Analyzing the Real Estate sector - Part 2

Make sure you have read Part 1 of this series first.

Indicators to Track Realty Industry Cycle

As we have already seen in the previous article, the real estate sector is extremely cyclical in nature, with each phase of the cycle lasting several long years. Therefore it makes sense to have a macro view of the industry as a whole and try to gauge where we stand and what's coming next.

The screenshot above lists some of the key metrics that we can use to make a sense of where we stand in the realty cycle.

Cycle Time - If we are 3-4 years from the bottom sales, it means that we might be near the top already. Or if we are 5-6 years from Top sales it means that we have already experienced a long period of correction and consolidation and we might be nearing a renewed positive wave.

Rental Yield - This is a forward-looking indicator. If the rental yield is below the long-term yield (eg 3%) it might be an indication that the market is now headed toward a downturn, while if the rental yields are high, meaning that the property prices have already dipped too much, we might be nearing the start of a bull phase.

Interest Rate - If the rates are higher than the mean of the last 5-6 years, it indicates that the market is currently saturated, and buyers are willing to pay a premium just to get in. This indicates that the top is in and a correction is on its way. While if the interest rates are low, this might be because fewer people are interested in buying homes, indicating that it's either the bottom or the bottom is near, which shall be followed by an uptrend.

Price CAGR - If your friends are boasting about how a property they bought 2-3 years back has already doubled/tripled in price, it is indicating that the top is in, and now the market might be heading towards a downtrend soon, and Vica-Versa.

What is a Real Estate entrepreneur doing - if an industry veteran is no longer buying, it means he or she has sensed the overvaluation and is waiting for a market correction.

Govt support as distress sign - If the state govt. is offering tax rebates and other incentives for people to buy homes, this help would work in favor of vitalizing the realty sector and bringing back some life. While if the govt. is not offering any such incentives, it means the market is already doing too well and may be at or near its peak.

Financials and Valuations

This is where things get weird, as typical skimming through income statements and generic financial metrics such as the PE does not work in the Realty sector. This is because of a shift in the accounting method from the project completion method to the delivery-based method.

Earlier in the project completion method, if the builder has completed 50% of the construction then he can show the advances collected as revenue, but now under the delivery-based method, the builder can not show revenue (in the income statement) until the keys to the finished buildings have been handed over to the new owners, while prior to handing over the keys all the advances collected will be simply mentioned on the balance sheets as "advances" under liabilities.

What does this mean?

Well, it means that while the construction activity is going on, the costs would be displayed on the P&L statement on a recurring basis quarter after quarter, while almost no revenue would be shown since the delivery has not taken place.

So you see that the costs and revenue of a Real estate/construction company exist in different time frames, and that is why a typical look at the PE ratio or a glance at the income statement won't convey the full story.

Let's look at an example.

On the left, we have the income statement, and on the right, we have the balance sheet.

Let's close in on the income statement to see the numbers more clearly,

For year ended march, 2021 (second column from the right) we can see that the total income has been 25,931 Crores, total expenses are 25,901 crores and the net profit after tax is 172 crore.

Now on the face of it, the net profit has only been 0.6% of revenue and the financial picture of the company does not look at all. However, let's have a closer look at the assets and liabilities of the company:

Look at the row "Advance from Customers" and the second column from the right, INR 39,815 Crores. All this would be converted to revenue on delivery! So effectively if we were doing accounting the old-fashioned way, the actual revenue would have been 25931 + 39815 = 65746 Crores or about 40k crores of additional revenue.

So we learn that while analyzing companies in the realty sector, its crucial to track inventory and advances.

Two KPIs that become important to track/measure are:

1. Advances/Inventory: This tells whether the sales velocity is higher than the construction velocity or not. A ratio means the company is able to sell more than what they are constructing. The higher the ratio the better.
2. Inventory/Sales: This gives an idea about the incremental growth revenue pipeline the company is building. The lower the ratio the better.

Broadly speaking, we need to have a healthy understanding of the correlation of the construction targets, how much of those targets have been achieved, and how much of that has been sold.

Valuation -

For rental projects, one can estimate/forecast the rent collected and multiply it by the average sector multiple for similar companies. (Net Rent * multiple).

For residential projects supposed to be sold out, we can value projects by the Mean of the last 5 years of area constructed * per Sq. foot rate * industry multiple.

For a company involved in multiple projects, the ideal way would be to do individual valuations for each project and then add them up.

That's it for Part 2.

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