In late 2005, we decided not to invest in a property in Pune because we felt property prices in India had started to resemble a bubble. We felt like fools for the better part of two years after that. Much more interesting to the readers than our personal finances will be that the large public property companies had recognized quite a while ago that the inevitable property bust was coming. With these companies now teetering on their liquidity, it’s startling to compare their response to a declining market with their counterparts in arguably the worst real estate market in the world right now—the US.
It’s not uncommon for folks in the US investment community to believe that there will be a few bankruptcies among the large US home builders before the recession ends. What’s not widely known is that these companies, unlike the ones in India, are cash generating machines in a tumultuous market.
Debt net of cash at the four largest US home builders fell from $17 billion (Rs82,790 crore) at the end of 2006 to less than $6.5 billion at the end of 2008, a decline of at least 60%. This underlies what every viable business should exhibit—either generate cash in a cyclical upturn when margins are high and you have pricing power, or generate cash in a downturn when you are not investing for growth. After all, what comes into the coffer is what matters the most, especially when you are debt laden in a downturn.
If US builders can generate cash in an environment of brutally declining transactions—new home sales are down at least 75% from their 2005 peak—and falling prices, it really is incredible that the Indian companies can’t.
On the face of it, Indian realty companies have two major advantages over their US counterparts. One, pre-selling that is typically associated with most residential projects in India should allow the Indian companies to operate with positive working capital; put simply, the cash inflow from staggered customer payments is used to fund construction expenses.
Two, a large part of the land held by large companies tends to be bought from the government at below-market prices. The second advantage should allow Indian realty companies to operate with very juicy margins and returns on capital, even when real estate prices are not stratospheric—and they largely do. The first advantage should show up as prodigious cash flow generation, which has been largely missing.
Ramesh Chandra, Unitech’s chairman, contends in his FY08 annual letter to shareholders that they had realized the real estate bust was upon them in the second half of the fiscal. Result? The company is unlikely to generate cash this fiscal either when they’ve already had at least 12 months to adjust their business to today’s realities. What went wrong? We wish we knew. The opacity of the reporting of these companies sees to it that the clarity on various business decisions, that clearly have not worked well, is little.
We can wager a few guesses.
One distinct possibility is that for all the talk of being aware that real estate is a cyclical industry, these companies did not pre-sell as much as they should have for the lure of being able to sell at a later date, at a higher price. These companies use the percentage of completion method to record revenue, in other words, to show revenue growth they must build, so revenue growth came with accelerating building out of projects.
Another possibility is an initiation of projects in too many different markets at the same time. While these companies are now trying to slow the quantum of real estate they are delivering; clearly these efforts have come late in the game for all the recognition of the slowdown early in the cycle. What the US home builders have managed well is keeping their proportion of variable costs high, and hence keeping their cash flow going in the downturn.
While labour inherently isn’t as flexible in India, it should anyway be a much smaller proportion of costs and shouldn’t stop the Indian companies from emulating the US ones.
It would be unfair to hold the managements responsible for not anticipating that debt rollovers would become impossibly difficult. However, they can be held responsible for the amount of debt that has been piled on, as well as the profile of the debt—what gives to leverage is the commercial real estate that these companies hold, levering that part of the business makes intuitive sense, but not with short-term debt.
In any case, that part of the business is tiny for most of these players. Given the inherent cyclical nature of the residential build and sell model and what should be less of a capital intensive business than in the US, the amount of debt piled on didn’t make sense.
Interestingly, the US home building market is as fragmented as India’s. The public home builders represent only about a quarter of the industry. Also in many cases the founding families still run the companies.
Yet, if these companies can be disciplined, it’s only about time the realty companies in India break out from their old ways of doing business and realize that being a public company means you can’t operate it like your family’s fiefdom.
Rajeshree Varangaonkar and Bharat Indurkar have day jobs with US-based hedge funds. They write every other Thursday. Send your comments to firstname.lastname@example.org