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Monday, April 2, 2018

Understanding the Real Estate Sector in India - The past & the present




India's property market has been the subject of an enduring slow down for the past three years. Weak sentiment, low affordability and a complete lack of trust in the underlying system have sucked the oxygen out of the system. Let us first have a look at some major headlines on the sector that have featured across different tabloids and website








Now, lets turn the clock back to 1994 -

A booming primary market for equities meant that entrepreneurs across the country were flush with funds for the next big move in expanding business. However, most of the Rs 36,000 crores that was raised as 'growth capital' eventually found its way into real estate as a vehicle for parking these surplus funds until they could be channeled into business. This catapulted into a stream of speculative demand that propelled real estate prices to dizzy heights ( so much so that Nariman point was touted to be the most expensive real estate parcel in the world)

Only when the tide goes out is when you discover who has been swimming naked.

The widely held belief across investor groups in the country was an illusion that realty prices could never correct. After all, land is a finite resource and demand for real estate is infinite. In a blue sky scenario of perpetually rising prices, it would not take second guessing as to where most of the liquidity in an economy would be stationed.

What followed, was a mirror image of perception

Property price corrections across different micro markets. H/T - India Today

In light of what we have just discussed, it is not difficult to understand why scores of foreign investors have had their apprehensions on the Indian property market for the longest of times. Real Estate in India has historically been a Pandora's box due to the absence of a proper regulatory framework governing the sector at large - anecdotes of home buyers being duped of their hard earned savings by land bank hoarders are in abundant supply wherever one looks.

On this backdrop, let us first try and understand some of the basic elements of this byzantine industry. There are two key aspects we will discuss in this regard - the sector's contribution to GDP and the element of cyclicality that plagues the business at large

Real Estate is an umbrella term that encompasses different segments namely residential, commercial, hospitality and retail. It forms nearly 8% of the country's GDP and acts as a catalyst to nearly 250 other ancillary industries. Needless to say, any sustained upswing in an economy needs the realty sector to be in the pink of health. 

This is what Abhishek Lodha, MD of Lodha Developers has to say on the far reaching consequences of a prospering real estate market in an economy - 

Housing and construction have always played critical roles in the economy, with construction now the largest employer in the Indian economy. Progressive and developed nations like the U.S.A. , China, and U.K. are some examples, which demonstrate that no economy has grown sustainably without housing growth. We saw how Indian employment and investment grew significantly on the back of the ‘positive wealth’ effect created by housing growth in 2004-2010.
Let's not even for a second, forget the fact that cyclicality is an embedded feature of this sector, not just domestically but on a global level as well. The fortunes of real estate are closely linked to the overall macroeconomic scenario across borders - which in turn is a culmination of several other moving parts - interest rates, fiscal policies, so and so forth. 

Unlike equities and certain commodities, Real estate cycles are far more prolonged - both on the upside and downside. A typical cycle lasts for as long as eighteen years across developed economies -(from peak to trough and back to peak)


Real estate Cycles in the United States( courtesy - Fred Foldvary)


Some important points to note from the above graphic would be
  • Construction activity and land prices peak out almost at the same time
  • Peak to trough movements take anywhere between two to three years to culminate
Cycles in India though, have been much more compressed and volatile as the sector opened up to foreign capital only since 1991 thereby increasing alignment with the global market at large

The fond memories of the boom of the nineties gave way to the misery endured during the turn of the twenty first century. From trough to peak and back to trough, property prices In India traversed a decade of volatility beginning 1992, before eventually bottoming out somewhere between 2002 and 2003
A sample of all real estate companies in India as complied by Ace Equity adds impetus to our observation - Return on Capital Employed slid from a dizzying twenty seven percent in FY'95 to a lowly six percent by FY'04! In tandem, net per-tax margins slipped a whooping 90% from their highs in 1996!

RoCE and Pre tax margin for all companies in the realty sector
(Source - Ace Equity)


A rising tide lifts all boats.

Relaxation of FDI Norms in 2005 promulgated the sector to a wide global audience of investors for whom this market provided a direct avenue to participate in the growth story of the economy at large. Incumbents as well as newly established ventures lapped up the influx of foreign money as a bountiful source of capital to spur activity in the sector. The Indian market though, was just another beneficiary of the global rally in property prices which eventually culminated with the onset of the subprime crisis in the United States. 

