Real Estate (cycle) - Will pessimism give birth to multibaggers!

Investing Strategies
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Dear All

I invite your views on Real Estate sector which has been beaten down out of shape.
A lot of macro changes are happening which are long term positive for Real Estate :

  • Decline in inflation and therefore fall in interest rates which is boon for both Developers and Home buyers
  • Passage of Real Estate bill to bring much needed transparency and `Governance’ in the RE industry
  • Government push in form of Smart cities and Housing for all
  • Real Estate is a basic necessity and Sector faces no threat of competition from China or other country or threat of devaluation of currency, etc.

There are 2 business models currently followed in the industry:

  • Traditional land banking where Developers hoard huge land banks e.g. DLF, Unitech, Ansal API, etc.
  • Joint Venture wherein Developer ties up with Land owner in form of JV thus reducing Capital investment e.g. Godrej Properties, Aashiana Housing, etc.

Though many Developers have tried to have pan-India presence but its still predominantly a regional play because of peculiar regional characteristics like approvals, procedures, local customer preferences, culture, etc.

Geographically, we can classify developers: (list not comprehensive)

  • North India: Ansals, DLF, Unitech, Anant Raj, Aashiana Housing
  • Central India: Kolte Patil, Sunteck Realty, Tata Housing, D S Kulkarni, Oberoi Realty
  • South India: Sobha Developers, Prestige Estates

But I believe the best way for purpose of stock picking would be Debt levels on Balance Sheet and Corporate Governance:

Category A: No Debt / Negligible debt and good corporate governance - Godrej Properties, Oberoi Realty, Prestige estates, Sobha Realty

Category B: Manageable debt and fair Corporate Governance - DLF, Anant Raj, DB Realty

Category C: High Debt and Bad Corporate Governance: Unitech, Ansal Properties

Market has its own ways of rewarding companies in bull run hence, it is not necessary that Category A Companies will get the highest premium when the Real Estate sector picks up. Category B or C company having good customer understanding can also be one of the top plays due to its land bank acquired very cheaply and understanding of local political system and the requirement of the customers and network of brokers and agents.

I think Companies with business model of having JV with Land owners will initially be more favorable as sector recovers but later, they may lag behind due to non availability of land at reasonable prices or JV at reasonable stake. Recent passage of Real Estate bill and Land acquisition act will definitely increase the cost of acquisition of land.

The Real Estate sector till date has been supported and funded by inflow of black money which played a huge part in 2003-2007 boom but in future it may not play as big a role because of strict rules and monitoring.

Disclosure: Have started building portfolio of Real Estate stocks

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Thanks for starting this thread. I had a couple of thoughts:

Do we have to only consider Developers/Builders for a play on the Real Estate cycle? What about closely related industries - Cement, Sanitary ware, Tiles, Electrical fittings, Plywood & laminates, housing finance etc. There could be good bets in these categories as well.

Coming to the listed RE companies - You might want to consider valuations - A few of the good ones already quote > 20 times trailing earnings and you should also consider their history of wealth creation for their share holders.

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You are quite correct. This can also be played by betting on related industries.
However, valuation wise I find it much cheaper and under owned than compared to housing finance / sanitaryware / plywood and laminates stocks.

Real Estate is a cyclical industry. In bad times, their earnings go down drastically (consequently high PEs) and stocks are beaten down out of shape. However, when there is incremental demand after absorbing surplus, there is 3-4 fold jump in bottom line due to increase in volume sales and increase in price realization. In previous cycle most of the Real Estate stocks were languishing at very low levels but with rise in demand stocks went up >10x-20x on back of 3x-5x jump in earnings.

They are cyclical plays and hence you cannot buy and hold them forever and thats the reason why they are known more for wealth destruction than creation…I think one can buy them when there is too much pessimism and sell when there is a change in business cycle.

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Housing finance stocks have given very good returns in last 4 years, so have tiles, pipe stocks etc… Is this really the bottom?

