The hottest space in the market for the last 12-15 months has been real estate. It's been phenomenal the way some of these stocks have moved up, much to the disbelief of most of the observers.
The rise has been absolutely astronomical in many of the real estate stocks from the start of this year. How do you value real estate stocks because most people do not seem to understand how to look at this sector and how to value companies here. While some look at cash flows, others look at land banks. But there is a little lack of clarity in how to look at this sector.
Manish Chokhani, director, Enam Securities and Arvind F Pahwa, MD, JP Morgan Asset Management gives their views on how to approach the real estate sector now.
According to Chokhani, offtake rate, selling price, developers' credibility, ability to deliver are key for residential property valuation. It is also important to factor in title issues while valuing property. Chokhani forecasts realty companies to account for 10-15 per cent of market cap in few years.
Arvind F Pahwa believes that one needs to consider quality and the location of land bank for valuation. He feels that the current valuation of real estate companies is reasonable. He expects oversupply in the real estate market due to cyclicality of the business.
Excerpts from CNBC-TV18's exclusive interview with Manish Chokhani and Arvind F Pahwa:
Some say it's crazy, some say it's still undervalued and some are just confused on how to do it - what is the best way to approach this sector now?
Chokhani: Well, all three are right. In a way, it's probably among the easiest things to value and if one breaks it down in common sense terms, there is a value for land and there is a land bank therefore, which is NAV based.
Then, there is a developer who has a developer margin that normally should be cash flow based or a quick thumb rule that people use is EV/EBITDA. When you are able to lease out the whole aspect eventually into REET (Real Estate Excise Tax), which we still don't have in India. They will effectively be valued as bonds giving you a fair stream of rentals. So if you break down companies on that basis, it is fairly simple, it is not so complex.
What kind of a market cap or enterprise value would it give a business, which has 1000 crore (Rs 10 billion) of land bank. What is the right way - because right now, what the market is probably trying to do is, if you have 1000 crore of land bank, it could arrive at something close to Rs 1000 crore in terms of market cap as well?
Chokhani: Currently, the market seems to be valuing Rs 1000 crore more than it actually is. Let me give you some perspective - think of the cheapest space that any developer or land owner sells in the country. It would probably be an IT park, it's probably the cheapest rental, probably Rs 35 a square foot for a month, thereby implying about a 4000-4,500 per square foot capital value for developed space.
If you knock out about Rs 1,500 odd for cost of development and about Rs 500 as developer margin, effectively the land acquisition cost to build an IT park, can be upto Rs 2000 per square foot. If you take that Rs 2000 per square foot and divide and make it back to an acre, which is roughly Rs 50,000 square foot an acre, in effect, one can buy land at 2000 times 50,000, which is is about Rs 10 crore (Rs 100 million) per acre and still turn a profit.
Now to put that into context, one can buy agricultural land, which lot of our IT companies have done on the outskirts of Mysore or Bangalore, starting from Rs 10 lakh. So it's literary a scale of 1:100 from unexplored, undeveloped land to land, which eventually becomes developed.
I am not saying that all the parks will get developed, will get sold and will get filled, so you will have a capacity mismatch there. But how do you value it - do you value it at Rs 1 crore per acre or at Rs 10 lakh per acre or at 10 crore an acre?
That's really where the struggle is and I think it's early days for the market. One doesn't know how many of these will get built like it happened with malls, similarly with IT parks or a lot of townships and residential projects, which are coming up. That's what everybody is grappling with.
In that sense, how do you differentiate between a company that's just sitting on a land bank - like a developer, who will go on to get rental income from it and another, which is perhaps focussing on those large SEZ projects that we have been hearing so much about?
Chokhani: The developers could, for instance, buy land, which got sold in the textile mill area in Mumbai, which at that time, looked like absurd values. But if you do make this Rs 1,500 cost of development ballpark for low-end stuff and add Rs 500 developer margin, if you can make this Rs 2000 spread as a developer, you are pretty much going to get EV/EBITDA like an engineering, construction type of company.
For the land bank owner, like I said, it is the game of how one can equalise the value of land, which one is getting with the space, which people will buy, and the variables there will then be the rate of offtake at which one can sell it. As regards to an SEZ developer, in theory that they could be buying land at Rs 10 lakh an acre.
If over the next 10-15 years, the value of this goes up to even half of Rs 10 crore per acre, which I mentioned, the value captured is enormous over here. So one can afford to wait and play the waiting game.
