Realty check: Concerns overlooked?

Realty check: Concerns overlooked?
The Hindu Business Line, Investment World, June 7, 2009, Page 1

Special home loan rates have helped revive buyer interest in residential property.

Vidya Bala

The realty sector has been the star of the recent stock market recovery. The most battered in the 2008 fall, it is a sector on which domestic brokerages, fund managers and private equity investors were uniformly bearish, even as late as March this year.

Yet, real estate stocks were the first to be singled out in the recent stock market rally. The BSE Realty index was the top gainer among the key indices, with a stunning 209 per cent return from March 9, outperforming the Sensex by 124 percentage points.

Rags to riches

Larger companies HDIL, Unitech and Puravankara Projects, as well as smaller firms such as Ansal Housing, Lok Housing and Prajay Engineers Syndicate all trebled, although the small-caps caught up a little later.

The rally also resulted in some of the real-estate companies being ‘re-rated’ from throwaway valuations to an actual premium over the market. For instance, Orbit Corporation is currently priced at 22 times its trailing per share earnings, compared to just four times in March! Earnings for the company declined over the quarter and the full year ending March-09. Clearly this decline was factored in way ahead, going by the ‘downgrades’ on these stocks early on; the premium, therefore, appears to be for future earnings.

Are earnings of realty companies likely to see a quick recovery? While there are tentative signals of a revival in the sector, some concerns remain unaddressed. Concerns that can well drag the recovery process and, in turn, belie the strong faith currently placed in realty stocks.

Listed below are some reasons why the market ‘upgraded’ the sector and factors that suggest the road to recovery may be longer than anticipated.

Reasons behind the rally

That the BSE Realty index is still 35 per cent below its year ago levels (the Sensex is only 3 per cent below) points to the simplistic conclusion that ‘those that fell most must rise the most’! However, setting aside this unsophisticated theory, there are fundamental changes too — the real estate sector has seen stimulus measures coming its way.

For one, the restructuring package offered by banks for developers has resulted in many realty companies finding a medium-term solution to liquidity issues. Two, ‘special’ home loan rates have paved the way for the return of some buyer interest in residential property. Three, with commodity prices stabilising, realty players have been willingly passing on cost savings and trimming their profit margins by offering significant price discounts to revive volumes.

More recently, funds flowing into Real Estate Investment Trusts (REITs) elsewhere in the world, have revived hopes of fresh infusion of equity through routes such as qualified institutional placement in Indian realty firms. The above events have translated into a less threatening liquidity situation for players and a tentative revival in the residential segment.

Cash yet to flow

While the market may have quickly built these events into future earnings expectations, the above factors do not really alleviate several persisting concerns. Take the case of debt restructuring: Unitech restructured about Rs 2,300 crore of its Rs 8,900-crore debt in FY-09.

Similarly, in March, Omaxe restructured about Rs 450 crore of its over Rs 1,500-crore debt. Now, restructuring typically allows corporates to convert their short-term commitments in to long-term borrowings, thus buying them more time for repayment. This essentially means developers are not really reducing their debt levels; they are merely postponing their obligations.

This is perhaps why Fitch Ratings chose to downgrade Unitech’s debt restructuring early this month. Fitch notes that the revised terms envisaged an extension in maturity profile together with higher interest and/or additional security for Unitech.

Developers continue to have debt-equity ratios of anywhere between 1 and 2.5 times. While such leveraging may not be a cause for alarm in better times, the liquidity crunch has magnified the risks of high debt, as even a single default in the sector can once again result in tightening liquidity. The challenge for these companies would, therefore, be to generate sufficient cash through sales — new launches — that would help project execution and allow servicing of interest commitments on borrowings.

High dependence on new projects to generate cash flow and revive the working capital cycle is also a risky proposition. Launches by big-ticket names such as DLF, Unitech or Puravankara Projects, especially in regions new to them, have been fraught with delays, either on account of pending approvals or lack of funds.


Unlike a year ago, when developers, especially the premium brands, often received time-linked payments (where customers had to pay the instalments periodically, irrespective of the stage of construction), buyers are far more wary of locking in money now. Most of the realty players, including DLF, have moved to construction-linked payments by now.

In other words, while up to 10 per cent of the property value may be received upfront, the rest will come only at different stages of completion. Now this poses the risk of a ‘Catch-22’ situation where developers need money to construct, but funds trickle in only if the project makes progress.

Further, stiff clauses in favour of the customer, such as penalty for delayed completion and allowing units to be traded to prevent mass customer exits, are only likely to add to balance-sheet pressure for developers, unless the execution schedule is near perfect.

Volumes at a price

Another strategy that has offered hope for revival of volumes and improved cash-flows is the increased focus on middle-income housing. Companies such as DLF, Unitech and Puravankara were the early birds to opt for this strategy. After initial reluctance, players decided to lower prices/offer discounts as this segment continued to be price-sensitive.

Companies such as HDIL and DLF have clearly seen an improvement in volumes because of such forays in the latest quarter compared to December. (Any revival, though, pertains only to residential space and not the commercial/retail segments, where projects have been put on hold).

Orbit Corporation and HDIL have, in fact, seen a growth in sales on a sequential basis. However, profits have more than halved over this period. Clearly, volumes have come at the cost of profitability.

Going forward, even as more companies may show improvement in sales aided by discounts, the super-normal profits of the past couple of years are unlikely to return. Operating profit margins could be whittled down to realistic 15-20 per cent levels from the current 40-50 per cent. This is bound to have implications for valuations of realty stocks, which commanded a premium for high profitability earlier.

Everyone’s not equal

One significant feature of the rally in realty stocks is that the market appears to take cues from positive developments for larger players such as DLF and Unitech, and extend it to the entire sector. Here, again, smaller and mid-sized players do not possess the business diversity or ability to raise cash quickly through sale of other assets, to demonstrate a quick turnaround.

An Ansal Housing or a D. S. Kulkarni Developers may not be able to sell a hotel asset or a wind-farm business or divest stake in a telecom subsidiary, as was the case with DLF or Unitech, to quickly raise cash. For smaller companies such as Omaxe or Prajay Engineers, given their exposure to certain States/regions, a local or regional revival in demand may be paramount to a turnaround.

Without quick monetisation of assets, smaller companies would be largely dependent on bank funding; this source of finance, though more relaxed now, remained expensive (until the March quarter), with interest rates hovering at 13-15 per cent. Debt servicing will, therefore, remain key for smaller companies to stay afloat. Cash flows from launches would largely serve this purpose.

The above concerns have been highlighted not to cast doubts on whether a realty sector revival is possible but to underline the fact that the recovery in earnings may not be as easily or quickly managed as the market seems to expect.

With liquidity concerns alleviating, investors’ focus should now probably shift to improvement in volumes and those, in turn, translating into revenues (if project execution happens on schedule).

Companies that record growth in revenues over the next three quarters, even with marginal improvement in earnings, may be the ones on a revival path. Here again, it may be challenging for most companies to keep their profit margins intact; the ones whose profit margins are less hurt may be the superior ones with higher pricing power and operating efficiencies.

Until then, it would be prudent to lock into some of the profits made on stocks that now enjoy double digit P/Es (see Table). On this account, the market has still kept the P/Es of smaller players at modest levels, perceiving higher risks. Any run-up in their valuations may have to be viewed with caution.