Still Under The Weather

Nobody can argue with the underlying potential of the real estate sector, but the crisis of 2008 had caught these companies napping. Many of them had over-leveraged themselves on the hypothesis that property prices could not come down. They believed that constantly rising prices would ensure a steady stream of end users and speculators. But over the last two years events have taken an altogether different course. And now many real-estate companies find themselves trudging along the long road to recovery. Let’s review their progress.

Overview
Demand: Buyers have returned to the market but not in such numbers as to wipe out the inventory of real estate companies. Residential inventory stands at 11 months, 50 per cent below its June 2009 high. On the other hand, commercial inventory stands at 61 months, 33 per cent below the June 2009 peak. In the residential segment, the decision to focus on low- and mid-price housing has paid off. However, commercial demand is still low. The outlook of the IT sector, which prior to the crisis accounted for as much as 75 per cent of the total demand for office space, has turned positive. This provides hope that absorption rate in the commercial segment will pick up.
Supply: It appears that many developers have misread the demand numbers. According to analysts at IDBI Capital, developers have misinterpreted the recovery as signifying a demand for premium housing. This is the segment that many of them are focusing on once again. This is especially visible in Mumbai, where, on account of high-priced projects being offered, demand has begun to show signs of peaking.
However, in the commercial space, developers are being cautious. They have reduced supply everywhere except in Noida. Combined with the increase in absorption rate, this is leading to an easing of the inventory situation.
Pricing: This is another key issue concerning the sector. According to a recent report from IDBI Capital, developers are holding on to their prices, expecting that buyers will take the plunge if prices do not fall in the next few months. In fact, some Mumbai-based developers have even jacked up their rates by 5-10 per cent in the last two to three months to create a boom-like hype and confuse buyers.
As a result of all this, volumes could come under pressure. Already the smaller companies without access to funding are finding it difficult to hold on to their inventories, and in places like Mumbai many are prepared to negotiate on prices.
Affordability: Growth in property prices slowed down after the crisis, but it is fast catching up again with the growth in income levels. IDBI Capital found that property prices in Mumbai and Gurgaon are currently 30-40 per cent above their 2008 peak. As a result, affordability (gross annual salary/property price) has once again deteriorated, as witnessed in the Mumbai market in early 2008. This does not bode well for the sector. If prices rise beyond affordability levels, customers could well stay away from the market.

Financials
The trailing 12-month earning per share (EPS) of the BSE Realty Index rose 42.87 per cent (y-o-y) in Q3FY11. But when you look at company-wise growth in EPS, it ranges from 150.63 per cent to -37.87 per cent (y-o-y). This is too broad a range and hence the BSE Realty’s EPS growth cannot be taken as a proxy for the sector. Sales for the 12 months ended Q3FY11 rose 46 per cent (y-o-y).
Debt remains an issue for the companies belonging to the BSE Realty Index. At the end of FY10, the average debt-to-equity ratio (consolidated) stood at 0.75. But analysts at Standard Chartered Equity Research are hopeful that this will fall to 0.5 in FY12, primarily due to an increase in net worth led by capital infusion (mostly through qualified institutional placements). But higher inventory levels and lower advances from customers could play spoilsport here.
It is expected that the sector will generate positive cash flow this year: Standard Chartered Equity Research estimates that the sector will earn about Rs300 crore, after gobbling up over Rs14,000 crore cash between FY07 and FY10. The overall cash flow of BSE Realty was a negative Rs3,118 crore in FY10.

Valuation
The BSE Realty Index has lost 484 per cent from its peak (January 14, 2008) while year-to-date it has lost 18.7 per cent compared to the Sensex losing 7.14 per cent. The current price-to-earnings ratio (P/E) of the index is 40.8, even after correcting so much from its peak. Nonetheless, this index still commands the highest valuation among all the sector indexes. Moreover historic P/E ratio doesn’t hold much water in case of real estate companies, since it is a well understood fact that these companies are unlikely to command their earlier valuations anytime in the near future.
Price to book value is a much more accurate measure for gauging these stocks. One might argue that using price to book value as a yardstick depresses the value of these stocks. But it does give us the worst-case scenario for these companies.
The average price to book value of BSE Realty is now 1.88, which implies that these stocks are trading at a price higher than the cost price of the net assets they have in their hands. Even this figure is misleading, because book value does not take into account consolidated debt, which in the case of real-estate companies is quite significant compared to standalone debt. For example, DLF had a standalone debt of Rs12,638 crore while its consolidated debt stood at Rs21,677 crore, 71 per cent more (FY10). But it is not the worst offender — the average consolidated debt is 193 per cent higher than standalone debt. If you discount the consolidated debt, the average P/B become three, with as many as three companies having insufficient assets to support their debt.
If this isn’t enough to scare you, consider this: as many as seven out of 15 companies are cash flow negative, i.e., they are yet to earn anything out of their business and have to service their debt from elsewhere. Further, Ackruti City and DLF’s interest payments are more than what they earn from their businesses.
The bottomline: valuations are not cheap. Rather they appear expensive considering the weakened fundamentals of these companies. The more real estate players drag on this game of who-blinks-first-on-price, the more they will suffer. Rising interest rates, high carrying cost of inventory, and rising commodity prices will make it harder for these companies to stage a comeback.