Real estate: Tides are turning

Before we begin, I would like to say a lot of my learnings were from @equityinsights from X(formerly twitter) , Ishmohit sir of SOIC and Hiren Ved sir of Alchemy capital and it would not have been possible for me to write this without their insights and learnings.

Post 2008, the Realty sector was amongst the most neglected and hated sectors of India. A lot of it had to do with corporate governance, cycle downturn and global financial crisis. However, the tides are turning and the realty sector can become one of India's biggest wealth creators in the years to come. What has led to this shift? How big is the opportunity? Where is the opportunity, and how do we analyze these opportunities? This blog will cover it all. I will try my best to cover everything you need to know!

Industry overview

Lets get some groundwork done before we get into the details.

Cyclicality

Before we get to the merits of the sector, a crucial thing to understand is that the real estate sector is very cyclical in nature. This means that the industry is highly dependent on the economic business cycle and is very susceptible to the laws of demand and supply(who isn’t, though?). The last upcycle ended in 2008-09 and started showing signs of improving post covid. That is a down cycle of 12 years! The cycles are pretty long; hence, one should be cautious when evaluating these businesses.

What causes these cycles?

Real estate businesses experience growth when they introduce new products or properties, leading to increased sales. However, during these periods, businesses often overestimate the demand in their region and launch more than the current demand. This results in a surplus of inventory, which remains unused and weighs down the businesses' balance sheets.The realization that the demand is not as robust as anticipated prompts a shift in focus from new launches to selling the existing inventory. This, in turn, leads to a period of little to no growth and a subsequent downcycle!

RERA

RERA, or Real Estate Regulatory Authority, came into existence in 2016. It was an authority which was meant to improve the transparency and efficiency of the whole sector. It has played a very important role in the story we are in today. RERA was responsible for cleansing the industry of illegal and unethical practices. The authority introduced numerous laws such as escrow accounts, advance payments, focus on timely completion, etc., which led to a couple of important things. First, it increased the buyer's confidence and trust in real estate, which led to higher investments and demand. Secondly, the cost of being a real estate player became significant as the laws were more stringent than ever and costs increased. Due to this, the weak players were wiped out, which led to the consolidation of the whole market. Only the strongest survived, and they started taking over the market share.

Regional presence

The game changes every 100 km, which is why a lot of real estate players are dominant in their states and prefer to stick to that area. Hence, it is important to look at different real estate businesses in terms of their region of operation. Tier 1 cities are leading the growth(luckily, that's where most of the listed players are), but the strongest growth is visible in Bangalore and Delhi NCR region. We will go into its depths later. There are players trying to become pan India, but it's still a regional market. 

All of this has been in place for a while now, why is the cycle turning now?

Triggers of growth

1. Immense TAM

credits:Alchemy capital

When we compare India to the emerging economies and the developed nations of the world, we realise that India is below the pecking order and has a lot of room for growth. Not only is there a gap between the real estate market cap against the total market cap, but the total market cap will also expand as Indian econony keeps growing and reaches new heights. The alpha in real estate growth is very high.

Note: this data is after the China real estate breakdown and hence not fair to look at.

2. Rising disposable income and RERA

As the real GDP per capita starts to increase (real meaning positive despite of negeting inflation factor), it was noticeable in the countries discussed above that the spending in real estate increased at the same rate or faster in some other cases. Higher income leads to increasing capital meant for saving and investing: which often finds its way to real estate.

Alchemy capital conducted a study where they analysed the ratio of real estate's market cap to the total market cap and segregated them into different timelines. This is what they found.

We can notice that as the GDP per capita increased in 2002-2007, there was a huge net positive difference in Real estate market cap/total market cap. Post that, the GDP per capita kept falling and that too below the inflation rate which led to strong devaluing of the sector.

Another thing to notice is that the GDP per capita was at its bottom when RERA was introduced, and that led to the further beating of the stocks(it led to an initial slowdown of business)

However, after Covid, there has been a change. A new trend emerged: working from home became popular and demanded extra room. That is where the trend reversed. Adding to that, We finally beat inflation in terms of GDP per capita and grew at 9%, and for the next few years, we are expected to grow at 10%+

Adding the disposable income with the cultural shift of buying big homes, with RERA cleaning the industry up with tight regulations and organised listed players taking market share, the real estate sector can boom and increase its share drastically!

3. Volume driven upcycle?

During the 2002-2008 cycle most of the gains for the real estate players was price driven. For example, the prices per sqft in Delhi compounded at 23% between 2002-2007! Most of the growth we investors want was already covered by the price increase!Adding to that, the prices post RERA have barely compounded and have failed to beat the inflation. It was truely one of the worst times for the whole sector.

Therefore, there might be a case the prices might do better than inflation in the coming years but the main growth can actually come from volume of sales! Why? Booking area growth has been the profit driving area for real restate players which means that more products are being sold.

A good way to understand volume leading growth is to understand the inventory of the real estate players in their respective cities. This data below shows that the inventory is falling continiusly despite rising launches. Demand is outpacing supply! and that means upcycle will continue :)

4. Value Migration

Due to the nature of the business, such as regional dominance and increasing compliance costs, the big listed players are capturing the market share of the smaller unorganised players. 

