At first blush, real estate stocks look grossly undervalued. The BSE Realty index of BSE is trading at 1.4 times its past book value, the lowest in two-and-a-half years.

It’s a big comedown from the dizzying heights of the bull run. In 2007, real estate companies were trading at 65 times past book value.

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Surely, land is a finite asset and the value of the land banks of property companies would be worth more. But then the correlation between land prices and the stocks of real estate companies has been tenuous at best after the financial crisis.

The basic problem for real estate companies is leverage. Property firms were among the most indebted and it proved to be their undoing as the global financial crisis unfolded. The BSE Realty index lost the most among sectoral indices, down 72% before the start of the next rally in March 2009.

That problem never really went away, even though many property firms raised fresh equity during the past couple of years. High debt continues to suffocate companies, with some showing an increase in net debt levels in the first quarter of this fiscal year from the end of the last year, according to data compiled by Motilal Oswal Financial Services Ltd. DLF Ltd, for instance, saw its net debt at 21,500 crore at the end of June, about 100 crore higher from three months ago. Phoenix Mills Ltd saw a sharper rise in debt to 790 crore, up 23.4% from a quarter earlier.

While this increase may seem minuscule, what it means is that companies are not able to generate cash flows at the desired level. The June quarter earnings for the sector were disappointing. Most of the bigger companies such as DLF, Unitech Ltd and Housing Development and Infrastructure Ltd showed a fall in profits from a year ago. Margins were affected and are under further pressure as interest rates continue to rise.

With real estate companies refusing to cut prices and a slowdown looming, things are only going to get tougher. For instance, sales registrations in Mumbai fell 31% from a year ago. Even the outlook for commercial property is gloomy as firms shy away from capital expenditure.

In short, even if the real estate sector looks attractive in terms of valuation, it will continue to be a pariah till companies find a way to generate cash. That may not happen this fiscal year.

Graphics by Ahmed Raza Khan/Mint

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