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Thanks for starting this thread. IMHO, Real estate as a sector will not create any wealth
for shareholders in foreseeable future because of the simple reason that the property
prices in last few years have reached out of the common man reach even after decent
correction) which would translate into less volume growth; unlike last 10 years where the prices of the properties are reasonable and huge black money was pumped into the sector to create artificial demand. Regions like NCR have more than enough inventory for next 5 years even if we consider decent amount of job related migration in this region.

There are other factors like high material and labor cost which would be difficult for the builders to pass on because of already high prices. We will keep getting decent trading opportunities in these companies but surely they won’t be qualified to be called as wealth creators.

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SNAPSHOT :
Real estate in India is overpriced, while rental yields are too low to make sense as a good enough investment.

If the property market were to function as efficiently as the stock market, real estate prices should crash, but the market is rigged.

The fundamental reason why property prices have to fall is because they are no longer affordable to the vast majority of Indian middle class households.

For more details : http://swarajyamag.com/smart-cities/why-indian-real-estate-will-see-a-crash-or-at-least-a-long-period-of-stagnation#.Vv5UwcFadtw.twitter

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Even historically rental yield in Indian market has been very low specially compared with high interest rates at which money is borrowed.

Real estate markets in Asia have never functioned efficiently be it in India, China, Hong Kong or Singapore - they are all rigged. This is also because Real Estate in Asia is the primary place of investment for majority of its citizens unlike in the west where most of the investments are in financial instruments

But yes affordability is something that we need to compare with historical levels and see how far market prices can fall or remain stagnant.

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So i look at this sector a little differently…I agree, real estate can be a great place to look at, given the valuation and the pessimism. But the demand supply gap is large. Just by this fact, sales could be muted. This is how I would segregate the sector

  1. Land Bank models vs JV
  2. Luxury/ High end vs Mid/low income
  3. Regional vs National

What I like is that it is a consolidating sector. I see number of serious players reducing with time. Given the new regulations, ‘Branded’ players are likely to benefit and in fact gain business off the players with bad practices.
What I don’t know is how soon the demand-supply gap will narrow. Also corporate governance is just so bad and when you add the fact that most deals have a substantial Black money component, its very hard to take these companies seriously.
Take DLF for example = Owns prime land in the heart of Delhi. Even if you were to discount it for current inflation, interest rates, over supply etc, it still looks cheap on a MarketCap basis. But then you add the fact that the promoter has all sorts of allegations on him including the recent Panama papers etc, it is highly questionable if he cares about creating any sort of shareholder value and if the under valuation benefit will ever pass on to shareholders. When you look at DLF, you know the numbers don’t mean much and I would say that much of it would just be created through innovative accounting … DLF is just an example, most companies would be similar, if not worst. I would think, Its hard to put in serious money with such promoters. Though a basket bet on undervaluation may turn out rewarding
But my idea is to look at players who are actually benefiting from all this bad perception, high debt, bad governance etc. People who have cash now, sales are growing well, and are national. Godrej Properties comes to mind. Alpha may not be as high as some pure under valuation plays but you know you’re in good hands. One can also look at Godrej Industries, in fact the other businesses are wonderful too and act as a buffer. Also why not guys like Piramal Enterprises, IL&FS - indirect and partial plays but no issues on governance or debt. And they are likely to benefit as much from any improvement in the real estate cycle.
In terms of governance, players like Sobha, prestige, Sunteck, Oberoi, Kolte-patil, Mahindra Life etc all seem fine but they are regional players and so one has to also take a view on a particular region. I think, given the inventory overhang, the over supply may last for a long time so one has to be very selective.
Also I would think niche players catering to areas in tier 3, 4 cities may find it easier due to less competition. Players like Ashiana, Prozone, Poddar etc… I see more and more players focusing on speciality areas like retirement homes, shopping complexes, slum redevelopment etc. Obviously anything in this space will be cyclical and should not be hung on to forever.

Views invited

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IMO, atleast in this thread, anyone giving opinion that real estate “should crash”, “overpriced” , “not affordable to the comman man” etc should disclose their source for such data, would also be nice if they disclose if they have invested in real estate (not the stocks) or waiting to invest .:grinning:

DISCL: More than 90% of my overall assets is in Real estate (not the stocks).

BTW. Nice thread!

