Avoid realty stocks even if they look good

Avoid realty stocks even if they look good

Over the past six months, the BSE Realty index has underperformed the world real estate index by 47%, according to a report by Standard Chartered Bank. Since April 2010, BSE Realty has underperformed BSE 500 by 36%, according to Mumbai-based brokerage firm Ambit Capital Pvt. Ltd.

Also See | Land Reserves (PDF )

BSE Realty has taken a beating primarily because of the ongoing probe into irregularities in granting second-generation (2G) telecom spectrum by the Central Bureau of Investigation. Most chargesheeted companies have links with real estate firms. Apart from high property prices in key markets of Mumbai and Delhi-National Capital Region, rising interest rates are also posing a challenge to homebuyers. Lower sales across projects are a big concern.

However, there are contradictory signals in the market, too. The sector’s gross debt-equity ratio is likely to reduce to half by FY12 from the levels in FY09, according to StanChart’s report. It attributes this reduction to fund raising activities. The report predicts that valuations of these stocks will improve as these companies are on a stronger footing than in 2008, as most ongoing and soon-to-be-launched projects will contribute to their operating cash flows.

In such a scenario, is it a good time to buy stocks of real estate companies? Says a Mumbai-based real estate analyst, who did not want to be named, “Valuations of these stocks are lower and looks attractive at this point but lot of these stocks are coming with headwinds." Fundamentally, sales across residential and commercial projects and the land reserves of a company determine the cash flows of a company.


Residential space: Companies that are developing mid-range affordable residential projects will register better returns in the long run. For instance, New Delhi-based real estate firms, Unitech Ltd and Ansal Properties and Infrastructure Ltd, have benefited in the recent past by launching affordable housing projects.

The StanChart report says that about 50% of ongoing and new projects will contribute to the sales revenue of firms such as Oberoi Realty Ltd, DLF Ltd, Prestige Developers Projects Ltd, Unitech, Indiabulls Real Estate, Housing Development and Infrastructure Ltd (HDIL) and Sobha Developers Ltd. Says Parikshit Kandpal, a research analyst, “Companies with better saleable residential projects will give better results."

Sales depend on location too. Certain markets such as Hyderabad suffer from low absorption and high inventory. That would mean that companies focusing on Hyderabad alone may not do so well. On the other hand, the ones whose presence is substantial in cities such as Noida, where sales are high, will benefit.

Commercial space: The StanChart report says that over the past few quarters, the pan-India absorption of commercial space has been around 8 million sq. ft. Pick-up in office leasing will also reduce the strain on balance sheets and provide steady annual income, it adds.

“As most developers keep commercial projects as security to repay their debt, firms with projects having good absorption rate will have better cash flows," adds Kandpal.

A report by BNP Paribas Real Estate and Infrastructure Advisory Services Pvt. Ltd also corroborates the trend of increasing absorption level.

What it means for you: While some firms are exposed only to the residential space, bigger firms have a diversified portfolio. Companies showing regular rental income from leasing would be in a better position to reduce debt compared with those that are just into residential sales.

Says Aalok Shah, research analyst, India private client, IIFL, “We remain cautious on the sector and prefer companies with excellent track record, execution skills, comfortable debt position and preferably a pan-India presence."

Land Reserves

Most real estate companies have large land banks, which can last them for the next 15-25 years, according to the StanChart report. Price appreciation over the years pushes up the net asset value of companies who have been holding land for a long period of time. DLF, Oberoi Realty, Prestige Estates and HDIL have high land reserves.

What it means for you: Companies with high land reserves are likely to have higher operating margins when they launch their projects. Operating margin is the percentage of revenue that a company generates from the sale of residential units. This revenue can then be used to pay the company’s investors and the mandatory tax on sale. Higher the operating margins better would be the stock value. “Companies that have historical land have benefited with increase in land rates in smaller cities," adds another Mumbai-based analyst who also didn’t want to be named.

Other Checks

Apart from the above mentioned aspects that are specific to the real estate sector, before buying you need to run regular checks required while picking stocks of any other sector.

Understanding a company’s financial performance based on the debt-equity ratio and overall debt is one of the most important aspect. The debt-equity ratio helps analyse the extent to which a company is using borrowed money. In the present scenario, when the interest rates are higher, a company with high debt-equity ratio will be a more risky bet.

Mint Money Take

Finally, numbers mean nothing in an industry that works on obfuscation and is the final resting place for slush money, owing to lack of proper regulation and opaque dealings. Our take: stay away from these stocks even if you spot possibilities of a rally.

Rising interest rates will affect sales in residential and commercial projects, which would eventually impact developers having high debt. Moreover, investigation into the 2G case is not yet over and the fact that some companies chargesheeted have links to the real estate sector may not bode well if the tables turn against them. At this point, therefore, it is better to avoid the sector.

Graphic by Yogesh Kumar/Mint