Dipen Sheth

The great Indian realty sale is currently under way on Dalal Street. Emaar MGF called off its much-hyped initial public offering, while market leader DLF has crashed by over 30% from its mid-January peak market cap of over Rs 2,00,000 crore. Likewise, Unitech has lost some 45% in market cap. Ditto for challengers like HDIL, Indiabulls Real Estate, Purvankara and Sobha.

Will India’s real estate stocks live up to the hype, or will they become dogs in our portfolios? These questions haunt us as we grapple with the first significant contraction of the newly discovered real estate sector on Dalal Street. After all the frantic hype dished out by analysts, I think this is as good a time as any to figure out how exactly to look at real estate stocks, especially for the long term.

To begin with, let’s get a basic fact straight. The real estate market is an asset market. Real estate is like debt, equity, financial derivatives, precious metals and art in the sense that investors buy, hold or sell real estate assets, aspiring to earn profits over time. Of course, they might choose to use this real estate (or let it out for use by others) in the interim.

Like any other asset market, real estate is subject to three prime drivers: expectation (or speculation), money supply (interest rates) and demandsupply (scarcity-glut cycles).

When speculative frenzy takes over, real estate prices hit dizzy heights that are simply not fathomable to ordinary folks (a 1,500-sq ft, 3-bed apartment on upscale Pedder Road in Mumbai can set you back by over Rs 5 crore today). Or when interest rates rise (money becomes dearer), the appetite for mortgage financing shrinks, so real estate appetite (and price) declines. But it’s the third mentioned of the prime drivers, i.e., demand-supply dynamics, that’s behind the current real estate upheaval in India.

With a growing economy, favourable demographics and mushrooming mortgage options, there seems to be no end to the demand for residential, commercial and retail real estate. This is a structural growth story, no less. In anticipation, most real estate companies have been quick to grab the basic raw material: land. And it is this “land bank” that is behind much of the speculative frenzy in real estate stocks.

It’s important to see exactly how big a land bank a company is hoarding in terms of years of future development. Many companies have accumulated over 15 years of requirements, while I do not see any land that is going to contribute to revenues beyond 7-8 years as being relevant for valuing them. What if I was to knock off some of the much touted land banks for real estate companies and then value them?

Some companies that have been early land grabbers are now enjoying the benefit of the buying spree by later entrants, which has pushed up land value to levels where theoretically handsome profits can be booked by simply selling off the land they hold. Some of the land buying has surely been visionary in nature—DLF and Unitech’s holdings in Gurgaon are good examples. But the spate of exorbitantly priced, high-visibility mill land deals in central Mumbai, for example, is feared to lead to over-supply, which demand may not exactly be able to absorb.

With land banks in their pockets, companies begin to roll out development plans more clearly. And this leads to an apparently predictable set of cash flows. Analysts like yours truly rush in to make elaborate spreadsheets, and discount the cash flows to present value and subtract current debts from this figure. This promptly translates into a net-net figure called net asset value (NAV) per share, against which the current market price (CMP) is weighed to figure out whether to buy the stock or not.

Thus, CMP/NAV is the bargain ratio used to figure out whether a company’s scrip is adequately valued on the market. I wish it were that simple. The two big problems valuing real estate companies in this manner are execution (or sales) risk and price risk. What if the projects were to get delayed or are sold later than anticipated (even if developed on time)? The cash outflows would not get delayed as badly as the inflows, leading to severely back-ended net cash inflows, busting present values used for NAV calculations. Also, if prices were to be lower than anticipated in my spreadsheets, net cash inflows would shrink, with a similar effect on NAVs. At the end of the day, the uncertainties boil down to the capability of the company to construct, develop and sell according to schedule. And to be able to do this at a price that would earn enough cash flows to do justice to the calculated NAV per share.

The supply overhang seems scary, even as IT and IT-enabled services companies (the prime movers of the real estate) scale down their growth plans. I fear that not many real estate companies will be able to hold their prices, as real estate supply ramps up over the next few years.