Many direct stock investors consider healthy revenue growth, low competitive intensity, cheap valuation, and a long upcycle just beginning as the ideal investment scenario. Some believe that real estate stocks fit these criteria.
The Indian residential real estate market has improved after a prolonged downturn. There has been a significant reduction in unsold inventory, and the registration of home purchases is on the rise. New solid home bookings indicate that a few large and reputable players have emerged as winners, with annualized growth of 33% between FY20 and FY22. This trend is continuing in FY23.
The real estate industry went through significant changes in the last two decades. In the early 2000s, the residential real estate industry was largely unregulated and attracted numerous players seeking high returns with minimal risk. Real estate prices steadily increased until 2013 when they sharply declined. Following this, the introduction of the Real Estate Regulatory Authority (RERA), demonetization, and the Goods and Services Tax (GST) resulted in a severe shakeout in the industry, leaving only a few players with strong balance sheets and access to cheap loans. These players are now well-regulated and meet the success criteria of brand, balance sheet, execution, and sales engine.
Currently, the real estate industry is well-regulated, and the leading players have solid balance sheets and access to low-interest loans. Equated monthly installments (EMIs) are also more affordable due to rising take-home salaries. Demand is driven by urbanization, nuclear families, and a desire for larger homes. However, the real opportunity lies in the supply side. Following consolidation, only 30-40 major players meet the requirements of brand reputation, financial stability, execution capabilities, and sales engine. This creates a classic bull market scenario, with strong demand and limited supply leading to "pricing power." The most significant barrier to entry is trust, which is built over the years through consistent delivery.
Realty firms offer attractive operating characteristics, with project internal rate of return (IRR) in the range of 20-22% annualized and healthy pre-sales growth of around 18-20%. This, coupled with high entry barriers, presents a compelling business proposition. Additionally, since these companies develop commercial offices and retail malls, the three segments combined have significant growth potential. When valuing real estate stocks, revenue is only recognized upon property handover, not on "percentage completion," per accounting norms. Consequently, project margins appear lower, and working capital appears inflated during the initial years, despite ongoing pre-sales. Thoughtful investors use an assumed percentage completion method and estimated profit margin to determine the "modified" earnings before interest, taxes, depreciation, and amortization (EBITDA) and compare it with the company's enterprise value (EV). This results in a "modified" EV/EBITDA multiple, making real estate stock valuation comparable to that of "regular" stocks.
Real estate stocks provide a strong combination of growth and profitability, yet trade at modest multiples. While some investors believe they should trade at NAV, the regular cash flow based on milestone completion makes NPV less relevant. Unsold inventory is currently at a 10-year low and has a greater impact on real estate prices. Although rising interest rates could reduce demand for apartments by increasing EMIs, home loan rates are still close to pre-covid levels, and demand for real estate remains robust.
Real estate stocks present an enticing investment opportunity, as they offer robust revenue growth, healthy IRRs, a wide moat, and cheap valuations, which experienced investors know can lead to excellent returns.
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