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Realty Bubble:Fund Managers React

Real estate stocks saw a surprising upward move on the markets which, for all intents and purposes, was contrary to the situation on the ground

The article first appeared in the 15 November - 14 December, 2009 issue of Mutual Fund Insight magazine, that looked at the reality in the real estate sector. While we present the case, it is put in perspective by leading fund managers in the mutual fund industry. We highlight here, their views:

After being beaten to abysmally low levels, real estate stocks are back from the dead. Sure, the times have changed and economic conditions have improved. Nevertheless, realty stocks have no business being where they are at the moment — soaring on the stock market.

Read main report: The Realty Bubble

Pan-India residential demand is estimated to be over 7.5 million units by 2013 across all housing categories, of which 85 per cent is expected in the mid segment and affordable housing segment. Of the total demand, 60 per cent would be generated in Tier 1 and 2 cities (top 7 cities in India). Mumbai is expected to witness the highest cumulative demand of 1.6 million units whereas Bangalore and Hyderabad are expected to see the highest CAGR of 14 per cent.

The office market is expected to witness a fall in demand in the year 2009 with an expected absorption of 27 million sq ft. The period from 2010 onwards will see the markets experience a healthier demand with a CAGR of 19 per cent (2009 to 2013). The highest demand is expected in Bangalore and Chennai. Demand is due to improving economic conditions, positive market sentiments and growing corporate confidence.

—’Survival to Revival - Indian realty sector on the path to recovery’

Report released in September 2009 by Cushman & Wakefield in conjunction with GRI India.

Fund Managers' Views

You cannot make a blanket case on the fortunes of all companies in this sector. However, you may have an investment case for a select few. It is a very ‘pick-and-choose’ kind of situation. Those companies that have been ahead in terms of monetising their land holdings, launching projects at correct price points, raising money and cleaning up their balance sheet may survive and succeed. The key is to be able to achieve sales to the customer and execution of projects at the ground level. In terms of our holdings in Morgan Stanley A.C.E. Fund, we been very selective, with Phoenix Mills as a play on commercial real estate and Sobha Developers as play on residential.

Jayesh Gandhi,

Executive Director, Morgan Stanley Investment Management

We are positive on real estate but in very select geographies — basically Bombay, Pune and Bangalore. We are not positive pan-India, be it Delhi or NCR. These are niche markets where builders are focussed. As IT picks up, demand for housing in Pune and Bangalore will.

We have seen evidence of prices going up and demand increasing. New project launches have also witnessed a decent response. Builders are no longer negotiating or offering tremendous freebies.

I do not believe in low-income housing as a value creation mode for the stock market since the margins will be very low. The whole business rests on buying land cheap and selling it at a much higher cost.

If interest rates move up, there will be an impact on this sector. Housing is the single largest driver for economic growth. This sector has a huge multipler effect. If you kill housing, you kill economic growth. In 2003-04, one could get a fixed rate loan at 7.25%. Now a floating rate loan is available at 8.5% - 9% while a fixed rate loan can go up to 11%. The market will absorb interest rates going up to 0.50%, but any move higher than that will have a negative impact.

Prateek Agrawal

Head - Equity, Bharti AXA Mutual Fund

There is a huge demand for real estate in India. But my negative view on real estate is based on one fact: There is a significant amount of corruption in the land acquisition process. Left to a more “free” market and an improved zoning process, the cost of real estate would decline.

But greed too has played an important role in holding real estate prices down for the past 12 months. Driven by their own frenzy to get rich, real estate developers have started to build too much property. The projects under construction are probably 5x what the actual demand will be at the price points being currently quoted. Drop the price by 20% and the demand could jump by 100%; still leaving an oversupply of 2.5x. But drop the price by 40%, and probably every square foot available will be sold out. The “problem”, though, is that all the developers will be bust.

So, rather than let this happen, the government arranged for the Indian banks to bail out many of these debt-laden developers. The per cent of real estate loans to total loans given by banks was 2.6% in May 2007 and 2.9% in May 2008. It rose to 3.7% in May 2009. The actual amount of real estate loans rose from Rs 451,600 crore (May 2007) to Rs 944,990 (May 2009).

The surge in the Indian stock markets also gave the developers a further respite: some of them were able to sell their overpriced shares and pay off some of their debt. But they are still leveraged and there’s a limit to what banks can lend to the real estate sector.

Companies and businesses built on government favours can disappear pretty quickly. Companies with no public sympathy can disappear pretty quickly when the monopoly over zoned land is challenged.

And if you happen to be around as a shareholder, remember it took Satyam a few minutes to lose 70% of its value.

If you are an investor in the real estate stocks dancing to this music, stay close to the door.

Ajit Dayal

Chairman & President, Quantum Mutual Fund

The big players today bought huge acres of land on the outskirts of cities like Bangalore and Delhi years ago. Every time the city “expands”, its circle increases and the outer city becomes part of the main city. That is when they develop the land acquired and build housing. DLF and Unitech have benefitted by acquiring land over the past decade. DLF bought land from the farmers and that is how Gurgaon was built. But to implement that strategy now will take another decade at the very least to realise. Investors were buying land outside Kolkata, but that has backfired. At the end of the day, the business is about converting acres into square feet. And it looks all very rosy in excel sheet projections, but this sector is in for some hard times. I do not believe that these companies have ‘cleaned up’ their balance sheets. They just got lucky that banks bailed them out and the stock market picked up.

Fund manager (who preferred anonymity and has offloaded his real estate equity holdings.)  

The promoters of real estate companies have a very ‘get rich quick’ mentality. They lack long-term vision. Their attitude is to buy a piece of land and make a good profit on it. When there is a favourable change in market conditions, they jack up their prices. Instead of being so price driven, they should be more volume driven. As a result, real estate stocks are very volatile. And if interest rates start rising, once again these stocks will get hit. If one had to invest in such stocks, it’s safer to invest in real estate companies that specialise in a particular geography, rather than pan-India players.

Fund manager (who preferred anonymity)  

Read main report: The Realty Bubble

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