Though fund managers have stayed away from the sector, some players deserve a second look.

Vidya Bala

Avidly chased in 2007 and unceremoniously dumped in 2009 — this best describes the market's relationship with real estate stocks. From massive IPO subscriptions and lofty double-digit valuations afforded to companies in this space in 2006-07, the real estate sector has now been exiled from institutional portfolios, with many fund managers guardedly declaring they do not hold any real estate stocks.

A 6 per cent decline in sales and 40 per cent decline in net profits for about 30 mid and large-cap real estate companies in 2009-10 may only seem to reinforce the market's apathy to the sector.

However, absolute returns of stocks such as Orbit Corporation (545 per cent), Mahindra Lifespace Developers (475 per cent) or Brigade Enterprises (365 per cent) from their March lows suggest that the sector is not to be entirely ignored.

Are investors missing out on opportunities, albeit select ones, by entirely neglecting the sector?

While some stocks did deliver, mediocre returns from large-caps such as DLF or the abnormal decline in Ackruti City suggest that careful stock-picking holds the key to reaping returns from this sector.

As the sector inches its way back to health, investors can still reap rewards by looking for some key performance indicators that provide clues to a sustainable recovery.

No herding together

Real estate companies in the country, thanks to the varying market dynamics across regions, do not demonstrate uniform performance traits.

While major economic downturns, such as the one in 2008, do result in an across-the-board hit on performance, the revival and the ensuing growth depend on the region of operation, presence in segments within the realty space and the business and financial strategy adopted.

The past year has demonstrated that developers with unique models, such as slum rehabilitation or those that stuck to their home-base, especially in tier-I cities such as Mumbai or Delhi, emerged out of the woods sooner.

Housing Development and Infrastructure (HDIL), with its transferable development rights in the premium region of Mumbai, or Peninsula Land, that bravely persisted with its strategy of converting mill land into commercial space in prime areas, or Anant Raj Industries with its stable cash flows from leased assets in Delhi — all saw a steady improvement in their financial performance soon after the worst quarter of December 2008.

It is worthwhile noting that these companies were not entirely immune to the downfall. HDIL's revenue for FY-10 was a good 36 per cent lower than FY-08. Anant Raj's lease rates too saw a free fall; it, however, it generated positive operational cash flows in FY-09 and FY-10 — a rare feat in this cash-starved industry.

Peninsula Land, on the other hand doubled its sales in the last two years as the craze for prime space in Mumbai never waned. What was common to these companies?

The outperformers retained their business models, which were already unique, had high entry barriers and room to quickly monetise their assets, if required.

Sticking to plans

This does not mean developers who altered their strategies were left out in the cold. On the contrary, those who chose to quickly shift strategies did move to greener pastures faster than the others. Puravankara Projects and its bigger peer Unitech are cases in point.

Both these companies stuck to their changed strategy of focussing on residential projects, especially in the mid-income segment. While this meant compromising on margins, volumes came to their rescue. Puravankara's operating profit margins, for instance, more than halved to 15 per cent in FY-10 from 38 per cent in FY-08, clearly a result of lower realisations. The company has stuck to its mid-price range in budget homes. Given its stronghold in Bangalore (with 66 per cent of its land bank), the company may be able to ramp up profitability once demand for high-end residential projects pick up in the IT-driven city.

Unitech too, rapidly launched its mid-income housing projects to revive precious volumes and put on hold its commercial projects, what with residential accounting for 95 per cent of its projects sold/under construction. On the contrary, its peer DLF, though among the earliest to announce projects for the middle-income group, did not make much headway for two reasons: the company feared that aggressive launches would lead to a pile-up of inventory. As a cautious strategy, it had kept debt under check and new launches meant increasing debt.

As the market revived, DLF preferred to once again focus on its comfort zone of upper, middle and high-end housing as well as commercial projects. Hence it made little headway in its ‘downturn strategy'.

Unitech, despite the high debt, sold a record 16 million sq ft during FY-10. Companies that follow a steady strategy over the medium term, although they feel the pain initially, do grow faster during the upturn.

Lower debt, but cash-flows?

While reviving cash-flows from their business was one thing, most companies also had to tackle their high levels of debt. Over Rs 10,000 crore of qualified institutional placements, besides promoter money and restructured debt packages, ensured that most realty companies brought their debt levels under control. However, equity expansion is often accompanied by earnings dilution. For companies such as Indiabulls Real Estate, Sobha Developers, Unitech and HDIL, the equity expansion was 50-67 per cent between FY08 and FY10.

This meant profits had to keep pace or risk a dilution of per share earnings. While HDIL proved its mettle in this regard (on a q-o-q basis), Indiabulls Real Estate has been struggling to grow profits; the result – earnings dilution.

Unitech and Sobha Developers too have been making painfully slow progress to grow their per share earnings after significant equity expansion. DLF, Puravankara Projects and Phoenix Mills, Mahindra Lifespace Developers and Brigade Enterprises, to name a few, managed without equity infusion as they had no fear of high leverage. As almost a year has passed after the major fund-raising, investors may start to focus on whether companies with high equity expansion, are able to grow earnings at a similar pace a couple of quarters from now. Those who do not may be laggards on the stock market. The earnings accretion should also be in line with the stock's price earnings multiple.

Cash infusion, whether from equity or otherwise, was a one-time relief for many realty players, and was primarily directed to pay off debt. Revival of operating cash-flows was, therefore, key to ensuring that working capital cycle was moving at a healthy pace.

Surprisingly, though companies in the sector seldom recorded positive operating cash-flows in good times, such as Puravankara Projects, Peninsula Land, Anant Raj Industries and Sobha Developers did manage this in the latest financial year; all of them registered negative operating cash flows in FY-08. Tough times perhaps prodded these players to become prudent in managing funds.

With sales volumes trickling-in for most companies, investors would do well to look closely at companies' operating cash-flows. Even if they aren't positive, faster debtor turnover compared with previous years may itself be an encouraging sign.

With interest rates set to head north again, realty companies that are not self-sufficient in cash may take deep cuts in the bottom-line as interest covers may drastically slide down.

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(This article was published in the Business Line print edition dated August 15, 2010)
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