Realty stocks - Sifting hype from reality

Hold tight, for you may soon be swept away by a torrent of initial public offers (IPOs) and the theme for the next couple of months may well be real estate. If you missed the bus, don't worry, there will soon be more options to choose from. While you may have to leave the contentious part of valuation of the land bank and projects to the analysts, it is important for investors to know if the company's business model deserves the valuation it asks for. We discus s a few business models of listed and soon-to-be-listed companies to get an idea of their impact on profitability and risk profile.

Euphoria toned down

A price-earnings multiple of 80 or 100 seemed a perfectly acceptable valuation for real estate stocks in 2005 and part of 2006. And these are stocks that are even today, yet to touch a market capitalisation of Rs 3,000 crore. The euphoria appeared well placed. The real estate sector had long been neglected by the investing community; despite the increased real demand for residential and commercial space that was there for all to see.

Further, with most companies in a nascent stage of business — having executed a few projects, but possessing large land banks and ambitious plans — the PE was not considered an appropriate tool to evaluate players. Above all, the stocks enjoyed a scarcity premium — there were not too many listed companies in the realty segment. But this incredible northward journey did not last long, as a broadbased market correction and a series of curbs on financing to the sector by the RBI served as effective speed-breakers.

The general market euphoria ensured that the interest rate hikes of October 2005 and January 2006, did not affect sentiment towards realty stocks. The market correction in May 2006, followed by a series of interest rate hikes, however served as a trigger for a crash-landing of almost all the realty stocks; most plunged to their 52-week low in July 2006.

By December, two interesting developments took place. Relatively larger companies, such as Parsvnath Developers and Sobha Developers, were listed. The existing stocks also recovered; only, this time, the valuations were more modest, as earnings rose and prices did not recover to their previous highs. Not only did the IPO candidates provide a better understanding of the business, listed companies began to disclose more about their land reserves and plans.

Are land banks for real?

Realty companies do hold large tracts of land, but investors have to ask several questions before they assign a value to the land bank on a company's books. The first question is whether the ownership is for real. Valuation of the land bank is no longer just about 'location', it is also about 'title'. A company such as Ansal Properties & Infrastructure, with prime land in the NCR, would no doubt command a premium to Arihant Foundations with land in Chennai and nearby areas. The premium would however, be justified only if much of the land is owned by the company or if it has obtained title for the same.

A company that secures development rights for the land (while the landowner continues to hold the title) should not be treated on par with a company which actually owns the land. Similarly, land for which the company has entered into an agreement, but is yet to receive title, also need to be viewed with caution, as the acquisition process can get stalled, resulting in delayed projects.

In this context, joint development, where the landowner is also entitled to a share of profits from the project, appears to be a good model. This has worked for DLF, which has developed the DLF city partly using this model. This method appears a better option as the landowner is also equally interested in completion of the project.

Diversified or regional?

It is commonly believed that a diversified land bank is better than a concentrated one, as it can mitigate the risk of slowdown or price correction in one region. However, diversification is not a prerequisite to identify a good real estate play. Companies such as D.S Kulkarni Developers or Prajay Engineers, primarily focused in Pune and Hyderabad respectively, have recorded superior returns on equity, thanks to their early entry and understanding of the local market.

In fact aggressive geographical diversification by a small or mid-sized company may need to be viewed with caution, as it carries the risk of locking capital in unknown territory. Among the present listed companies, those with turnover of less than Rs 300 crore have remained largely regional players, with a few cautiously diversifying to other locations.

Revenue models

Investors also have to make a distinction between contractors and developers. Real estate companies in India can be broadly classified as contractors or developers, or a combination. Contractors do not buy and develop land; rather they just execute projects for corporate or residential purposes, or for municipalities. Until 2006 Sobha Developers derived a major proportion of its revenue through contracting work, mainly for corporates. BSEL Infrastructure too did a lot of contracting work for local municipalities as well as civil work in West Asia. These companies have, however, graduated to becoming developers.

On the other hand, developers typically buy/enter into agreements to buy land, build or sub-contract the work and then sell or lease the buildings to third parties. While a few companies are pure developers, others follow a mix of contracting and developing. However, contracting may yield lower operating profit margins than developing, as gains from land price appreciation are absent in the former.

For instance, the OPM of Sobha Developers in FY07 stood at 22 per cent, against 56 per cent for Unitech. For a number of companies (see Table), higher OPM have come about from super-normal gains on low-cost land, though this may not be sustainable in the long term given that land prices are running ahead of property prices in some locations. However, if companies replenish their land reserves with a sufficient lead-time of, say, three to five years between purchase of land and execution of projects, their margins may remain superior.

Such a strategy not only helps lock into the land cost, cushioning against inflation, but also allows the land price to appreciate, after providing time for any intermittent correction. We believe that for developers, land replenishment at the right place and time is the key to sustaining margins.

Sell versus lease

Most realty players in India have had a build and sell (rather than lease) model for two reasons. One, they have traditionally focused on the residential segment, catering to home-buyers.

Two, most of them prefer to have cash flows to meet capital requirements for the next project. But this strategy provides little room for capital appreciation of the property.

Now, with companies diversifying into commercial and retail projects, the leasing model is slowly gaining ground.

While selling ensures periodic unlocking of capital, the lease model offers regular cash-flows in the form of rental yields, and protection during a downturn. This is because rentals have traditionally been stickier and tend to fall less sharply (relative to property and land prices) during a downturn, thus providing some cash-flow to the asset-holder during corrective phases.

Anant Raj Industries is one of the few companies that at present relies on the rental model (focused on commercial projects) as the prime strategy. The robustness of this model is reflected in its OPM and net margins — 84 per cent and 64 per cent respectively in FY07, amongst the highest in the industry.

However, the capital-intensive nature of the model has resulted in the company resorting to periodic equity infusion through private placements to fund expansion plans.

With the merger of its group/associate companies, the company will soon have other business segments such as residential, that will ensure phased capital unlocking.

The above examples capture how the Indian realty space has evolved and how investors need to use different yardsticks to evaluate real estate companies based on their business models. However, with Indian realty still at a nascent stage, domestic companies are still in the experimentation phase. Execution risks, therefore, remain high.

Key success factors

Based on the above, investors may need to put real estate stocks through the following filters before arriving at an investment decision:

Apart from land location and ownership, does the company earmark each piece of land for a specific project? If it does, it indicates that the company has well-defined business plans.

Does the company have a track record of developing sizeable areas or does it have a huge land bank and ambitious plans but little experience in executing projects? Then, the risks of execution may be high.

Margins in the realty business can vary substantially based on the business model and kind of projects undertaken. If a company is transitioning from one model to another, are current operating margins likely to be sustained?

The business is capital-intensive. Does the company enjoy access to funds and what are the funding options for new projects?

If the company is diversifying to new geographies, what is its approach (such as small exposure in various locations or through joint ventures with local players)?

If the company is experimenting with new strategies or new businesses (see related story "Experimenting with success"), is it a small proportion of its total business to start with?

If it is a regional player, how differentiated is the company's business from others in the sector?

What is the average turnaround time taken to convert land into building? Longer gestation periods carry the risks of a downturn and change in client/consumer preferences, which could impact demand.

Does the company have a history of executing projects on time?

Is the project subject to a number of legal/regulatory hurdles (such as procedures involved in SEZs, slum rehab or redevelopment of dilapidated buildings) that may delay project execution?