Understanding Real Estate Market

Real Estate (RE) market has been one of the most talked about and widely covered by analysts. Also it is one of the sectors that has seen best booms and worst busts vis-a-vis other sectors. In fact, Asian crisis of 1997 and ongoing worldwide slowdown (the Sub-prime crisis) owe their losses to RE.

RE is part of a larger category of assets called Real Assets. Real assets are assets like real estate, gold, commodities, etc. which are tangible, unlike shares and bonds which are paper securities. Shares and bonds don't have any intrinsic value in themselves but these represent assets and hence hold values. RE is the oldest asset used by investors to park their surplus monies. In fact, it is believed that due to scarcity of land in historical periods, other securities like shares, bonds, etc. were developed. Even in today's times when investors are losing their risk appetite everyday and cost of capital is rising with each day passing, RE still happens to see major deals involving billions of rupees.

In India major players in this sector are:

Akruti City	DLF	Unitech
Indiabulls RE	Omaxe	HDIL
Peninsula Land	Sobha Developers	Parsavnath

Major Activities

As with any sector, RE also has a 'project life cycle' which can be broadly divided into following activities:

1. Land acquisition and conversion – This stage requires lots of approvals and permissions from various regulatory authorities. Apart from being the first, these activities are most risky ones. But following the fundamental principles of finance (for more risk, investors demand more return), this section of RE life cycle is most rewarding for investors.
   

   
   

2. Construction and development – Once the developer (one which undertakes the responsibility of placing a structure on a piece of land) has acquired the land and taken necessary approvals and permits, it starts the work of building structures. This can be done either through some third entity (construction contractors) or the developer can do this itself. Companies like DLF, Unitech, Sobha Developers are said to have strong execution skills.
   

   
   

3. Sales – This is the marketing section for developers. Here the industry gets exposed to retail investors who lured by discounts, easy loans, and so on. The credibility of Developer is what end-users/investors take very seriously for reasons like clean title. No one wants to put his/her money into some investment which tomorrow is claimed by many or is under litigation for some reason. A good developer is also believed to bring a quality product in the market.
   

   
   

With each section, some other attributes like type of investor, investment horizon, etc are related. Let us put these in form of a table :

Attribute ↓ Stage→	Land acquisition and conversion	Construction and development	Sales
Type of Investors	Private Equity, HNIs	SPVs, Retail	Corporates, Retail
Investment Horizon	Very small (months to 2 yrs)	Small – Medium (1 to 3 years)	Long*
Risk	High	Medium	Low
Return	High	Medium or Low	High, Medium, Low*

* Depend mainly on the market condition, whether boom or bust

Cash Flows of a RE company

Outflows
Cost of Land and related expenses	x x x
Construction and Development Costs	x x x
Interest	x x x
Admin and other costs	x x x
Inflows
Sales	x x x
Rentals/Leases	x x x

Valuation of RE assets

Some of the prominent methods of valuation are:

1. Build and Sell – Discounted Cash Flow (DCF) Method. In this method, we discount the prevailing actual sale prices at cost of capital.
   
2. Build and Lease – DCF method. Here we capitalise (divide) the prevailing rentals by the cost of capital.
   
3. Assets in construction stage – EBITDA (Earnings before interest, taxes, depreciation and amortisations) multiple. This method requires, first, estimating the sales price and then reducing from it the average direct expenses to arrive at EBITDA.
   

Why Boom!!!

Though it is not possible to list out the factors/reasons behind a boom in any industry, but with loads of research and analysis, experts say that the last rise in investments in RE was due to the following reasons:

1. High Liquidity in the market – Having a lot of investment in a particular sector, more so when it is not able to absorb so much lead to spiralling of prices. Any RE project can take 3-5 years from initiation to sale. It is not that with more demand, the supply will increase instantaneously. But why was there so much liquidity in the market? Reasons:
   
   1. Huge foreign inflows
      
   2. Low cost of capital
      
   3. Active retail investment, through easy loans and increasing affordability (specially the salaried class)
      

   
   

2. High Valuations – backed by high liquidity and churning of capital within project stages led to high valuations. Churning of capital is supposed to take place when investment horizons fall and still market rewards you with handsome returns. What is said to have happened was that investors were realising their investments pretty soon and were re-investing in other projects as there was huge demand (at least in reports and forecasts, if not in real life!). Mathematically, if you have increased cash flows in few years against smaller cash flows in a stretched period, you will have a better NPV or IRR. This churning of capital happened mostly in the first stage of 'land acquisition and development'.
   

