Is the time ripe to invest in real estate stocks?

After a long down cycle, the Indian residential real estate market has turned the corner. Unsold inventory is at multi-year lows, registrations of home purchase are booming and new home bookings are strong. The winners are a few large and branded players who’ve grown new home bookings at annualized 33% between FY20 and FY22, and the trend is continuing in FY23 too.

Before moving further, some history is in order. The residential real estate industry of the early 2000s was a bit like the wild west, with hundreds of players catering to strong demand being driven by the three drivers of rapid urbanization, massive cash dealings and cheque-based investors looking for robust returns with negligible downside. Real estate prices rose secularly till 2013, then slowed sharply. Then came the real estate regulatory authority, or Rera, followed quickly by demonetization, and the goods and services tax. This led to a brutal shake out, with only a handful of players surviving.

The real estate industry is now well regulated; leading players have strong balance sheets and access to cheap loans. EMIs, or equated monthly instalments, are much lower now, adjusted for rising take-home salaries. Demand is being driven by urbanization, nuclear families, and a desire to own larger houses. But the real opportunity lies in the supply side. Post consolidation, barely 30-40 large players meet the success criteria of brand, balance sheet, execution and sales engine. It’s a classic bull market set-up, with strong demand and weaker supply leading to ‘pricing power’. The biggest entry barrier or moat is trust, built over the years of consistent delivery.

The operating characteristics of realty firms are quite attractive, with project IRRs in the range of 20-22% annualized, and healthy ‘pre-sales’ growth of roughly 18-20%. Coupled with high entry barriers, this is a potent business proposition. Since these companies also develop commercial offices and retail malls, the three segments taken together have a long runway of growth (see table). So how should we value real estate stocks? As per accounting norms real estate company revenue is booked only on handing over of the property, not on ‘percentage completion’. This results in project margins appearing depressed and working capital seeming inflated in the initial years, even though pre-sales continue to happen. Thoughtful investors use an assumed percentage completion method and estimated profit margin for deriving the ‘modified’ Ebitda, and compare it as a ratio with the company’s enterprise value (EV). This results in a ‘modified’ EV/Ebitda multiple, which makes real estate stock valuation comparable to valuation of ‘regular’ stocks. Ebitda is short for earnings before interest, taxes, depreciation, and amortization.

Let’s compare valuations vs. growth. Despite offering a better combination of growth and profitability, real estate stocks trade at modest multiples. Some people believe these stocks should trade at net present value (NPV) of all their projects (NAV). They feel that since NPV falls when interest rates rise, real estate stocks need to fall, too. We point out that while revenue is booked on completion of project, the cash is received regularly based on milestone completion. Hence NPV is not so relevant. Others fret about too much supply, but real estate prices are much more sensitive to unsold inventory, which is currently at a 10-year low. Another fear is that rising interest rates will raise EMIs and reduce demand for apartments. Home loan rates have recently risen, but are still close to pre-covid levels. And, demand still remains very strong.

Experienced investors know that the best returns are made when there is a wide disconnect between attractive fundamentals and poor investor perception. With robust revenue growth, healthy IRRs, wide moat and cheap valuations, real estate stocks offer an attractive investment opportunity.

Anil Sarin is CIO of Centrum PMS