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I think Real Estate is going through an inflexion point -

  • It takes nearly 2-3 years to get approvals from the Government, it is not possible for the Developer to buy land and sit idle till approvals are obtained and hence they resort to Pre-launch booking.

  • to improve their profit margins the builders change the designs to either add additional floors (which are not approved) or increase super area to extract more more from the customers

  • Till 2-4 years back, end customers were always hapless and at mercy of builders

  • Whatsapp groups, forums like indiarealestate forum and pressure for better disclosures have changed all that - today customers unite together and go against the builders which I think is the inflexion point for this sector. Today customers demand month to month progress on the website and prompt response from Customer care. This is changing the face of Real estate.

Real Estate stocks are trading on average at 0.1x to 1.1x P/BV valuations. Though it is very difficult to ascertain true intrinsic value of their land holdings and it maybe a value trap. However, in some cases, it is beyond doubt that current market valuations no way reflect the value of their large land holdings.

I recently bought my first house (which is under construction). I went through in detail about the Project and the builder and then went to the site to see progress on the project as well as their past projects. I believe gradually builders will need to change to the environment and bring about better corporate governance and disclosures or perish. It is only a matter of time.

We need to find builders that are first to change and would benefit the most.

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Today the whole sector is on buying spree. Any specific news ? Lots of value getting noticed suddenly.

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Yes Real estate stocks are up 3 to 16% !!

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Wanted to buy Anant Raj and kolte patil…price moved up 3% and 10% :(. Will wait for some correction

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Dear Savishesh

I have been liking Kolte Patil & Godrej Properties; but was results were coming flat since past few quarters. Also there sales figures were bit disappointing. There is lots of value but was not buying since market was ignoring this sector. Today’s move in the sector; feel that these stocks have made there intermediate bottom. I have exposure in Kolte Patil but did not add at lower levels bcas of there CEO, CFO leaving the company, was thinking something must be wrong. I have very high regards for the management though.

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Dear Manish

It is difficult to say when Real Estate sector will turnaround in terms of growth in Revenues and Profits or if this is intermediate bottom but when a sector is ignored, we becomes skeptical and choose to ignore even small small positive developments that ultimately bring about turnaround in the sector.

I choose to buy shares now because I am very bad in buying stocks when they move 25% - 55% in a session or two, owing to price anchoring bias and fearing if its a trap.

I have read Annual Reports of many Real Estate companies. Few positives that i have noticed:

  1. Focus towards execution and delivery of existing projects rather than launching new projects
  2. Focus towards reducing debt - most companies in the sector are taking small small steps to repair their balance sheet and bring down debt.
  3. Consolidation - in last 5-7 years lot of small small builders had mushroomed. So in effect, the actual fall in demand was not as much as the demand got distributed into so many players. Now with financial difficulties, lot of consolidation is happening or the small players are closing down shop. This would eventually help the organised and big branded players.
    4, Greater transparency and regulation in the sector with new Real Estate Act and Land Acquisition Act.

Moreover, if people continue to sit on the fence, foreign players like Brookfield Asset Management, Sequoia, would continue to acquire good commercial assets

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I think several of the real estate companies are making good disclosures. Ashiana. Sobha Kolte Puravankara etc.
I feel we should keep an eye for an improvement in sales bookings across at least few companies yoy. I think that should be one valid good signal.
Also the technical analyst can monito the charts of few good real estate companies to detect any change in trend.

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How would you define a good Real Estate Company ??

From the customer’s perspective:
A Company that is good on execution and quality and delivers on time, a Company that shows month to month progress of its projects on their website, a Company whose CRM is prompt, well trained and treats customers respectfully even in difficult times.

From the Investor’s perspective:
A Company whose management has integrity and ethics and respect for minority shareholders, proper disclosures - like quarterly analyst presentations and conference calls.

Most Companies turn ugly when they have overstretched themselves or run into roadblocks for one reason or the other. In bad times almost all companies stop their analyst presentations and disclosures or answering to queries of analysts or shareholders. I don’t know how it helps them…its akin to putting your head in the sand and hoping worse shall pass on its own. That’s why I have more respect for managements that respect minority shareholders even in bad periods and are open to answer queries and concerns of shareholders.