   
   

3. Regulatory Support – Recent years have seen government encouraging this sector with passing of SEZ Act, fast clearing of projects (mainly SEZs), tax benefits, etc. Though one can argue that banks were asked to value their investments in RE sector with more risk-weightage.
   

Why Bust?

The reasons behind the crisis could be many. Some of them are:

1. Diminished affordability – With Central Bank's aim of taming inflation, we saw lot of pressure on interest and other statutory rates in 2008. The result was falling economic activity as the cost of debt rose to high levels and investment decisions became all the more difficult. Businesses, whether big or medium or small had to bear the increased cost and wherever possible the increase was transferred to consumers. However, RE was one of those which suffered the most. At the producers' end, high cost of debt made it difficult for developers to execute the existing projects and to go for new ones. Since RE is another capital intensive industry in which any typical project has more than 50% debt, things became all the more difficult. Developer's found it difficult to complete the financial closure of projects on time.
   

   On the consumers' side, rise in cost of loans and hence increased EMIs (Equated Monthly Instalments) reduced their appetite for making investment in the sector. In fact, many who had taken these loans for self-accommodation purposes also bore the brunt. Actually not only the rates were increased but also Loan-to-Value ratio (if value of property is Rs. 10 lacs and the loan that could be availed by mortgaging this property is Rs. 5 lacs, then L-t-V ratio is 50%) was reduced. Though now things are recovering with RBI bringing down the interest rates and issuing directives for encouraging banks to lend in this sector.
   

   
   

2. Faulty estimates – When oil was at $147 a barrel, analysts forecasted a price of $200. When Sensex was at 21k forecasts for 30k were not few. I think this is the way some analysts/experts use market scenario to make themselves famous. Nevertheless, year 2007 had many reports published that talked about acute shortage of land in India. I am not an expert to comment on the real demand/supply situation, but I am sure many of these reports exaggerated the real situation. The result, oversupply.
   

   
   

3. Exit by PE funds, foreign investors – PE funds, as said above, have been one of the main players in this rally. However with falling valuations and high cost of capital, it became difficult for them to invest. Moreover now they either had the choice to sell their investments at loss or wait for some more time. Whereas, foreign investors were busy withdrawing money from risky markets and refurbishing their domestic balance sheets. RE being one of the risky sectors, saw more redemptions. However, one can argue that the current mouth-watering valuations should bring more investments by strategic investors like PE funds, big developers.
   

   
   

4. Overall fear or recession – No economy I think has been able to save itself from deteriorating investor sentiments. All are worried about worldwide recessions, with exceptions being countries like India, China, Russia and other developing nations. But even economies like India saw losing investor appetite and more due-diligence. Investors' which are even more scared prefer to sit on cash or bank deposits rather investing in other assets. This further brought down the valuations.
   

   
   

What's next

With recent proactive actions from RBI and stable investor actions, one can expect that the market will not fall drastically, atleast from this level. But we may see some more declines as the 4^th quarter results are going to be worse than 3^rd quarter. As far as RE market is concerned we still may be able to see some downside because of cash-strapping of developers, decreasing profits of investors like Corporates, PE funds, HNIs, etc., increasing unemployment and some other reasons.

But if one was to forecast what one may see in coming times:

1. Lower real-market interest rates
   and L-T-V ratio – By interest rates, I don't mean to say only statutory rates (as I believe that a lot has been done by our Central Bank). Interest rates here refer to the market interest rates which are currently different from bank rates. Actually it is stated by many that banks have not passed on the reduction in cost of money done by RBI to the consumers. And one of the main reasons behind it is that banks are sitting on cash. More so for RE sector due to its riskiness. Lenders are discounting valuations to large extent.LTV ratio is also said to be higher compared to year 2007 levels.
   

   What we shall see in future times is lower real-market interest rates and lower LTV ratio.
   

   
   

2. More investments – With easier financing, one must see RE industry coming back on track with existing projects completing on time and new projects getting investors. But investors need to be more sceptical about the business model of the developers, contractors and other related businesses like facilities management, asset management, etc. This is because no one is sure of what will happen in future – whether Corporates (one of the major customer class for developers) will perform good or whether PE funds and foreign investors start pumping their investments in this sector.
   

   
   

3. More government support – As a sector RE is one of those which hires millions, has countless ancillary industries and brings much foreign investment. It is, I think, one of the agenda's of government to bring this sector on track. Already RBI has asked banks to go forward to in lending RE sector.
   

   
   

Let us all hope that we see more lucrative investments with robust markets in future times.