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The curious case of real estate stocks

Sep 16, 2010

Indian stock markets have been scaling highs in the recent past. And the rally is fuelled by strong performance across sectors. However, the real estate sector as a whole has remained laggard and underperformed broader markets.

Before dwelling into the details of underperformance let us start with a simple question.

What is a derivative? It is a financial instrument whose value is derived from an underlying asset, isn't it? So if the underlying asset increases/decreases in value the derivative should move in the similar direction. Now in the real estate context stock prices could be deemed to be the derivative of the property in question. So the real estate stock prices are in effect a reflective of what is happening in the property market. This is true for any hard asset with a listed paper on the bourses.

Now coming over to the recent underperformance of real estate sector, we believe what has surprised us the most is disconnect between the movement in derivative (stock prices) and the underlying asset (real estate). Real estate prices across cities have witnessed significant appreciation in the recent past. In fact, prices across some regions have even surpassed the 2008 highs. However, if one has a look at the stock price performance of the same listed developers it has remained muted to say the least.

Here is a table which displays the stock price performance between 2008 (when the stock prices were at peak) and now.

ParticularsPrice as of 31st Jan 08Latest pricePrice Performance
DLF804.67340.7-57.7%
Unitech378.6585.9-77.3%
Sobha Developers707.25371.5-47.5%
HDIL880.85273.6-68.9%

After having a look at the table it is evident that the stock prices have not moved in sync with the real estate prices. Although the stock prices do not move in direct tandem with real estate prices they are co-related. Here we see the co-relation test fail to a certain extent.

We believe the primary reason for this disconnect is "FEAR" which is keeping investors away. Further market is also questioning the sustainability of these high prices in future and discounting the stock prices to that extent. Fears of increase in interest rates due to high inflation might also be driving the investor's sentiment away from the sector.

To add further, we believe that the stock price valuation in the boom days of 2008 primarily used to happen on the land bank under possession. The higher the land bank the higher the valuation of the company. Markets were ignoring or attaching little value as to how the land bank was acquired (through debt or internal accruals) and whether the company had necessary resources to execute the project on time. No wonder markets are irrational!

However, post the debacle - apart from land bank - execution and strength of the balance sheet have become the most important factors. Even if a company has a sizeable land bank, market is not willing to attach a premium to it if it is at a cost of stretching the balance sheet. In simple terms, land bank factor in determining stock prices have narrowed to a great extent.

These days, Mr Market is willing to attach more premium to cleaner balance sheet and a better execution track record of the company. The land bank era is behind us perhaps. And thankfully so!

Unless the real estate companies deleverage their balance sheet by improving their cash flows and improve their execution track record, the disconnect between the stock prices and property prices will prevail. Stock prices are likely to move up if there is an improvement in cash flows and execution. Or else, no matter where the property prices move, stock prices will remain isolated without any co-relation.

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