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Real estate: Have you looked at these key points?

Jul 15, 2010

The real estate pack has traditionally been a high beta play. Being cyclical in nature, the industry does not find favour amongst many value investors. The real estate pack as a whole is known for market outperformance when the economy is in boom. But it has also been at the receiving end during the downturn. Thus, timing the real estate cycle plays a very important role if one plans to cash in on the cyclical upturn. But we are aware that timing the economic cycle is an equally difficult task. Thus rather than focusing on cycle vagaries, one should focus on certain important parameters before taking an exposure to the real estate pack. Here we list out a few factors to be considered while investing in a real estate story:-

Land bank quality matters and not size: Realty stories in India are sold on the basis of land bank. It is the land parcel which the company owns that ultimately determines its value on the bourses. And the company with the largest land bank is perceived to be the best one. No wonder markets are inefficient!

However, what the markets ignore here is the quality of the land parcels and the means (debt) to expand the same. Companies with huge land banks generally quoted at premium valuations. But when the correction surfaced these companies were the first ones to get hit. Why? Apart from size what matters most is the quality of land parcels. So just because company "A" has a larger parcel does not necessarily mean it is better than company "B" which has a smaller parcel. It could be the case that company B's parcel is strategically located as compared to company A. So company B can effectively quote at a premium despite being smaller in size. Thus, bigger is not better from the land bank perspective, isn't it?

Here we present a list of few companies with land bank details and their price performance over the last one year.

Particulars Land Bank ( m sqft) 1 year price performance
DLF 416 -19%
Unitech 327 -8%
Parsvnath Developers Ltd. 194 12%
Sobha Developers 131 52%
DB Realty 61 NA*
Anant Raj Inds. Ltd. 44 -5%
*Listed recently

A look at the table suggests clearly that it is not the size of the land bank that leads to eventual underperformance/outperformance. It is the quality that matters. This is evident by the price performance over the last one year. Both the real estate behemoths, DLF and Unitech, with largest land banks have witnessed price depreciation over the last year. Compare this with the smaller size players. City centric players have outperformed their larger counterparts.

By presenting the above table, we do not mean to say that companies with huge land banks do not have quality land parcels in their portfolio. What we try to convey is that larger size should not to be confused with quality. And size does not depict quality.

Leverage a BIG concern: It is a known fact that the real estate developers stretched their arms beyond their means during the real estate boom. In order to acquire land bank, majority of the developers leveraged their balance sheet as if there was no tomorrow. But now when these debt repayments are due, all of them are facing the heat. We have seen many of them raising equity to pay off debt and some have even lined up for IPOs. Some of them have managed to escape the liquidity crisis but majority of them still have huge debt on their balance sheet.

But why did they pile up so much debt? If we were to answer this in one word, we would say "greed".

Debt on the balance sheet especially for the real estate company is all about the vision and the expansion plans the company has in store for itself. Companies acquiring land with the visibility for the next 2-3 years (lower debt to funds land parcels and near term visibility) are best placed during the volatility of the economic cycles.

Outright Sale Vs Lease: Whenever a developer builds a commercial property, he has the option to sell the asset outright or lease the same. Generally, when the prices are in upswing, the developer would prefer to sell the asset and cash in on the market frenzy. But it should be noted that leasing the same asset will provide the developer with stable rental income. This can cushion the funding woes during liquidity crisis.

Let us take an example of Ansal Properties to understand the sale vs lease model for commercial assets. Ansal Properties built the entire Connaught Palace area in New Delhi. Had it not sold the commercial space outright at the first instance, Ansal Properties would have been India's largest real developer today. Larger than even DLF and Unitech!

Thus, it should be noted that developers having a stable rental income do appear a bit conservative but are best placed when the tide turns.

Regional concentration: Real estate industry is characterized by complex frameworks that require large number of approvals with long gestation periods. Familiarity with few regions provides advantage to the developers. Venturing into new areas can create bureaucratic hassles. This could extend the time line of the project launches. Thus, city centric domestic plays are better placed as far as execution is concerned than the larger companies with pan India presence.

Thus, if one keeps in mind the factors highlighted above, one would be in a better position to understand the real estate companies.


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