A few years ago I had made a thematic presentation ‘India’s Consolidation Wave’ at Flame Investment Lab, Pune. The basic idea was to demonstrate using actual data from multiple industries that how some of the better-run companies were consistently growing faster than the industry and hence winning market share from their smaller/weaker/inefficient counterparts. At that time, I highlighted some of the key enablers supporting this trend – brand, distribution, and economies of scale.

Later when Demonetization happened in 2016 and GST got rolled out in 2017, the ‘Unorganized to Organized’ became a hot theme and many investors expected unorganized (smaller firms) to shut overnight while organized guys (listed companies) to grow multi-fold. Naturally, these investors and analysts were bound to get disappointed.

While I also mentioned GST, in my presentation, as an additional trigger supporting this trend, it was no way going to happen overnight. This is a multi-decade trend and shall continue to progress slowly but surely.

Since then, there have been some additional triggers supporting this trend – with the IL&FS fallout that led to the NBFC crisis and risk aversion in lending by banks, the access to capital for smaller and inefficient players has become a challenge. This has further restricted their ability to compete effectively with large corporations that continue to have access to capital at competitive terms or have enough internal accruals to fund their growing Capex and working capital needs.

The regulations too, have been getting tightened making compliance difficult for the smaller guys. Take, for instance, RERA, which has forever changed the way developers operate, accelerating the consolidation in the real estate sector. We are also seeing this play out in other sectors like Broking, Banking, NBFC, etc. where stricter and ever-evolving regulations are making it difficult for smaller players to stay competitive.

More recently, the COVID led economic shutdown has been the biggest black swan ever, hurting the unorganized economy much more than the large corporations, due to the former’s inherent vulnerability – the inability to manage working capital during such prolonged lockdown, lack of scale, concentrated operations in terms of region, product, vendors and customers, dependence on keyman (sole proprietor/partners), etc. One of our portfolio companies had a market share of 50-55% in the first-quarter versus 35-40% pre-COVID, as most of its smaller competitors could not run their factories. While it will be unrealistic to expect this to sustain, but some part of market share gain is likely to be retained. We should be prepared to see horrible macro numbers and industry level contraction, and yet corporate India (listed space) could surprise us with their numbers – a larger share of a smaller pie.

In Nov 2019, I had written an article ‘10 reasons why long-term investors shun real estate stocks, and why its time to do the opposite’. Real estate is one sector where I continue to see massive consolidation, so it is time to revisit that post and update what we are observing currently.

The uncertainty regarding how the economy would recover from COVID shock, risk of job losses, and pay cuts is real and here to stay for a while. Accordingly, the demand for housing is bound to go down, after all, it is the biggest investment decision of an individual’s life wherein he/she commits life savings for downpayment and an obligation to pay EMIs for the next 15-20-25 years. However, the very same COVID shock has also led to some positive triggers which are enabling a new set of buyers in the market.

1. Affordability: The majority of the real estate purchases are financed via a home loan, and the level of interest rate has a major bearing on that decision. In order to induce demand, the central banks world over have slashed interest rates. India is no different and the interest rate for home loans is now down to 6.5%-7% which is lowest in at least 15 years. It was 10-11% just a couple of years ago. Further, if one were to adjust for the interest subvention for the first-time homebuyer and tax benefits, the monthly EMI isn’t a lot higher than the rent one pays for the accommodation whereas in the former he/she ends up owning the property after the loan is repaid. Over the last few years, real estate prices have either been stagnant or slightly lower which has led to a decent time correction in housing prices and with such low interest rates, the affordability has only improved.
2. Fear: The sudden lockdown led by COVID has induced some sort of fear among people who preferred to stay on rent even though they could afford a place of their own. Individuals have been compelled to think about scenarios like ‘What if we were asked to vacate during a lockdown?’ or ‘What if something happens to the bread earner during the pandemic? The dependents should at-least have a roof of their own.’
3. Upgrade: An average home isn’t built to comfortably accommodate the entire family getting house arrest for 24 hours a day and seven days a week, which is how life has been since mid-March. This is especially true in metros like Mumbai and Delhi where real estate is so expensive that most families stay in small apartments – decent for sleeping but most of the waking hours of adults are spent outside the home either for working or leisure activities and kids for school/tuition/sports. There are families who can afford to upgrade to bigger houses and accordingly are in the market looking for ready-to-move-in properties.
4. Work-from-home: The work-from-home is here to stay for a while and even when normalcy resumes, many corporates might continue to have a balanced approach towards this. There have been many companies like TCS making bold statements that hint at a possibility of this becoming permanent. Till now it wasn’t practical for an individual working in BKC or South Bombay to stay in Navi Mumbai or for those working in Delhi/Gurgaon to stay in Bhiwadi, so they had to stay closer to the workplace most often on a rented premise as owning is too expensive in a central business district. However, with work-from-home being a reality, some part of this population is finding comfort in settling a little away from the workplace by buying their own apartment at an affordable price point. Further, even those who own a place near the workplace but belong to category (3) above i.e. finding the current home to be smaller are now looking to upgrade to a bigger house at the same or lower cost by going 10-20 km away towards the suburbs. If this trend picks up pace, the segment to benefit most would be affordable to mid-premium segments around the outskirts of metros & large cities.
5. Govt. Impetus: The sector remains extremely important for the enormous employment it generates, the linkages it has to the core economy, including consumption of cement, steel, and building material, the revenue it brings to the exchequer through registrations, etc. The Government very well understands this, as is reflected in the plethora of measures taken since 2017– incentives offered to first-time homebuyers, including interest subvention, increased tax benefits, exemption from GST on ready-to-move properties, etc. as well as a host of similar sops extended to developers & Joint Development partners (landowners), including tax exemption, tax relaxation, infrastructure status, among others. The latest is a steep cut in stamp duty charges by the Maharashtra govt. from 5% to 2% and this could be followed by other states too. So for an apartment worth Rs 1 crore, it is an additional saving of Rs 3 lacs.

