy, including consumption of cement, steel and building material, the revenue it brings to the exchequer through registrations etc. The Government very well understands this, as is reflected from the remedial measures taken – incentives offered to first-time home buyers, including interest subvention, increased tax benefits, exemption from GST on ready-to-move properties etc. as well as a host of similar sops extended to developers & JV partners (land owners), including tax exemption, tax relaxation, according infrastructure status, among others.
One of the strongest drivers for real estate demand is interest rates – the lower the differential between rental yields and home loan rates, the higher the probability of people living in rented premises turning home buyers. In other words, when the EMI isn’t going to be too much higher than the rent you pay, it makes sense to own the asset rather than continue on lease. The home loan rates over last few years have fallen from 11-12 per cent to as low as 8 per cent and it continues to fall further based on the repo rate cut from RBI. Add to that government incentives and tax benefits, the adjusted rate falls to around 5 per cent compared to 2-3 per cent rental yield. The differential is close to being the lowest in a long time and is expected to induce demand.
However, the bigger problem hasn’t been the lack of demand; rather, it has been a case of over-supply. The previous cycle saw the influx of new entrants who expanded recklessly with customer advances. About 70-80 per cent of these developers are stuck in the slowdown and many may not be able to keep up with new operating ways under RERA. Many leveraged developers holding illiquid land banks and incomplete inventory are going bankrupt.
New launches have also slowed down sharply and are lower than units being sold, which is slowly but surely clearing the excesses built-up over the previous cycle and this shall pave the way for the next upcycle. Whether that happens in the next one year or two remains to be seen; however, the direction seems clear.
Am I implying the next boom in real estate asset class is around the corner? The answer is NO. I think despite the time correction of the last few years, the prices are still elevated, considering the rental yields. To my mind, this could be a rare cycle where stocks of real estate developers could do well, even though prices of underlying assets may not move much. This is because the 20 per cent surviving developers will cater to the entire market (including what’s vacated by the other 80 per cent) and grow volumes exponentially over the next 4-5 years.
Either ways, it is far simpler and convenient for investors to deploy capital in stocks of real estate developers rather than buying underlying property – one can deploy smaller amounts, spread it out, can diversify across developers and geographies, and still enjoy the liquidity without maintenance overheads, and transaction costs of brokerage and property registration.
Some key micro-markets have one or two-well managed listed players that fit the criteria of market leadership, long and credible track record of execution with on-time delivery and customer trust, a strong balance sheet and sensible capital allocation history. Some of these are trading close to their book value – implying that we are getting an entry with the same terms as the promoter did decades ago and deriving all the goodwill and potential growth for free.
Thanks to new accounting standards, developers have moved to project completion method, taking away all management/auditor discretion – the revenues and costs are now being accounted for only at the time of actual possession by the buyer.
Thanks to the underperformance of the last few years, listed real estate is an under-owned and under-researched sector with hardly any representation in frontline indices. When things indeed turnaround, they shall be scope for re-rating for those showing swift execution capabilities.
[“source=moneycontrol”]
