Idea Book On Investing In Real Estate Developers

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Investors got fantastic returns investing into real estate developers. However, as times become difficult, it is important to separate the grain from the chaff. I present some bits of knowledge I collected while analysing real estate developers. These, I hope, will help investors identify the great developers and thus make better investment decisions. The list is to be read in addition to prudential investment and valuation principles and practices.

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Idea Book On Investing In Real Estate Developers

  1. 1. 09
 
 September
 Idea‐Book
on
 Investing
in
Real
Estate
Developers
 Rahul
Deodhar
 Investors
 got
 fantastic
 returns
 investing
 into
 real
 estate
 developers.
 However,
 as
 times
 become
difficult,
it
is
important
to
separate
the
grain
from
the
chaff.
I
present
some
bits
of
 knowledge
 I
 collected
 while
 analysing
 real
 estate
 developers.
 These,
 I
 hope,
 will
 help
 investors
identify
the
great
developers
and
thus
make
better
investment
decisions.
The
list
is
 to
be
read
in
addition
to
prudential
investment
and
valuation
principles
and
practices.
 RAHUL
DEODHAR

  2. 2. Investing
in
Real
Estate
Developers
–An

idea­Book
 
 Introduction
 Real
estate
developers
have
been
a
significant
part
of
value
creation
for
investors.
And
 they
will
continue
to
be.
However,
as
times
get
difficult,
it
is
important
to
pick
the
right
 developers
to
invest
in.
While
these
are
logical,
they
are
often
ignored
in
my
experience.
 I
 believe
 first
 thing
 a
 developer
 must
 be
 sensitive
 to
 is
 business
 cycle.
 Irrational
 optimism
leads
to
a
fatal
failure
in
preparing
for
eventual
slowdown.
 Similarly,
 land
 bank
 quantity,
 quality
 and
 cost
 determine
 the
 future
 earning
 potential
 and
growth
of
the
developer.


 Developers’
also
need
an
ability
to
manage
through‐cycle
earnings
for
the
company.
In
 search
of
quick
profits,
developers
often
condemn
the
company
to
future
revenue
de‐ growth
and
lower
or
negative
profitability.
 Cash
flow
management
and
debt
structuring
is
other
critical
part
of
real
estate
business
 that
can
make
or
break
the
company.
 Lastly,
I
mention
some
ways
in
which
real
estate
developers
prevent
value
realisations
 for
the
listed
entity.
 I
 hope
 these
 learning’s
 will
 be
 helpful.
 These
 do
 not
 comprise
 the
 complete
 list
 and
 must
 be
 used
 in
 conjunction
 with
 standard
 investment
 and
 valuation
 procedures
 and
 practices.
 
 
 License

 The
 work
 can
 be
 shared
 for
 non­commercial
 use
 through
 proper
 attribution
 as
 explained
 in
 Creative
 Commons
 Attribution­Noncommercial­Share
 Alike
 3.0
 Unported
License
 
 2
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  3. 3. Investing
in
Real
Estate
Developers
–An

idea­Book
 Understanding
Business
cycles
 Real
 Estate
 Industry
 cycles
 lasts
 10‐13
 years
 peak‐to‐peak.
 Over
 this
 period
 prices
 decline
to
troughs
and
start
improving
again.
The
volumes,
generally,
start
picking
up
 as
 prices
 pick
 up
 and
 peak
 volumes
 occur
 when
 prices
 are
 roughly
 80‐90%
 of
 their
 peak
value.
 Cycle
in
growing
city
 Cycle
in
declining
city
 

 The
actual
prices
and
volumes
at
peak
and
trough
depend
upon
the
state
of
the
city’s
 economy.
 In
 a
 growing
 city
 the
 through‐cycle
 average
 prices
 tend
 to
 move
 up
 (as
 represented
by
dotted
line)
whereas
they
decline
in
a
city
with
declining
economy.
At
 the
 country
 level
 certain
 cities
 tend
 to
 lead
 the
 growth
 whereas
 certain
 others
 lag.
 Beijing
is
an
example
of
growing
city,
while
Detroit,
US
is
example
of
declining
city.
 The
good
developers
understand
the
cycle
and
where
their
cities
are
within
the
cycle.
 The
best
developers
adjust
their
businesses
to
become
structurally
sound
as
we
will
see
 further.