Those were few pointers on what could drive demand. Although let’s assume overall demand will still crash by 20-30%, but is that enough to conclude it will be bad for the market? After all, isn’t it the supply that is a more reliable indicator for a turnaround in cyclical industries? So let’s turn our attention to supply.

Real Estate as a sector has been in a downtrend from the last 6-7 years. This got further accelerated post-implementation of RERA which altered business economics forever. Landowners prefer only credible developers as their Joint Development partner making it difficult for an average developer to stay asset-light, leaving no option for them but to buy land upfront. However, a developer can no longer launch a project and seek customer advances without getting RERA approval, and similarly, he cannot divert funds to other projects or to buy more land, as advances are kept in an escrow account. Banking and NBFC channel have been averse to lend to real estate given the existing stress in the sector further curtailing the access to capital.

If one sees overall inventory in the market (projects launched with unsold inventory) one would get an impression of massive over-supply, however the vast majority of these projects are stuck with little to no construction activity. The resolution could take a long time and no new buyer would dare to consider these even at a discounted price (think Jaypee or Mantri). The inventory from tier 1 builders with a credible track record isn’t too high even considering the prevailing low absorption rate. Once the demand picks up from end-user for ready-to-move-in (happening as I write this), this inventory could be absorbed in a couple of years.

The fresh supply (from these credible builders) could take a while to get launched; it takes 1-2 years to close land deals and get approvals for land use conversions, and another 1-2 years for regulatory approvals (over 50 approvals needed). 

What happens to Real Estate prices then?

As the quality inventory gets picked up, the prices could finally show some action. Even if its just 10-15%, it could attract the investor community back into real estate leading to some sort of a virtuous cycle, wherein the buyers are making quicker decisions as prices are going up while the investors are adding some fuel to the fire.

Last few months the central banks all over the world have pumped massive liquidity into the system, the world has never ever seen this kind of liquidity. Eventually, it should be inflationary for most asset classes. A lot of flows have found their way into equities world over, back home Nifty is just a few percentage points below all-time high despite all the negative news, gold has had quite a run last few months and is near all-time high and, so are cryptocurrencies and what not. Real Estate by value is the largest asset class globally and it is likely that it will get its fair share of the flows. Based on some anecdotal evidence, I understand that the land prices are already up anywhere between 10-20% in metros and top cities over the last couple of months.

There has been hardly any uptick in realization (price per square foot) since 2014, while the cost (labor, cement, steel, etc.) has gone up considerably eroding the profitability for this sector. Finally, this trend could reverse, and a higher realization for existing inventory and subsequent phase launches would lead to a mean reversion in operating margins.

We are probably at the bottom of the cycle and there are few branded real estate developers with a credible track record, net cash balance sheet, and clean corporate governance still available below book value. There is no point in looking at their recent P&L as they follow possession/completion based accounting which implies the newly launched units they sold in the recent quarter will reflect in P&L only once possession is handed over to the customer (that is 36-42 months later), while the current period’s P&L reflects sales and profitability of units sold 36-42 months ago (not applicable to the sale of ready-to-move-in units as those get accounted immediately). Accordingly, any P&L based valuation metric – price-earnings, price-sales or EV-EBITDA serves no purpose. For valuation, the most reliable indicator in my opinion is the book value and the expected mean reversion in return-on-equity based on area booked, while for tracking execution, the most relevant operating metrics to follow are 1). area booked, 2). area constructed & 3).operating cash flows.

Mean reversion is a very powerful and relevant concept. Pharma was struggling since 2015 and by 2019 most investors had forgotten all about it with no triggers in sight. However, valuations and operating margins were below the long-term average and one was positioning himself for luck. 2020 brought surprises for the sector and it became the hottest theme in just a matter of a few months catching up with all the underperformance of the last few years. Real estate seems to be in a similar boat – unloved, under-researched, and under-owned with hardly any representation in the indices. Will the asset class get lucky this time? Fingers crossed.

Disclaimer: One of the largest allocation in Stalwart Advisors’ Model Portfolio is a real estate developer where promoters recently increased their stake via open market purchases. This is not a recommendation to buy/hold/sell. As always, our job involves betting on the future, a lot of assumptions go into forming an opinion and we reserve the right to go wrong as we have also been in the past. Please consult your financial advisor before acting on it.

For any queries or feedback, please write to us at support@stalwartvalue.com

PS: Even in the US the new home sales have surged to the highest since Dec 2006 for similar reasons mentioned above. The following article by BloombergQuint talks about it: https://www.bloombergquint.com/business/u-s-new-home-sales-surge-in-july-to-highest-since-december-2006