The article is the cover story that appeared in the November issue of Wealth Insight magazine and looks at the murky state of affairs in the real estate business and how their stock is affected.
Real estate stocks are back from the dead. The global meltdown has vanished, economies, especially the Indian one, are generating bountiful gains, consumer confidence is returning, corporate convictions are back to their best and stock markets are soaring. But despite all this, one segment has no business of riding a bull market frenzy — the realty stocks.
Realty was beaten to its lowest depths in 2008 and early parts of 2009. Nothing has happened since then to revive these businesses. But now, within the blink of an eye, the recovery process, as charted on the Bombay Stock Exchange (BSE) Realty Index, saw these stocks, in the current bull rally, gaining 247 per cent (March 9 to October 23) and the index climbing to a 52-week high. As can be seen, realtors’ greed still knows no bounds and this threatens investors. We list here reasons that may bring ruin to the sector.
1. Stretched Valuations
Real estate scrips have run too far ahead of their underlying valuations. At current prices, BSE Realty Index trades at a mammoth 41.19 times the previous four quarters earnings, making it 189.25 per cent more expensive than Bankex and 84.04 per cent 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.
Everybody is agreed on stretched valuations, but what is really eye-popping is the extent of rise in the last bull rally. The highest for the index was 13,482.88 points (January 11, 2008) before it was felled by the global meltdown, to a low of 1,346.83 points (March 6, 2009) — it is still down by 8,969.9 points, or 67.52 per cent.
2. Debt Crunch
Weakening consumer confidence in 2008, as the slowdown squeezed the economy, made 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 year before 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.
This forced realtors to live off borrowed money. At the end of March 2009, they (BSE Realty index components were considered) 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 their 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.
3. Floundering on Greed
Worse was to follow. At a time when they should have been looking to book as many sales as possible, with demand diving to lows, these companies kept hoarding an inventory that was as large as Rs 30,035.55 crore, i.e equivalent to 2.73 times current sales figures. They even went on increasing prices too.
The reason why they did not want to reduce inventory had to do with their desire to avoid lowering prices that would slash margins. Companies like DLF had suddenly found that they were being compared to the Tatas, Birlas and the Ambanis. Price cuts would have led to a fall from grace. Instead, they decided to create a demand and supply mismatch to achieve their own desired level of profit. This is nothing but greed, as it is better to off-load current inventory, even at lower prices, to survive a crisis.
It moved Deepak Parekh, Chairman, HDFC, to say in DNA: “All factors relating to greed — aimed to make quick money and more money — could have been avoided if we had a real estate regulator. We have regulators in other sectors, but we are reluctant to have a realty regulator.”
4. Cash Generation Crisis
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 are 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 prices, extended deadlines, 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.
But there is another source of funds, unwilling though it may be. Public sector banks (PSBs) 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. Now those loans are in danger of going bad and PSBs have been forced to open their lockers again.
5. Facing Crackdown
But, 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 for 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.
6. Asset Creation Alarm
While it is a good sign that these companies are able, and willing, to tap the primary and secondary markets, but most of the fresh inflows are being used to retire old debts. No assets are being created to take the sector to a new growth path. If the trend is like this, all those who participate in the upcoming offerings, will be left short-changed, since the return on equity will be diluted. Other investors too have no reason to rejoice.
7. Uncertain Demand
But amidst all the panic over a bad situation turning gradually worse and the future not holding out much hope, has come one ray of hope. But that may have already been compromised. In the second quarter of 2009-10 the demand for commercial real estate jumped 15 per cent while residential demand in the first quarter increased 10 per cent.
There is uncertainty on this score too as buyers have been burned by their profligate habits. In Parekh’s words: “The main reason for the crash was over-leveraging by end-consumers. Liabilities ballooned on poorly-designed products that were beyond the means of the borrowers. Over-leveraging magnified their profits on the upcycle, but wiped them out when prices fell”.
As such, there is no surety about the demand — how much of it is consumption demand, or speculative. Rampant fudged figures prevent any stable outlook being given. It could be that the revival in demand has been powered by speculators. Or, that the realtor/intermediary nexus may have jacked up numbers.
8. Excess Inventory
But the experts who are hailing this fact are also saying that it will take some 2-to-3 years to get rid of the excess capacity lying just in the commercial inventory. Add the housing inventory and the task gets even tougher. Moreover, under-regulation of this industry ensures uncertainty even about the inventory.
9. Churning Assets
The perverse power play by the industry has led to a situation where only the big companies can eye survival, that too by the cannibalisation of their own assets. Companies like Unitech and DLF are still standing because they had built-up side businesses and they are busy selling these non-core assets. DLF plans to sell Rs 5,500 crore worth of assets (wind power business, hotels). Unitech has already sold its stake in a telecom venture, hotels business and an office complex. A smaller company, BPTP, which outbid DLF and others to win the biggest-ever land deal for Rs 5,006 crore in an auction for a plot in Noida, says it is unable to pay the remaining 75 per cent of amount due.
10. Jumping Ship
No one is sure about realtors’ long-term future. But the economic recovery is holding out hope. However, they 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 — they are racing against time to collect as much money as they can from gullible investors.
In short, all the variables like low interest rates, high loan disbursals, high property prices are visible and together, they are setting up the industry for a final fall.
Also Read:
RBI Holds Rates, Ups Realty Provisioning
MFs Hit By Banks & Realty Stocks' Crash
Realty on Razor's Edge
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