Real estate stocks are presenting an attractive investment opportunity due to a combination of factors. After a long down cycle, the Indian residential real estate market has turned the corner, with the unsold inventory at multi-year lows and new home bookings strong.
This trend is being driven by urbanization, nuclear families, and a desire for larger homes. The winners in this market are a few large and branded players who have grown new home bookings at an annualized rate of 33% between FY20 and FY22.
The real estate industry has undergone significant changes since the early 2000s. The industry was once like the wild west, with hundreds of players catering to strong demand driven by rapid urbanization, massive cash dealings, and cheque-based investors looking for robust returns with a negligible downside. However, regulatory changes, such as the introduction of the real estate regulatory authority (Rera), followed quickly by demonetization and the goods and services tax, led to a brutal shakeout, with only a handful of players surviving. The industry is now well-regulated, with leading players having strong balance sheets and access to cheap loans. EMIs are much lower now, adjusted for rising take-home salaries.
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.
Valuing real estate stocks can be challenging. Revenue is only booked on the handover 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. However, thoughtful investors can 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 the valuation of ‘regular’ stocks.
Despite offering a better combination of growth and profitability, real estate stocks trade at modest multiples. Some people believe these stocks should trade at the net present value (NPV) of all their projects (NAV). However, others point out that since revenue is booked on completion of the project, cash is received regularly based on milestone completion, so NPV is not so relevant. 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 they are still close to pre-covid levels, and demand 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.
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