Why are real estate stocks rallying when cash flows may worsen after RERA?
There is little doubt that the implementation of the Real Estate (Regulation and Development) Act, 2016 (RERA), will be a game changer for the real estate sector. Ironically though, it does not justify the rally in realty stock prices mirrored in the 109% rise in the BSE Realty index since January last year compared to a 29% rise in the benchmark Sensex.
While improved governance and accountability under RERA would be good for homebuyers, new procedures and costs of compliance may worsen near-term cash flows of large listed developers. The point is that cash flows have already showed stress during the last few years, even when sales were robust.
A report by SBICAP Securities Ltd says that between fiscal years 2011 and 2017 (FY11-FY17), only one company (Sobha Ltd) generated positive operating cash flow (OCF) in the core development business out of the four leading listed realty developers. While Sobha’s cumulative OCF was Rs1,800 crore, DLF Ltd, Prestige Estates Projects Ltd and Oberoi Realty Ltd reported negative OCF of Rs3,000 crore, Rs1,000 crore and Rs400 crore, respectively during FY11-FY17. The core development cash flow was measured as the total pre-tax OCF minus annuity from rental business/other business operating profit.
Strangely, OCF was weak or negative in spite of strong sales bookings at least during three out of the seven years under consideration. Only Sobha managed its cash flows in sync with the ramp-up in business, whereas some such as Prestige Estates had a cash burn in spite of strong sales during the period.
The point to drive home from an investors’ perspective is that prior to RERA, real estate developers had the benefit of pre-sales, where they could secure customer advances, even before they got the sanctions and approvals on the project. In future, “the front-ended cash flow model will shift to a more working capital-intensive model, with higher emphasis on execution”, adds the SBICAP report. Costs of approvals and mobilizing the project will have to be borne by developers before marketing a project, with tight accountability of cash spent even after the project is flagged off.
Moreover, some of these listed developers are present in large cities where most of the unsold inventory is concentrated. In addition, some like DLF have capital locked up in large land banks, which could be hard to monetize. Buyers’ preference of ready-to-move-in homes (due to bitter experiences in the recent past) will add to cash flow stress for developers.
So the housing market may be attractive for buyers, and RERA governance may ensure transparency and adherence to commitments by developers. But, it may lose charm for investors and developers in the medium term. The return on equity has steadily declined in the recent past, particularly in the housing segment. According to Anarock Property Consultants Pvt. Ltd, the share of private equity investments in the residential property market fell from 59% in 2016 to 37% in 2017.
Only developers with exposure to commercial property rentals that are rising steadily may be able to buttress cash flow stress in balance sheets.
In other words, it may be a long haul before the rally in realty stock prices is backed by strong cash flows. A sales increase may only be a mirage, hardly enough to generate profits for these firms.
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