Investing in real estate stocks? Careful!

Real estate stocks have been on fire in 2006. Unitech raced ahead, by an unbelievable 3,000 per cent, CHD Developers was up 756 per cent and Ansal Properties & Infrastructure, 366 per cent in 2006. With returns this crazy, it is not surprising that the initial public offer of Delhi-based Parsvnath Developers was over-subscribed 50 times in November 2006 and Sobha Developers' IPO 62 times.

The buzz around the sector and stocks is encouraging a whole rash of IPOs to run to the markets to raise money. DLF alone plans to raise Rs 12,000 crore (Rs 120 billion). Another 11 wait in the wings for the approval of the Securities and Exchange Board of India. If all the planned IPOs see the marketplace in 2007, we would have put in over Rs 16,314 crore (Rs 163.14 billion) into real estate stocks.

What's behind this land rush? The re-rating of India, of course, and a re-rating of the real estate industry, that historically has suffered low discounting on the back of the large black money component in all land deals in India. But with the corporatisation of this industry and the forthcoming regulations, the value of the land banks of real estate companies are being cited as the reason why stocks are soaring. But how correct are these valuations and should you join the real estate revelry?

Land banks. How do you value a piece of real estate? Location, taxes, and construction are some of the issues that need to be considered. No two houses in one building sell for the same price - there is always a difference based on a corner house or the floor. With such fine elements determining price, how do you value a real estate company and its stock? Land is an illiquid asset on the market and one of the least transparent, with very high transaction costs.

The current high valuations are largely based on the value of the land bank available with the real estate companies, with the underlying assumption that these will be developed in the near future, leading to a rise in earnings. Now the key questions: is a large land bank a sufficient condition for the high-rise valuations?

But gestation time is large. While valuing a real estate company, the investor needs to see not only the quantity but also the quality of land banks along with their location. Many of these are said to be around the special economic zones, but the future of the SEZ-led development is still not clear in India. The gestation time associated with the development of an SEZ may be very long.

The non-SEZ well-located land parcels, too, will take time to develop. This raises two questions. One, when will this land bank lead to cash flows? Two, at what price? The questions this raises are: with the rising cost of construction (both in inputs and labour), will the companies be able to maintain margins in future, how much of the current demand is effective demand and how much is a supply side push? These are the unsolved mysteries since nobody has a robust model for these predictions. Then, there are other more macro worries.

And interest rates are rising. The demand side can get constrained by the tightening monetary policy of the Reserve Bank of India. RBI raised the reverse repo rate by 75 basis points till July 2006. In October, it pushed repo rate by another 25 basis points to 7.25 per cent and, recently, it increased the CRR by 50 basis points effective in two phases. With the cost of home loans going up, the affordability goes down. Lowering of the residential demand pull may affect property prices in future.

And what if prices correct? What happens to stock valuations if the property prices start correcting? To find an answer, we looked at the revenue and net profit figures for Unitech for the last 15 years. They  grew at 17.41 per cent and 19.71 per cent per year, respectively, in the last 15 years. But the growth in numbers was not secular as Unitech saw lot of ups and downs, with the property boom years adding to the growth, and the slump years pulling it down. During the last real estate boom of 1991-97, sales were up from Rs 58.80 crore (Rs 588 million) in 1991 to Rs 267.55 crore (Rs 2.68 billion) in 1997, up 350 per cent over the period. Profit after tax went up from Rs 4.65 crore (Rs 46.5 million) in 1991 to Rs 18.82 crore (Rs 188 million) in 1997, registering an upside of over 300 per cent during the period.

The growth story took a U-turn after the boom period was over (1996-97). The revenue and profits for the company started falling. Revenue for the company fell by around 35 per cent between 1997 and 2001.

Similarly, profit after tax also fell by 62 per cent between 1997 and 2002. The fall was uni-directional and fell year after year. This clearly indicates that when property prices correct, real estate companies simply stop producing, or decrease the level of production, which makes it extremely cyclical in nature.

Stock valuations. The frontline real estate stocks are currently trading at sky-high valuations in terms of their price to earning (P/E) ratios (See table below). Will this trend carry on in 2007?

Let's look at Unitech at 193.06 times earnings. Even if we assume that the share price doesn't move from here on, the company will have to increase its earnings four times to bring the P/E ratio to around 50.