 

 
 3
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  4. 4. Investing
in
Real
Estate
Developers
–An

idea­Book
 Land
Bank
 Counter­cyclical
land
bank
aggregation
 In
most
cases,
land
prices
are
in
line
with
final
real
estate
prices.
Therefore,
land
bank
 aggregation
 needs
 to
 be
 counter‐cyclical.
 In
 established
 cities,
 this
 creates
 structural
 advantage
difficult
to
match.
Those
developers
buying
land
at
peak
cycle
will
lose
out.
 Land
bank
aging
 Land
bank
is
usually
bought
for
next
cycle.
So
a
established
developer
has
land
bank
for
 10
years.
In
other
words,
if
land
is
bought
today,
construction
will
start
in
after
5
years
 and
the
next
5
years
the
project
will
be
complete.
In
the
last
few
years,
the
developer’s
 land
 bank
 holdings
 shrank
 to
 2‐3
 years
 worth
 construction.
 This
 typically
 happens
 around
peak
of
the
cycle.
 However,
 redevelopment
 lands
 in
 central
 locations
 are
 difficult
 to
 hold
 for
 longer
 periods.
This
land
is
turned
around
very
quickly.
 Debt
free
land
bank
 Given
the
above
conditions
first
principles
dictate
that
developers
use
own
capital
for
 land
 bank
 purchases.
 Debt
 for
 land
 purchases
 severely
 hinders
 the
 ability
 to
 capture
 value.
 Hence
 developers
 financing
 land
 bank
 purchases
 through
 debt
 will
 be
 under‐ perform
in
the
longer
term.
There
is
also
a
risk
of
default
depending
on
total
leverage.
 Capital
management
to
overcome
cycle
mismatch
 The
 difference
 in
 land‐bank
 procurement
 cycle
 and
 real
 estate
 cycle
 causes
 financial
 mismatch.
 Developers
 are
 most
 leveraged
 at
 the
 time
 when
 prices
 are
 lowest
 (or
 at
 least
should
be)
and
they
are
cash
rich
when
land
prices
are
at
maximum.
Developers
 usually
 tap
 the
 equity
 markets
 during
 peak
 times
 (to
 get
 best
 valuations).
 So
 a
 mismatch
 is
 created.
 Developers
 have
 to
 manage
 this
 mismatch
 if
 they
 do
 not
 have
 capital
 to
 finance
 land
 purchases.
 Generally
 two
 ways
 are
 used.
 First,
 land‐purchase
 agreements
are
used
to
lock
in
the
price.
Second,
joint
development
agreements
make
 the
current
landowner
partner
in
the
project.

 Strategic
Land
value
inflexion
 Policy
 action
 or
 infrastructure
 developments
 lead
 to
 inflexion
 in
 land
 value.
 Aggregating
 land
 banks
 at
 strategic
 locations
 creates
 a
 structural
 advantage.
 Great
 developers
have
in‐house
experts
to
understand
and
identify
such
locations.

 
 4
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  5. 5. Investing
in
Real
Estate
Developers
–An

idea­Book
 Revenue
&
margins
 At
 a
 company
 level,
 revenue
 is
 product
 of
 total
 area
 sold
 and
 average
 selling
 price
 (ASP).
 To
 a
 certain
 extent,
 margins
 are
 independent
 of
 the
 top
 line.
 They
 are
 determined
 by
 the
 land
 bank
 costing.
 Nevertheless
 the
 revenue
 equation
 creates
 unique
challenges
for
the
developer.
 Maintaining
or
managing
revenue
growth
 To
maintain,
say,
10%
revenue
growth,
a
developer
has
to
expand
the
volumes
by
10%
 or
price
by
10%.
We
read
this
in
conjunction
with
the
current
position
in
the
business
 cycle.
Clearly,
in
an
up
cycle
it
is
easier
to
maintain
the
revenue
growth
momentum.
The
 problems
occur
in
the
down
cycle
when
prices
are
falling.
Here,
to
maintain
our
10%
 growth,
volumes
will
have
to
grow
more
than
10%.
Real
estate
prices
are
known
to
fall
 by
more
than
30%
over
the
down‐cycle.
So
clearly
the
pressure
is
huge.
But
there
is
a
 way
out.
 Developers
 adjust
 project
 mix
 to
 sustain
 the
 ASP
 level.
 This
 means
 at
 peak
 cycle
 developers
are
selling
lower
ASP
projects
and
concentrate
on
premium
projects
during
 lean
times.
This
makes
sense
otherwise
too.
Usually
lower
ASP
projects
are
far
out
and
 thus
 bear
 greater
 risks.
 Premium
 projects
 are
 generally
 closer
 to
 city
 centres
 where
 ASPs
and
saleability
tend
to
hold
out
better.
 Developers
 need
 to
 have
 the
 land
 bank
 profile
 to
 fit
 such
 strategy.
 Conversely,
 developers
with
high
cost
land
banks
tend
to
lose
out.
 Revenue
Augmentation
–
lure
of
commercial
real
estate
 With
 the
 huge
 cyclicality
 in
 revenues,
 developers
 are
 drawn
 to
 steady
 stream
 of
 incomes
offered
by
commercial
real
estate
(CRE).

