Friday, July 15, 2011

Reel Estate


Everyone seems to be of the opinion that the real estate prices in the metro cities is likely to correct downwards significantly. This is also borne out by many large projects (esp in cities like Chennai) that kicked off in 2007-08 madness, getting delayed in execution. In fact at Chennai, I see many projects still selling at prices below what they were launched at, apart from changes in plans that involve change in usage, cutting corners with regard to facilities etc.
The interesting dichotomy I see is with regard to the size and scale of the projects. In metro cities, the large projects tend to be on the fringes of the city or in ‘new’ growth areas, due to availability of large land pieces. Within the city, the supply of new housing stock is rather limited and the demand strong. So we have a situation where prices in the heart of many cities, for small projects, have risen dramatically. At the same time, prices have slumped in most large projects. Of course, when I mean slumped, it is still not juicy or attractive enough to become bargains, yet.
So what is holding up the prices? I see unsold stock, incomplete projects and steady prices. In 2007-08, most of the demand that came in was of a speculative nature, where hot money chased quick and easy returns. Book a flat at the ground breaking ceremony time at base price. As progress happens, the prices start to rise. Sell it off before completion and enjoy full profits with less than full investment. The banks and housing finance companies also contributed to this speculative frenzy by giving loans of 100% or more (some banks gave on furniture also!).
The 2008-09 crises saw hot money rushing for the exit. Prices fell, especially in the large projects in outlying areas. Projects got delayed, reshaped and prices stagnated. Many overpriced projects had to correct prices in a big way.
Now (two years since the stagnation) there still does not seem to be much recovery in prices. Projects still take time to sell out. Inflation in two years has been high, which means that the costs of construction have. So, the days of superprofits for the builders are coming down. I recall balance sheets of companies like DLF showing net profits of over 70% of sale value! It still has to come down to reasonable levels.
For the investors, this means that real estate stocks are untouchable yet. Many of the real estate companies are raising money through privately placed paper at high interest rates. Some companies are trying to reschedule their obligations. The debt on the balance sheet of most real estate companies is still at uncomfortable levels.
We also had a phase of euphoria with almost every real estate company projecting huge returns on “SEZ” development. Most now want to give back the land or change the use to something else! Unless there is corruption, it is unlikely that the usage would be allowed to be changed from “SEZ” to ‘commercial’. So, I would keep away from the SEZ dreamers for a few more years.
The shares of most companies still seem to be holding on (of course far away from the stratospheric levels of 2008-09). And given the lack of transparency and periodic bad news from one company or the other in the sector (Unitech and the 2G scam for instance) investors have no reason to put money in shares in this sector. Despite that, prices have not crashed nor have institutional investors ditched this sector totally.
The one inference I draw from all this is that there still is some serious money that is backing this sector. Is it legitimate money or money that has found its way through devious routes that is holding up this sector? To me the biggest risk this sector has is a fear or feeling of instability in the political environment. A scare from that direction can perhaps bring about a real slump in the sector.
As regards land, prices fell and then gradually recovered. Yes, large deals are not happening, but small investments in land continue to happen. Given the reducing retail participation in stocks, there is a diversion of money to real estate and precious metals. Tier two cities are witnessing firm to rising land prices.
The other interesting perspective is on the rentals. Commercial properties across most large cities have seen a steep decline in rentals. At the same time, an oversupply situation seems to be correcting itself with the withdrawal of a lot of projects. This perhaps implies stable rental situations. The one interesting fall out is that the newer properties command significantly higher rentals. Apart from offering better infrastructure, the new properties have a very large hidden premium. The carpet area to built-up ratio in new projects is significantly less. Regulators are continuing to play footsie with the builders by refusing to mandate uniform standards in measurement standards for real estate.
I would watch out and an eye on companies that are able to hold on to commercial properties and earn rentals from that. This seems to be a good strategy. Apart from that, I would also like to revisit companies with low to zero debt and with low profit margins. These are the companies that will do well when the next boom in real estate happens. As regards timing, difficult to take a call as to when we would see a revival in this sector. But this is one sector (if we can exclude the governance issues) where there could be value picks.

R. Balakrishnan
May 27th, 2011

(This was published in the 14th July issue of Moneylife)

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