Analyzing the Real Estate Sector - Part 3

(You may first want to read Part 1 and Part 2 )

Key Risks in Real Estate

1. Cyclic Industry - Both residential and commercial real estate businesses are cyclic irrespective of builder class. Negative investor sentiment impacts even good builders. Even well-run malls go through space reduction in bad times.
2. Unethical practices - Hoarding property in hope of selling at better prices. Although this works in the buyer's favor when the market is buoyant and fails terribly when the cycle turns. The builder then needs to book losses in their inventory and leads to delays in the project & loss of credibility.
3. Regulatory and Policy risks - The rules and policies with regard to land sales and property development differ from state to state. Some states are more real estate friendly than others, therefore when analyzing a realty company one should look at which states the company is operating in.
4. Interest rates - In India a bulk of the residential real estate is purchased on loans, interest rate plays an important role in deciding the affordability of real estate.
5. Macroeconomic risks - In a recessionary scenario, buying a house become the last priority as survival itself is in question for the lower middle class. Also, with the industrial slow down there are fewer jobs created and hence lesser demand for realty.
6. Lower Barrier to Entry - Anyone can become a constructor/builder. The real estate players themselves are not heavily regulated by any government entity, this affects the overall quality of players in the market.

Key opportunities

1. Good players consolidate the market eventually - Players who survive multiple cycles and continue to maintain a healthy balance sheet eventually lead the market and flourish in good times.
2. Smart Commercial Real estate - While the residential sector is quite saturated and unstandardized, things are relatively more stable in the commercial sector as the world is shifting towards various forms of compliance such as ESG, LEED certification, smart design, etc.
3. E-Commerce warehousing - Lots of deals happening here in the Private Equity (PE) space. Manufacturing and leasing with decent IRR.
4. Data Center Infrastructure - the requirement of data centers due to digital and data explosion could drive new revenue sources for real estate infrastructure creation.
5. Differentiated service-based real estate - a good example here is old age homes, as in the next 2-3 decades the proportion of senior citizens in India will increase and many might look to such services.

Finally, how do we invest in Real Estate?

We can identify individual sectors within real estate, see where the tailwinds and headwinds lie and analyze companies accordingly.

We can also invest in Realty Ancillaries i.e. companies whose growth is directly correlated with the growth in real estate. These would include companies that produce Tiles, Fans, Paints, Air conditioners, etc.

The other options are House Financing companies, however since these are purely interest-based, we at Ethica Invest can't recommend or condone investment in such companies.

Case Study - NVR

Although NVR is listed on the New York Stock Exchange (NYSE), it is an interesting company to study as it has been a 100 bagger and has sailed smoothly even post 2008 housing crisis and ression.

They have an interesting bussiness model, with a specialized lot acquizition strategy. NVR does not generally engage in land development, instead they acquire building lots at market prices from various land developers under fixed price agreements that require deposits, usually upto 10% of the aggregate purchase price.

If NVR fails to act under the contract then the deposit may be forfeited. This way even if NVR is unable to sell, the maximum they can lose is just 10% of the property value. This is one of the main reasons that NVR has been able to remain profitable even after the housing crash in 2008.

This strategy reduces the financial requirements and risks associated with direct land ownership and developement. As of the end of 2013, NVR had 64,000 lots through lot purchase agreements for an aggregate value of $5.8 billion, but through this acquisition straategy NVR only has deposits of approximately $372mm in the form of cash and letters of credit. This has historically allowed them to leverage themselves without the financial obligatiom and necessary capital.

Another interesting point is that 50% of long term stock options (as part of NVR's executive compensation plan) are tied to the firm's return on capital (ROCE) performance.

Some salient feature of NVR financials are:

1. Super healthy cash flow conversion cycle with the last 10 year mean being 57 days, something unheard of in India
2. Attractive asset turnover of 1.22 and fixed asset turnover of 1.76
3. Low debt to equity with debt being raised at right times when interest rates were lower (good real estate players wait for the bear market to kick in to make big ticket decisions)
4. Tremendous free cash flow generation year after year followed by prudent growth and buybacks

Despite all the above mentioned goodness, do note that the 10 year revenue growth rate has only been 4.9% while EPS grew at 8.9%.

Case Study - Oberoi

Oberoi Realty is a permium real estate seveloper based in Mumbai, and has developed over 39 projects at location accross Mumbai.

Its main interest is in Residential, Office Space, retail, Hispitality and Social Infrastructure properties in mumbai.

Other interesting points to note:

1. Works at very high margin (35%) due to premium branding and high focus on quality designs
2. Promoters take zero salary
3. Promoter has shown ability to sit and do nothing in bull estate cycle, and make attractive land acquisitions in bear markets utilizing the cash on books
4. Diversified revenue sources (as already pointed out in the begenning) with continuous cash flow generation.

PS - None of the stocks above are investment recommendation, they are being discussed only for educational purpose.

Some Interesting Books to read:

1. Inside unReal Estate by Sushil Kumar Sayal
2. Moguls of Real Estate by Manoj Namburu
3. The Consolidators by Prince Mathews Thomas

PPS - Shout out to Kumar Saurabh and his channel Scientific Investing for providing me the inspiration (and content ??) to write.

Thats it for this article, see you folks tomorrow.