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The Realty Bubble

Real estate stocks are inflated to bursting point and the companies in the sector aren't any better off

This article appeared in the 15 November - 14 December 2009, issue of Mutual Fund Insight magazine as its Special Report.

Real estate stocks are once again in the news. This time, for a variety of reasons, not just soaring prices and stretched valuations.

Companies like DLF, Unitech, Housing Development and Infrastructure (HDIL) and Sobha Developers have all posted a drop in net profit during the quarter ended September 2009, as compared to the same quarter last year. The numbers were not surprising since the quarter of 2008 saw higher demand that the one in 2009. On the flip side, they are all seeing a revival in demand with many industry analysts of the opinion that property prices have bottomed out and have already begun to rise.

Real estate companies are also launching affordable housing projects. Unitech launched UniHomes, where houses are priced in the Rs 10-25 lakh price range across six cities. Encouraged by the strong response, the company states that it plans to offer similar products in other cities. DLF is soon to launch a new brand of residential projects in the new 'value' housing segment. Residential projects in Bangalore, Chennai, Hyderabad, Gurgaon and Chandigarh are planned under this as-yet unnamed brand in the coming two quarters.

The bigger players are even selling non-core assets. DLF plans to sell Rs 5,500 crore worth of assets (wind power business, hotels). Unitech has already sold significant stakes in its telecom venture, hotels business and an office complex.

So there is plenty of good news � demand is picking up, property prices are rising, some companies have raised funds which have helped them de-leverage and improve their balance sheet, and some have even launched new projects at cheaper prices. But does that justify the euphoria?

First, a look at 2008

By October 2008, foreign banks were told to send all their money back to their 'home country' as their parent banks were in trouble and needed all the money back in safe U.S. government or U.K. or Euro government bonds. Foreign banks were not only refusing to lend more money to any Indian company, they even refused to extend or restructure or roll-over the loans that were falling due. To add to it, mutual funds were holding debt issued by Indian real estate companies and these companies were unable to repay. The Indian companies that had parked their surplus cash with these mutual funds wanted it back and the mutual funds could not repay it.

As consumer confidence weakened and the slowdown squeezed the economy, housing sales disappear. As sales went down, the cash to run operations also vanished. The combined net sales of the real estate companies fell by 39.47 per cent (compared to the previous year) to Rs 10,989.73 crore, while profits stood at Rs 4,470.23 crore, down by 43.82 per cent. Hence, they now had to sell Re 0.17 more of goods to make a rupee of profit. Real estate companies were about to go bust and had no money to repay debts. That is when they got bailed out by public sector banks (PSU banks) and realtors began to live off borrowed money. By the end of March 2009, they (BSE Realty Index components) had a combined market capitalization of Rs 49,471 crore, while the outstanding debt obligations were as high as Rs 31,008 crore! That is, these companies borrowed Rs 0.84 for every rupee of equity.

Another implication of having too much debt in the books is that the service cost also taxes the ability of the company to utilize the cash from operations, which stood at Rs 2,960.25 crore while their interest outgo was at Rs 3,946.35 crore (up 81.24 per cent). That is, these companies were spending more than what they were getting via their cash income just to service debt.

A more optimistic 2009

Now, it's true that realty companies are no longer on the verge of bankruptcy due to the thaw in the credit market and bounce back in the equity market. It has enabled them to tap, mostly, the institutional investors for cash. Till date they have raised more than Rs 10,000 crore via stake sales or through qualified institutional placements (QIPs).

The course of action is also being dictated by certain pressure groups who are desperate to get their funds back. These are the private equity (PE) guys. The result has been that a dozen odd companies have filed for initial public offerings (IPOs). There is Rs 14,963 crore worth of real estate IPOs in the pipeline. The extent of realtors' desperation is such, that in the primary market, 48 per cent of the total money looked to be raised, is by realtors. But there is a high chance of failure. In Emaar MGF's case, the IPO got mistimed, it then cut its offer price and extended the deadline, but still failed to attract investor attention. Now, it has slashed its IPO to almost half, from Rs 6,200 crore to Rs 3,850 crore.

Can these companies once again depend on PSU banks to bail them out? Not too likely. PSU banks raised exposure to realty loans from 2.9 per cent (Rs 62,178 crore) at the end of May 2008 to 3.7 per cent (Rs 94,499 crore) at the end of May 2009.

RBI gets cautious

The Reserve Bank of India (RBI), in its quarterly monetary policy review, has chosen to crackdown on realty, especially in its commercial sphere, saying, "In view of large increase in credit to the commercial real estate sector over the last one year and the extent of restructured advances in this sector, it would be prudent to build a cushion against likely non-performing assets (NPAs). Accordingly, it is proposed to increase the provisioning requirement for advances to the commercial real estate sector from the present level of 0.40 per cent to 1 per cent."

That is going to dry the funds flow, specially for commercial real estate, in the future. The tightening exercise also included raising banks' statutory liquidity ratio (SLR) by 100 basis points to 25 per cent. In short, the central bank is worrying about the property bubble and is already taking preventive measures.

The future?

Real estate stocks were the darlings of the stock market during the last bull run. The BSE Realty Index peaked at 13,482.88 on January 11, 2008 before it was felled by the global meltdown to a low of 1,346.83 (March 6, 2009).

This year, the index once again soared but is nowhere near its earlier peak. Nevertheless, real estate stocks have run far ahead of their underlying valuations. At current prices, BSE Realty Index trades at a mammoth 55.44 times the previous four quarter earnings, making it 4 times more expensive than Bankex and 2.5 times dearer than BSE IT. Realty leads despite the fact that sectors like IT and FMCG command a higher price-to-earnings (P/E) premium by the virtue of their superior corporate governance standards.

The economic recovery is holding out hope but no one can be certain regarding realtors' long-term future. Some of the big players buy land through numerous subsidiaries, count revenue from projects before they are fully built and book interest on loans from undeveloped land acquisitions as capital instead of operating expenses. The opaque financial statements and complex off-balance-sheet transactions make it difficult to really estimate how profitable these companies are.

Some may well take this opportunity, and turn it into yet another money-making story. By all accounts real estate looks like it's sinking, and the current revival has given many of its patrons the last chance to jump ship, at a profit. That could be the reason they are racing against time to collect as much money as they can from gullible investors. All the variables like low interest rates, high loan disbursals, rising property prices are visible and together, they are setting up the industry for a final fall.

This article appeared in the 15 November - 14 December 2009, issue of Mutual Fund Insight magazine as its Special Report.