Compiling specific data points on the listed companies in the sector threw up certain interesting pointers
  • Return on Capital employed, which had bottomed out near to ten percent (implying negative value creation as cost of capital was anywhere near fifteen percent) trebled to thirty percent by the peak of 2007
  • Inventory days ( which measures the sales velocity for real estate) fell from a peak of 377 days in 2002 to 289 days at the peak of 2008 
  • Even though there were healthy book profits reported during peak, cash flow generation from operations remained tepid, thereby stretching balance sheets across the sector
  • Add to that the rapid expansion drive companies had embarked on, Cash flow from investing further add to the leverage companies had to take on - debt equity ratios for a basket of all listed real estate stocks increased from 1.02x as of FY'03 to 1.7x as of FY'07
It is an anomaly when companies who are growing profits at triple digit rates are compelled to tap external sources of funding to fuel growth. Taking a sample of listed real estate companies for the period between 2003 and 2007, what we found was that despite supernormal growth in profitability, cumulative debt equity ratio increased from 1.02x in FY'03 to 1.31x in FY'07 - an absolute increase of more than fifty thousand crores!


Cumulative Cash from operations for the selected period was a mirror image of cumulative EBITDA!






“Bull markets go to people’s heads. If you’re a duck on a pond, and it’s rising due to a downpour, you start going up in the world. But you think it’s you, not the pond.”

Leverage and incessant speculation are two founding pillars of a bubble in any asset class. What we have understood from the above data is that companies resorted to debt as a substitute of cash flows -to hoard vast tracts of land as end demand from speculators blossomed. In the entire process, both the producer and the consumer chose to turn a blind eye to the cycle turning against their tide 


The magnifying effect that leverage has on a business is most evident when one delves deeper into the devil that lies in the details. For the entire clutch of listed companies, Return on Equity shot up to 45 percent in 2007 from a mere 3 percent in 2003. What's intriguing though is that asset turnover ratio only moved from 0.43x as of 2003 to 0.47x as of 2007. The end result? Value creation across the sector was a direct function of how much leverage each company burdened itself with

In his report titled 'The End Game of Speculation in Real Estate has begun' , Manish Bhandari aptly describes the feedback loop that fuelled the bull market

The "amplification mechanisms", whereby, a large increase in asset price is followed by a higher demand, as investors think that further increases in prices will follow. This "super-exponential" acceleration in prices due to a positive feedback (or "pro-cyclicality") leads to formation and then maturation of a bubble, which has happened in case of the Real Estate prices in India. 

An opportunity size catering to 125 crore Indians, growing in double digits is a lucrative proposition for a swarm of new companies wanting to have a bite of the cherry. And if you add a painful slowdown in off-take, what you get is the prefect recipe for a financial disaster in the making. 


In this entire slowdown, companies who have not been able to deliver on promises ( lack of execution capability) have met with a gnarly end as  plummeting inventory off-take and an inability to service leverage has broken the two major sources of funding that real estate development thrives on. A virtuous cycle of value creation built on the pillars of debt and speculation has metamorphosed itself into a inescapable debt trap for stretched balance sheets

Lack of accountability and capability have been at the forefront of dissent
for the industry at large

A complete absence of checks and balances at various stages of real estate development have for long been hunting grounds for several fly by night developers who have relied on the money of home buyers to accentuate other ventures.This eventually translated itself into a fragmented sector wherein no single player would have a definite command over his/her area of competence.

Let us have a look at what Arihant Superstructures' management had to say on the real estate market of a small town in Jodhpur



The trilogy

In an interview to BloombergQuint, Mohnish Pabrai succinctly talked about a trilogy of events that have shaken the Indian property market over the last eighteen months - Demonitization, followed by the double whammy of RERA and GST.

Let us understand the three events in greater detail.