 CRE
 acts
 like
 an
 income
 source
 till
 the
 valuations
 and
 cap
 rates
 become
 attractive.
 Thereafter
the
developer
can
sell
the
CRE
to
a
REIT
and
exit
at
a
handsome
profit.
But
 on
the
flip
side,
it
ties
up
lot
of
capital.
Further,
CRE
adds
to
the
risks.
 Commercial
 realty
 has
 altogether
 different
 risk
 structure.
 The
 commercial
 realty
 market
 is
 dynamic
 and
 demand‐supply
 need
 to
 be
 finely
 tuned.
 Reckless
 mall
 development
 is
 hindrance
 for
 developers
 and
 tenants.
 Developers
 in
 India
 and
 China
 are
 still
 to
 fine‐tune
 this
 risk
 assessment
 and
 response.
 Some
 Singapore
 real
 estate
 consultants
 have
 made
 great
 progress
 in
 this
 area.
 To
 protect
 themselves
 from
 CRE
 cycles,
 developers
 tend
 to
 house
 them
 in
 separate
 entities
 with
 asset
 itself
 as
 debt
 collateral.
 There
 is
 always
 a
trickle
 back
 of
risk
 to
the
 holder
 of
the
property
(the
 developer)
in
 commercial
 real
 estate.
 Hence,
 a
 base
 fee
 +
 revenue
 sharing
 arrangement
 is
 usually
 considered
better
compensation
for
malls
and
hotels.

 Aside,
most
potent
commercial
real
estate
is
car
parks.
Car
park
is
less
analyzed
area
in
 real
estate.
 
 5
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  6. 6. Investing
in
Real
Estate
Developers
–An

idea­Book
 Cash
Flow
and
Debt
management
 Cash
flow
and
debt
management
differs
greatly
in
residential
and
commercial
projects.
 Cash
flow
through
pre­sales
 Residential
 real
 estate
 generates
 cash
 before
 expenses
 through
 a
 process
 called
 pre‐ sales.
 This
 is
 a
 process
 where
 developer
 gets
 money
 from
 customers
 who
 pre‐book
 apartments.
Is
cash
flow
is
used
by
the
developer
to
build
the
project.
Top
developers
 are
able
to
generate
good
quality
pre‐sales
(sales
to
last
buyers
rather
than
investors)
 and
 it
 remains
 important
 source
 of
 cash.
 It
 helps
 developers
 take
 lesser
 debt
 than
 otherwise.
 However,
 there
 are
 groups
 of
 investors
 who
 pre‐buy
 these
 apartments
 in
 bulk.
 In
 return
developer
increases
the
selling
price
as
completion
nears
thereby
giving
a
return
 through
 asset
 price
 appreciation.
 In
 this
 form
 it
 is
 simply
 a
 form
 of
 project
 financing.
 This
 mechanism
 is
 similar
 to
 dealer
 sales
 in
 case
 of
 consumer
 goods
 companies.
 And
 just
 like
 dealer
 sales,
 the
 goods
 can
 be
 returned
 if
 prices
 crash
 drastically.
 Equity
 market
investors
cannot
discount
this
risk,
as
it
is
hidden.

