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Real Estate: The fallen angels! - Views on News from Equitymaster
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  • Mar 8, 2007

    Real Estate: The fallen angels!

    The 'Real Estate' sector, touted to be the next big thing has been badly hit in the recent correction with quite a few stocks losing more than half of their peak market capitalisation values. Infact, a few of them are ruling at their 52-week lows. What a turn of events it has been. It was not long back that the companies in the sector were being feted as real money-spinners and had become the toast of Dalal Street. What then led to the current gut wrenching declines? Although the sector being targeted was new, the malaise was old. Once again, markets took the daylights out of the investors who preferred mere promises to substance. In other words, thoughts about valuation and business fundamentals were given a slip and irrational exuberance had taken over.

      Current Price (Rs) 52-week High (Rs) 52-week Low (Rs) % Change* % Change**
    Unitech Limited 353 544 38 -35.1% 1331.6%
    Sobha Developers 640 1,179 621 -45.7% 89.9%
    DS Kulkarni 242 450 156 -46.2% 188.5%
    Ansal Housing 216 500 127 -56.8% 293.7%
    Mahindra GESCO 515 1,300 373 -60.4% 248.5%
    Parsvnath Developers 226 571 222 -60.4% 157.2%
    Lok. Housing 144 645 121 -77.7% 433.1%

    * % fall from 52 week high
    ** 52 week high upon 52 week low

    Recently, a new theme had emerged on the Indian equity markets, 'land banks'. In order to meet the rising demand for homes and commercial spaces in a fast developing economy, construction activity had reached feverish levels in the country. Not only real estate companies but companies from other sectors having free land for development were also witnessing significant appreciation to their market values on the back of expectations that the free land would eventually be developed and monetised. While there was nothing wrong with this approach, the fact remained that even loss making companies with poor fundamentals were witnessing such advances in their market capitalisation and this kind of euphoria was really unaccounted for.

    In so far as the real estate companies are concerned (companies with real estate development as their core business), these companies were entirely being valued based on their land banks i.e. the total land they own and no thought was given to important considerations such as track record of the management, execution capabilities and balance sheet strength. Further, even the lands were valued using a high per square feet rate, presumably on the back of the assumption that they will keep on increasing forever. This fact is borne out amply in the table below where the valuation levels for most of the companies are extremely steep at 52-week high levels. Infact, quite a few of them still trade at a significant premium to the overall market.

    Just to put things in perspective, let us assume that one expects Mahindra GESCO to be a ten bagger in five years time and for that to happen, its market cap will have to climb from the current Rs 19 bn levels to Rs 190 bn. If we further assume the company to be trading at a P/E of 20x at those market cap levels, then in order to justify such a growth in market cap, the company will have to grow its earnings at a CAGR of an astounding 113% from the current levels. While we are not saying that this is unattainable, very few companies on the face of this planet manage to achieve that kind of growth for 5 years in a row. Furthermore, if we are to take the growth in market cap from the stock's 52-week high levels, then the earnings will have to grow at an even higher 157%. If this is not enough, the 10 fold rise in market cap from its 52 week high levels would make Mahindra GESCO a huge US$ 10 bn market cap company. Now, how many companies in India do you know of that have a market cap in excess of US$ 10 bn and that too in such a short span of time.

    As shown above, just a small back of the envelope calculation can highlight the risks involved in investing in companies that trade at such gargantuan valuations. And the risks only get amplified in sectors such as real estate, which work under high gestation periods and are highly capital intensive. Add to this the fact that there are no clear valuation methods available for correctly valuing a land. Not to forget, the highly varied costs of land in different parts of the country. With so many uncertainties and risks involved, it was only obvious that such high valuation levels were unsustainable and sooner or later, rationality had to prevail.

      TTM EPS P/E on current price P/E on 52 week high P/E on 52 week low
    Mahindra GESCO 5.8 88.2 222.6 63.9
    Unitech Limited 8.2 42.9 66.2 4.6
    Sobha Developers 28.5 22.5 41.4 21.8
    Parsvnath Developers 13.2 17.1 43.1 16.8
    DS Kulkarni 19.6 12.4 23.0 8.0
    Ansal Housing 23.6 9.1 21.2 5.4
    Lok. Housing 86.7 1.7 7.4 1.4

    # 3QFY07 annualised EPS for Parsvnath and Sobha Developers

    Despite the sharp correction, we still believe that valuation levels for most real estate companies are still not reasonable from a medium term perspective and an investor should base his decisions after conducting a thorough analysis of all the factors highlighted above.



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