According to Liases Foras, a real estate consultancy, about thirty percent of all property transactions have traditionally been transacted in hard illicit cash - most of which emanates due to the stark difference between circle rates and market rates. By under-reporting transaction prices, the buyer benefits as he has to pay lower municipal taxes on his purchase and the seller benefits by way of a lower outflow of capital gains tax on the sale of his land.
A blanket ban on 500 and 1000 denominated currency notes bought the entire sector to a grinding standstill. The impact of this move was profound as transactions in markets such as the Mumbai Metropolitan Region( MMR) and the Delhi-NCR region (where a sizeable chunk of overall demand originates from speculators who want to make a quick buck by betting on price increases during the construction phase of a project) took a significant hit .

The first of the trilogy of moves well and truly separated the wheat from the chaff. Developers who relied on this channel of funding for augmenting their business were almost wiped out of the game overnight as the component of liquid cash was no-longer a bankable source of capital to tap into. Real estate development was slowly graduating from being one of uncouth practices and opaqueness to a consumer centric and transparent business model. 

After being in the works for several years and governments, the real estate regulatory act(RERA) was finally adopted in the summer of 2017. The provisions contained within the bill were remnants of a cleanup drive that would completely reboot the sector at large. 

Under the RERA Regime - 
  • companies have to first secure all clearances (which in many case can run upto more than fifty different applications) before launching a project to buyers.  (increased source of alternate funding)
  • Besides this, seventy percent of the booking amount received from customers will have to be maintained in a separate escrow account and shall be used for the sole purpose of meeting expenses pertaining to the construction of that particular project only.( increased accountability and working capital needs)
  • The home builder would be liable towards all defects arising out the construction of the project for a period of five years post completion. (better quality of construction and a need to have a skin in the game)

 In one his interviews, Khushru Jijna, Piramal Finance's MD crisply puts across the fallout effect that RERA would have on the dynamics of the sector at large - 


Indeed, the onset of RERA after the bombshell of demonetization has pegged the entire sector back to square one. As weak hands run for cover, fresh supply into the market has taken a beating and speculative demand as a whole has found alternate sources to deploy capital. 

The end game?

Image Courtesy - Livemint

  • New launches across different cities fell 41% YoY 
  • Sales continue to plummet, touching a seven year low as speculative demand gets wiped out of the market
  • The pace of incremental supply has fallen short of demand, thereby liquidating unsold inventory

Having dealt with the aspect of trust with the onset of the RERA, let us now understand whether prices are really conducive for home buyers as of date.

Pankaj Kapoor, head of Liases Foras, explains the issue of affordability in an interview to Economic Times -




  • Consumer affordability is a function of two distinct factors - price affordability and availability of financing
  • Cost of capital for buying a house (which is the loan rate charged by a bank) is near historical lows which further bodes well for a pick up in sales velocity

Mortgage rate trends in India



  • Low mortgage rates, combined with a time correction in prices points towards a multiplier effect in terms of affordability for the home buyer thereby pointing to meaningfully higher sales velocity. 

To conclude..

The lolapalooza effect that DeMon, RERA and GST have exerted on the Indian property market has chalked out a new path of evolution for the business of real estate development. From a 'pre-sale' model, companies would slowly move towards a 'build and sell' model wherein a significant portion of accruals happen at the later stages of construction. (Note that build and sell here refer to completing construction till a certain milestone before opening it up for sales.)

This shortfall in cash flows would entail latent demand for working capital by way of construction finance - thereby creating a natural barrier to entry. The flip-side of lower sales visibility at the commencement of a project would however propel an element of uncertainty as completed projects may or may not witness traction in off-take as demand is a cyclical element of economics.

Talking in terms of profitability, exorbitant property price rises fueled by speculative demand are a thing of the past - which would mean that a big part of the abnormal margins that accrued for real estate companies during the cycle of 2008 will take a backseat. The forthcoming up-turn in the industry shall typically be led by higher turnover ratios (a big reason for this is the demand emerging from affordable housing) , stable profitability and relatively lower levels of leverage.

In a cyclical sector everyone focuses on the demand side but not many focus on the supply side. When looking at the real estate sector with all the transitions happening the supply seems to be affected in two manners viz:
  • Fall in new construction
  • Consolidation among the builders bringing in new supply 
In lieu of these changes the structure of the industry should look much different than what it has been over the last decade. In the next post we will have a look at individual companies and see how they are adapting to change in the sector




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