How is it that you would go about valuing all these real estate companies and what are the parameters you would set out to give it any sort of market cap?
Pahwa: I would agree with Manish as far as the methodology is concerned. But I think the devil is in the details - somebody is buying agricultural land, there is lot of work to be done between converting that basic raw material into a finished product.
Many agricultural lands may get converted or may not get converted. Each state has its own local regulations, the FSI rules vary from state to state and even within a city, they vary from a particular zone to another. So while valuing real estate, I think various other parameters also need to be considered.
One needs to look at the quality of the land bank - where exactly it is located, whether it can be converted into usable constructible space or not and then factors like who is the developer, what kind of expertise does he have, does he have the capabilities of delivering such large square footage within that particular period.
I think these are some of the very important factors. I would look at qualitative factors, such as the quality of construction and what kind of construction is happening. I would look at all these factors rather than simply looking at the numbers, such as converting Rs 10 lakh per acre land into a finished product by adding a construction cost of Rs 1500.
The construction cost also can vary from Rs 1000-1800. It depends on how the cost of cement, steel and labour has been moving up. This also varies from city to city, from one location to the other. I would definitely give weightage to all these factors.
Also, while valuing real estate, we see that in projections, while doing the discounted cash flow or arriving at NPV, we simply take a projection of increase in the price by 5 per cent per annum. Let's understand that real estate is a cyclical business, it goes to its own cycles.
Just five years back, in 1995, when the crash happened, in Bandra-Kurla Complex a plot of land was sold at a particular price and in fact it's only now that the price has been matched. So obviously, you cannot have a situation where the prices of real estate will keep going up by 5 per cent per annum.
For a company, which has land bank of 5,000 crore, and does not intend to make either an SEZ or an IT park out of it, but simply wants to make residential buildings out of it and sell them. How would you value those companies?
Chokhani: I agree with what Arvind Pahwa had to say that it's just not enough to have the land and take the rate at which you can do the construction and the rate of offtake at which occupancy can be filled up in that project.
One needs to see whether this developer can actually be developed and sold, what the reputation of the developer is, and therefore what price he may attract as opposed to the building, which may be right next to him and so on. Of course the biggest problem in India is about title and no one knows for sure whether the land one is sitting on actually has got clear title.
But assuming all that is taken care of, as regards to residential property, you may tend to sell at these kind of prices upwards of Rs 4,000. You may tend to spend a little more on building amenities over there, so then the Rs 1,500 benchmark construction cost may now be Rs 1,800-2,000. The key variable, therefore, now becomes rate of offtake of the project and the price at which it can go.
As a buyer, what you typically will do is build cushion for some margin of safety. What seems to be happening currently though is that people are assuming that projects will be completed on time, they will all get sold 100 per cent, they will get the prices they want.
And as Arvind rightly said, we will continue to have 5 per cent escalation. My guess is, at some point, this market will get over supplied and it is a cyclical business. Where we are currently, seems to be where the stock market was in 1990-91 where the sector opened up and everyone went crazy and ga-ga. There was this error of optimism resulting, in many cases, peculiar valuations, while in some cases, attractive opportunities.
I think that's really a fair summary of where the sector is today. And again, like Arvind rightly said, the devil is in the detail but you must have your big picture right before you start delving into details.
Do you see a problem from the demand side at all because some people have been making the point that maybe the assumption that all of it is getting built will be sold very easily at current to better rates, which might not be a fair assumption and maybe the purchasing power is being overestimated, particularly in some of the metro locations in the country, is that a fair bit of skepticism or not?
Pahwa: There is a basic demand and I think the way the economy is growing, it is a good story. If the GDP continues to grow at 8-9 per cent, there would always be a demand for good quality real estate. But beyond a price, of course, there is always an issue.
Today, we hear of prices in South Mumbai of Rs 60,000 per square feet, how many people can afford to buy that? But if there are going to be just handful of buildings with that kind of product, then yes, they would be sold. But it is all a question of supply and Mumbai, for that matter, is a very peculiar case.
But the way the supply is going up in other cities, in real estate, there is always a time lag when demand comes in, you cannot have a product available. It takes atleast 2-2.5 years before the project is completed to give it to the tenants or the buyers and that supply is coming up with all cities where this demand was there - be it in Bangalore, Hyderabad, Pune, Chennai or Kolkata.
The present situation, as far as this year is concerned, the absorptions are pretty good. But what we have to wait and watch is how last quarter of 2007, 2008 onwards, the situation will be.
