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A reality check

Real estate stocks have soared to sky-high levels. But with growth staggering, it's time for a reality check.

By Krishna Gopalan        Print Edition: July 1, 2007

If there is any sector in the news for a while now, it's real estate. Sustained demand for housing coupled with large-scale development from IT/ITEs, hotels and business parks has fuelled the appetite for growth in real estate. That could just be one side of the story. With the slew of SEZ projects certain to generate massive demand for large tracts of land, the sector is headed just one way: forward.

Much of the hoopla surrounding the sector in recent times has been due to the initial public offering (IPO) of DLF, which was due to open on the day BT went to press. This largest ever issue could mop up a record Rs 9,625 crore at the higher end of the price band (Rs 500-550 is the price band). Not surprisingly, the issue generated a great deal of media buzz. And millions of eyes are tracking its progress.

 

That apart, real estate, so far, has not had a fair representation in the market. The sector-where annual transactions are estimated at about $12 billion-is now set to have a bigger say with the DLF listing; the company is worth Rs 93,720 crore at the higher end of the price band. "The sector is underrepresented at the stock markets and there is, therefore, a need for large listings," points out First Global's Director Shankar Sharma. He cites the case of a place like Greater Noida where land prices remained almost unchanged for around a decade before the movement upwards started. "In that sense, it is the catch-up effect that is prevailing in the sector," adds Sharma.

On diverse grounds

This industry's business models are diverse. Pure-play companies like DLF form one end of the spectrum and quasi-real estate companies like IVRCL form another. "A third category includes companies like Bata, which has large tracts of land, though real estate may not be their primary business," says P. Phani Sekhar, analyst, Angel Broking. Companies, in the latter category, acquired land at low prices a long time ago, and the upside on that at current levels is, therefore, huge. High EBITDA margins have been prevailing for sometime due to rising property prices and increasing sales.

Yet there are a few looming threats and the rising interest rate is high among them. A recent First Global's report states: "Hardening interest rates will put further pressure on the pat (profit after tax) margin since real estate developers carry enormous debts on their books." The rising interest rates, it adds, will impact the affordability of housing loans. Highly leveraged companies will face additional payouts on account of interest obligations.

Behind the reality boom

» Real estate stocks have soared on the back of rising land bank prices
» Better profit margins for companies that have got land on the cheap
» Real estate companies are also diversifying into hotels and SEZs
» Current valuations factor in future projects and current land banks
Besides, First Global's Sharma points out that the hardening interest rates and rising prices in overheated markets coupled with an oversupply situation in some areas could lead to an inevitable price correction. The current situation in the market has seen soaring interest rates that has made housing expensive. This is at a time when the real estate boom has clearly percolated to Tier-II and even Tier-III cities.

Analysts tracking the sector do think there is some hype which has resulted in some stocks being quite stretched in terms of valuations. Citigroup, for instance, in a recent report has put a sell/medium risk on the Unitech stock with a target price of Rs 430; the stock was quoting at Rs 596 on May 28 when the report was put out. Commenting on the sector, the report, while terming the situation as "tough times continue", states: "Transaction activity has slowed significantly where volumes sold over a quarter last year are now sold over 9-10 months. Property prices are stagnating given affordability issues, while some pockets in the north have seen declines."

Rich Valuations

Another threat is rich valuations. Most stocks trade at sky-high P-Es. The DLF issue is priced at a p-e of 42.97. These seemingly steep valuations factor in the land banks of real estate companies. DLF has about 10,255 acres of developable land that translates to a saleable area of 574 million square feet. But if the land prices begin to fall, it could impact stock market valuations.

Real estate, according to Sharma, is a pure commodity sector. "It is necessary for the business model to change and companies need to become more infrastructure focussed in their approach," he says. Therefore, it's necessary to be choosy when looking at the sector. Companies whose land banks are not factored in their market capitalisation appear better valued than those that have. It's best to look for cheap stocks.

For real estate companies, on the other hand, the key is execution of developmental plans. But ideally, investors can look at a medium-term horizon with some high-profile companies with good projects on hand. "The investor will need to have a time horizon of at least 3-5 years. It will be necessary to stick with the big names," says Sekhar of Angel Broking.

With high levels of sustained foreign investment flowing into the sector, the going could not have been better. That apart, the growth in businesses like IT/ITEs and retail, besides a housing boom, makes the Indian real estate sector quite strong. The question is, how long can the story hold out? For now, there are no clear answers. But investors can do well with a cautious, focussed and selective long-term approach.

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