A report by Crisil brings positive news for the real estate market: 'Market Share of Top Listed Real Estate Developers is expected to rise to 30-32% in FY25, a significant increase from 15-16% in FY19. The top listed developers are making strategic moves to consolidate the market, taking advantage of their regional dominance and managing increasing compliance costs. The market has seen a steady inventory liquidation in the top seven cities, reducing to ~2.4 years in fiscal 2024 from ~2.8 years in fiscal 2023 and ~four years before the pandemic. This trend, coupled with a healthy launch pipeline in line with incremental demand, is expected to keep the inventory comfortable at 2.1-2.3 years this fiscal, leading to a promising 10-12% Volume growth in FY25.'

Now that we understand why the industry is set to benefit. Let us understand the jargon of the industry and analyse the listed players of India.

Business specific Jargons

1. 
   

So real estate players are not just into 'real estate.' They have other business interests such as rental agreements, hospitality etc. So when we analyse businesses going ahead, remember that there are a lot of parts to the business which need separate attention.

2. Never look at P&L statement

The accounting policy of real estate players works a bit different. For example, I want to buy an apartment from you and I pay you the whole money. So you do get the money but you still can't record it as revenue. It can only be recorded as revenue when you deliver the apartment to me. Hence, PnL statements are a few years old and are obsolete. We need to look at the sales that are happening now and not the ones in the past. So what do we look at?

3. Variables to track

We can distribute the variables in two parameters. One is growth and the other is stability.

Lets look at variables for growth first

Growth

• Pre-sales: This is the number that is in the present. Suppose a real estate player launches a new property, you are interested and give some advance and get your name registered as a buyer. This is called the presales which show the intial excitement or interest of consumers in the new projects being launched.
  

• GDV: or Gross development value. If all the projects were sold right now, what money would the real estate players get? that stands for gross development value. It helps understand the scale at which the businesses are growing.
  

• Launches and land bank: This is somewhat related to the GDV and presales as all showcase the growth that can be achieved in the future. Launches are the new properties and project which are about to released, more the launches more the presales will be. A business which has a big land bank in key areas such as Bangalore, Mumbai, Delhi NCR means that are planning to expand their projects in these cities and that normally means strong sales growth.

• Regionality: Its always good to be in the citires which has the highest demand. We discussed above where which of the areas are showing the strongest growth. Being in a strong market gives the opportunity of price appreciation and increases TAM.

Stability

• Cash flows: If you want to save your capital, keep a focus on this variable. Everything in stability is a subsection of cashflows. A cyclical capital intensive business can take away all your capital if things go wrong and the only way that can business can reasonably recover well is if it has steady cashflow in hand. Cash fllows allow debt repayment in time( remember that debt payment is always steady but cash flows aren't: thats why annuity business is important)

• Collections: The money that the real estate players start getting against the advances. this is a very important number as it helps track cash flows of the business which are again key to survival in a capital intensive business like this.

• Annuity business: As we all discussed, real estate is a very cyclical industry and hence any stability to income is rewarded. Annuity business can be the rental income they are generating. Since this is a stable form of revenue which can be predictable, the more the better.

• Debt: Its natural for real estate players to have debt in their balance sheet. Just make sure it doesn't go overboard and starts harming the terminal value of the business.

Now that we know the key variables to track, we can form a framework of how to look at businesses.

Here is how I look at it. I want growth and i want it to be predictable. I want to see undervalued businesses which have scopes of rerating and i want to ensure the businesses are stable and will not collapse if the cycle turns. So let's begin.

Analysing the businesses

disclaimer: nothing is a buy or sell recommendation, I might be biased in a few companies.

The way we value businesses is using Marketcap/presales. However, that is incomplete because the annuity income should be valued at 10x of their income. Another thing we need to understand is that these companies have hotels and such businesses under their name as well, so they too need to be valued individually before coming to a conclusion.

DLF has a very good annuity portfolio but it still is significantly expensive, same is the case with Lodha developers.

I particularly like Godrej properties and Prestige. Both are well established names and are Pan India players. They both are guiding for strong growth and have a well balanced debt. Out of these two though, I like prestige more because they have a better annuity portfolio and are undervalued amongst the two and are also guiding for a higher growth. Moreover, they are guiding for annuity portfolio of 4000 crores + by FY28. Another interesting thing to note is that Prestige is planning to demerge its hospitality business and possible IPO it at 18,000 to 20,000 crores!! So subtracting 20,000crore for hospitality and 7000 crore for annuity gives a Marketcap/pre-sales 2.3 for the real estate business! Which is very attractive and gives good margin of safety

A few other businesses worth looking into are Max estate, TARC and Signature global. These three businesses are guiding for strong growth next year(espically Max and TARC) and are valued at a good multiple. One thing to be careful of is the debt of Signature global

Kolte Patil is a good business as well as its very cheap, negative debt and decent growth. My problem is that the growth as such a low base isn't justifiable. I would rather bet on stalwarts which are guiding for such growths.

I have provided you all the base for understanding this sector and a brief explanation to the businesses! I hope this was worth your time and helps you in the future!

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