A city like Bangalore, which had absorption of 10 million sq.ft of space last year, which is comparable to the highest in the world and is in the second year in running, whether we will continue to absorb that kind of space? - I am not so sure.
Till few years ago, Bangalore was the only city where IT companies were moving in. They did not have another option but today, there are cities like Hyderabad and Chennai, which are developing its own IT hubs and so are Gurgaon, Chandigarh, Jaipur and so there are so many options available.
So obviously, there will be compression on yields. One can see that in many residential and commercial spaces, where yields have gone down to as low as 6% or in some cases, even lower than that.
And so when yields go down to such low levels, there is always an option available for the user to take it on rent rather than buy and that is further substantiated by the fact that the interest rates have gone up, the capital from banking system is not so easily available as it was few months back.
For those who are into development or rentals, do you accord a premium in terms of geography or location in those that focus on tier I cities or maybe even have a more pan-India presence versus the others?
Chokhani: Yes of course, for some one who is very region specific may tend to go through a boom in the cycle if a particular region gets over built. To step back a bit - think of this as a cement business. In theory, you can build out a cement plant for $60-70 million per million tonne.
But the reality is that the stock market seems to be valuing this at $150-200 per million tonne. This is happening because like real estate, there is a period of shortage and probably '06-'07 are bonanza years in terms of profits. One almost inevitably knows that in 2009, you will see oversupply here and if one is valuing it today or not.
So those are the set of dilemmas that one deals with and like a cement company, if you are only operating in Andhra Pradesh, as opposed to someone who is operating all over India, surely your valuations will be different.
Similarly if you are going to operate one plant and not expand as opposed to someone who is going to expand and build more capability and thereby become a larger leading player in the business, surely your valuations will differ as well.
So it is exactly the same valuation principles - it just seems to look like a new asset class. But I am sure markets will get its hand around it very quickly and it is probably in a simplistic sense a very easy sector to value.
But if you had to look at investing in the listed stocks without naming any specifics, how do you marry the two? Do you think that it will move in tandem with the stock markets cycle or do you think it is part of the longer multi year run on real estate and hence invested it and hope to see even higher levels?
Chokhani: It is a multi year run and though one cannot agree with all the price, but again I want to just give you big picture here and not specific numbers right now. Our market cap for India is about $800 billion and one knows if you look across the region and across what is happening to our country and our GDP and so on, it is a very reasonable bet to say that 10-15 per cent of market cap will belong to real estate type companies.
This is very much the way one could take a view very early on telecom or power and so on that these would be large significant portions of market cap. So in theory, there is $80-100 billion of market cap available for this space and there is appetite certainly from the capital markets side for people like that.
Today, probably, there is just Unitech, which is about $10 billion and the rest are really much smaller companies. A lot of this gap will get filled up by issuance but a couple of people, who like Arvind said earlier, if you are able build the right brand image and the right pan India presence, these people will get valuations, which are going to be disproportionate to what the rest of the pack will do.
Again very similar to the cement sector, you always have Gujarat Ambuja at a premium as opposed to somebody else. Similar things will happen here. I am not suggesting that the valuations today makes sense. It probably is the first burst of euphoria, where a sector has opened up - no one knows how to value it really and a lot of things are getting overdone.
As a value buyer, are you seeing margin of safety in most of these names? I would think not. Having said that, you don't need to necessarily look at listed ones because there are a whole host of companies, which are going to approach the market and that maybe another way to get into this space.
A quick thought from you on how some of these listed companies are valued today because as we were discussing earlier some of these seem to be priced for a completely perfect scenario because they are getting market caps which are better than the land banks that they own at current market prices and at very high market prices, would you agree with those kind of valuations?
Pahwa: Real estate is the flavour of the month. So obviously, it is getting much more visibility compared to many other sectors. Again having said that, it goes both by the stock markets sentiment and as well as the basic demand in real estate.
For the real estate sector, both the things are doing very well today; the stock market sentiment is very positive, the sector variables are very positive. So looking at both these things, as on today, the valuation seems to be reasonable. But with one dip happening, how these valuations would change, I really cannot make any judgment on that.
But as I said earlier, being a cyclical business, there is bound to be some kind of an oversupply, which is again good and healthy for the market because till now you had a situation where vacancy rates in most places were practically zero or negative.
Buildings were pre-leased even before they were completed. Now, you will have a situation where the tenant has a choice to take the buildings on lease, you already have situations in many micro markets where there are lease free periods being made available for doing the interiors.
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