 Requirement
for
Debt
 Real
 estate
 business
 seems
 positively
 cash
 accretive
 business.
 But
 the
 cash
 flow
 is
 spread
 as
 shown
 below.
 The
 green
 zone
 represents
 sales
 period
 and
 is
 usually
 cash
 flow
positive.
Red
zone
is
where
land
bank
accumulation
happens
and
there
is
a
cash
 outflow.
In
red
zone,
typically
debt
requirement
is
high.
The
debt
burden
is
carried
by
 projects
under
construction
with
total
interest
cost
being
met
by
trickle
of
pre‐sales.
 Business
Cycle
and
cash
flow
situation
(Red
=
net
outflow
and
 green
=
net
inflow)
 
 6
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  7. 7. Investing
in
Real
Estate
Developers
–An

idea­Book
 Frauds
 Despite
prudential
regulations,
investors
often
wonder
if
a
company
is
ethically
sound.
 There
are
a
few
things
one
can
look
for
in
real
estate
developers.
 Non­arms
length
parties
 The
parties
who
sell
the
land
bank
and
those
who
buy
apartments
in
pre‐sales
are
often
 under
scrutiny.

 Land
bank
is
sometimes
held
in
joint
venture
companies
with
promoter
as
part
owner.
 The
price
paid
for
land
bank,
by
the
parent
to
the
JV,
should
then
be
subject
to
scrutiny.
 Often
the
land
bank
agreements
are
renegotiated
at
higher
prices
in
peak
cycle
times.
 Similarly,
 apartments
 are
 often
 pre‐sold
 at
 lower
 than
 market
 rates
 to
 related
 parties
 who
thereafter
make
a
profit
on
further
transactions.
 Building
 maintenance
 is
 another
 area
 of
 contention.
 It
 is
 usually
 carried
 out
 by
 sister
 concern
of
developer
and
there
is
no
bidding
for
lowest
cost
provider.
So
if
ownership
 structure
of
this
sister
concern
is
different
it
should
raise
a
flag.
 Missing
add­on
fees
 Often,
 cash
 component
 in
 apartment
 sale
 goes
 unchecked.
 Further
 the
 developer
 accepts
cash
fees
for
transfers
and
other
services
that
are
not
billed
to
the
company.

 Indian
 real
 estate
 market
 has
 a
 certain
 cash
 proportion
 to
 lot
 of
 deals.
 These
 are
 not
 reported
to
the
company
in
many
cases.
 Developers
have
a
single
real
estate
broker
and
all
deals
are
routed
through
this
broker.
 Such
 transactions
 are
 actually
 treated
 as
 costs
 for
 listed
 entity
 and
 promoter
 usually
 gets
a
kickback
from
the
proceedings.
 Misrepresentation
of
Land
Bank
 Land
bank,
as
a
rule,
is
amount
of
land
with
clear
title
and
relevant
clearance
for
end‐ use
as
required
by
projects.

 Land
titles
cannot
directly
be
attributed
to
company.
Company
often
needs
to
resort
to
 legal
procedures
to
get
clear
title
or
right
to
develop
the
land.
Such
land
should
actually
 be
ignored
from
land
bank
calculations.
 Further,
 lands
 often
 do
 not
 have
 clearance
 for
 real
 estate
 development
 use.
 The
 company
 might
 be
 holding
 agricultural
 land.
 While
 most
 developers
 can
 get
 the
 relevant
 permissions
 for
 conversion,
 the
 process
 is
 time
 consuming
 and
 legally
 uncertain.
 
 7
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 

  8. 8. Investing
in
Real
Estate
Developers
–An

idea­Book
 Conclusion
&
Disclaimer
 The
 above
 points
 are
 some
 of
 the
 points
 to
 be
 considered
 while
 analyzing
 real
 estate
 developers.
 The
 list
 is
 not
 comprehensive
 and
 must
 be
 read
 along
 with
 general
 valuation
principles
and
practices.
 
 About
Me
 I
worked
as
a
buy‐side
analyst
with
top
hedge
fund
client
of
Morgan
Stanley.

Prior
to
 this,
I
worked
for
CRISIL
Research
doing
industry
and
company
research.
I
have
over
8
 years
of
work
experience
across
various
roles
starting
on
the
shop
floor
to
investment
 analysis.
You
can
email
me
at
rahuldeodhar@gmail.com.
 
 
 8
 
 ©
Rahul
Deodhar
2009
 www.rahuldeodhar.com
 


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