At one time not too long ago, Unitech commanded respect and premium from the customers for its better quality of projects. Now it commands anguish, frustration, abuse of the customers, thanks to their overstretching themselves and poor customer care. Same with so many old names of the industry. The same also reflects in their share prices.

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From whatever little I have known about the industry the value accretion is unlikely to be passed to minority equity shareholders in majority of the cases. This is due to

  1. Periodic capital requirement for land, which is funnelled to various group companies because of cash component in land dealings + land aggregation being done through various companies (land ceiling act till recent past and masked accumulation of land by builder- to avoid surge in land pricing by sellers).
  2. The unwinding transaction upon project execution is not exactly a reverse of the above, it again takes a similar form as above from the company which executed the project.
  3. Further, the above mechanism also helps developers to funnel debt as equity in some form at later entity and leverage further and thus making it hard to resist the temptation to spread out thinly. Not to mention the easy money - customer advances (till recent past) with profit component built in sales prices, which is again put to use /speculate /take care off past sins (excessive debt).
    Further, with the above points, illiquid nature of underlying asset, and very low inclination to sit idle the chances are high to blow up at some point. Few builder tried to sit idle in 2010-2012 period, but the pressure to do something is high / even otherwise it becomes existential threat.
    Plus on the supply side for residential segment I believe the existing supply is developed with a misreading that the demand was actual demand. A lot of demand till recent past catered to unaccounted money. This demand appears to be drying up, so now there is an inventory overhang in many pockets. Current situation is like - the demand is for Nokia products and the supply is of Apple products.
    On the commercial side, a lot of interest from international investors is due to attractive differential yield even after factoring currency risk. Moreover, not many listed players have sufficient pipeline of commercial properties. The ratio of resi : commercial development with developers has completely altered for majority of the players after 2008. By the time someone gets into this segment the cycle may reverse again. It’s a long way forward for developers to manage a healthy resi : commercial portfolio.
    So companies with limited third party transactions, historical land banks / JV model, project segmentation in mid /lower market (resi) categories, and commercial projects on books may offer value. But again the assets in the books cannot be taken at face value due to various reasons.
    The new bill has the potential to be an antidote for various existing ills of the industry if implemented strongly. But again strong implementation will only increase cost of funds for developers and thus margin and returns compression. Consolidation may not be that simple an outcome - atleast in next 3-5 years.
    Further, I personally belive RE resi sector will benefit in high inflation /high inflation expectation scenario. Commercial can be directly linked to economic cycles or activity but again there are hardly any listed players with commercial portfolio /pipeline.
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Some of my views on Real Estate ( They are a bit opinionated (after all its my opinion :slight_smile: ) and hopefully Value Investing Focussed

1 - Behaviour - In Spite of being a B2C, there is no other sector where customers are treated so shabbily. There is no say for Consumers (even if the Real Estate Bill Comes in). Our terrace was owned by the Builder, till we went to court to get it back.( After 10 Years)

2 - Cash Transactions - Even if Residential Prop is in White, Commercial is almost 40% in Black. So whether the end shareholders will make money or not is seriously questionable. Also most of the payments to smaller vendors are mostly inflated for tax savings. The difference is usually adjusted using Related Transactions or Offshore Accounts.

3 - Bribes - Although everybody does it, in other sectors its usually one time. Land Clearance / Eco Clearance, Water, Power Blah Blah. For Real Estate is a regular and increasing cost. It will never go down. ( Builders in Mumbai have committed Suicides).

4 - Political Nexus - Even if a Company is found doing wrong (eg DLF) the penalty will will not even be 1% of anything. They simply wont be prosecuted.

5 - Management - Politicians, and their Sons, Daughters, Son in Laws, Nephews, etc

Nevertheless, I agree that if something is really down and out, its a good trading call.
But with all the negatives (esp Management), I doubt if it qualifies for Value Investing.

Further, Learning from the Masters - I don’t know of a Single Decent Investor - Either Domestic Biggies (RK, SB), FII, DII etc that have Indian Real Estate as major part of the portfolio. Its almost always a miniscule 2-3% range.

Thanks,
Manish

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