Saturday, May 19, 2007

Realty companies wont be able to sustain margins

Devina Mehra of First Global feels that property prices seem to be peaking and the rising rates are adding to the worry. She adds that the EBITDA margins of real estate companies are not sustainable and could come down to 20% from the current 40%.

Excerpts from CNBC-TV18's exclusive interview with Devina Mehra:

Q: What is your basic concern? Will the demand-supply situation, or the interest rate, which has gone up that will hurt margins?

A: Actually, it is a combination of both because property prices do seem to be peaking and in fact have come off a bit from the peaks in few of the hotspots.

The interest rate is going up and this time around you may not get land at the same low cost that was available a year or two ago. That is how you have seen these big expansions in margins.

If you look at the real estate sector and go back four years, the margins were much lower than what they are today; EBITDA margin for Unitech and Sobha Developers were all in single digits and even DFL was somewhat around 14-15%, and suddenly 50-60% EBITDA margins don’t look sustainable.

Q: So, do you think there will be a meaningful compression in the margins of companies like Unitech and Sobha Developers?

A: Our numbers are making small correction in the property prices; maybe about 10-15% and plus the interest rates hike will bring you to an EBITDA margin about halving, let us say an average of 40% down to 20-22%. But for real estate companies, talking of margins only; in some sense, is doing paper exercise, because for any other industry you can say I am predicting this EBITDA margin of 22%.

For real estate, there is a real danger of ill liquidity. So if you are a steel company, you know it. Maybe the hot roll prices will fall from USD 550-450 maybe to USD 400. That is how you know that at least you will be able to sell most of what you produce. But in real estate you can have inventory lying there.

If you have been to Belapur, for instance - the mid 1990s boom, there was whole CBD built-up and all those buildings remained completely unoccupied. So, that is the kind of gender in real estate, which is compounded by the fact that most developers are highly leveraged which is a cause of concern. If you look at DFL, the last reported number was close to Rs 10,000 crore of debt.

Q: What do you think then will be the biggest challenge for these companies in the next two-four quarters, they will have to leave with lower price points so that there will be a genuine change in the demand-supply situation?

A: I think it will be a bit of both, because in real estate, the ill-liquidity comes in at point, which is that you just cannot sell, the prices go down. The other one is, some of the low cost funds you were getting because the customers were willing to pay in advance for buildings get built up goes away, which means you have to fund the whole building and the customer only looks at a ready building. So there are combination of both.

Besides the inherent danger or rather the difficulty of evaluating real estate plays per se because they are taking many things just on faith that the land is there. The title is clear so on and many of those things become question marks because many time if you talk to the large housing loan companies, they will tell you titles, litigation and things like that there are a lot of causes for worry.

Q: The point on ill liquidity, which one is more vulnerable in that case. Is it the company, which has gone out for big-ticket growth or projects in the metro cities, or are those smaller ones?

A: You will have to go company-by-company and project-by-project for that, but there will be some areas which are already showing signs of strain; some parts of Noida, Greater Noida or White Field in Bangalore where you have already seen price corrections. But you cannot put the blanket thing saying that non-metros will do well, as it really depends on specific project. Real estate ultimately comes down to a local business, which makes it little more difficult to evaluate.

Q: The stocks have been rallying as the general perception is that interest rates will not harden. But if interest rates remain at these levels for the next three-four quarters with no meaningful dip, do you think its bad enough to dent a lot of things in the real estate space?

A: From the buyer’s point of view, we do not think interest rates will harden at least significantly from here on. But EMIs of the average borrower has already gone up significantly in spite of the fact that urban salaries have increased.

To understand this better, one should look at the ratio of income to EMI. Two years ago the average salary was 4.2 times the EMI, let’s say an Rs 20 lakh loan and at present it is 2.7 times. There has been a significant drop from about 24% of your income going towards EMI to about 38% now. Obviously, it’s going to have an impact on demand.

Q: From these valuation levels, after the pullback, you do not find compelling reasons to go out and buy most real estate stocks?

A: Individual companies are hard to value in this space given the many things that you have. One cannot go in depth into whether it’s the land bank or the titles, etc. We still do not have ratings on many of the real estate stocks, but it is the broad concerns that remain a risk area.

Q: Your report indicated that you are concerned about the leveraged position as well for some of these companies. If you had to compare DLF and Unitech on a balance sheet basis, which one holds higher?

A: The risk appears little higher in DLF. We do not have a final rating out, so I would not like to give a final comparative comment on the two.

Q: What is First Global’s take on the public sector banking space after the pullback, which has taken many banks close to new-highs?

A: We have placed a market performer on most of them. We were expecting rates to peak out and start correcting and that is what happening as real interest rates have gone completely out of whack. Inflation was not that much at high when rates were high last time around.

We were expecting some kind of correction. The public sector banks are the most highly leveraged because of their investment portfolio to the rate cycle.

Q: What is about the other rate sensitive - reacting to things other than interest rates on Friday - Bajaj Auto?

A: We like the Bajaj Auto demerger story more than the two-wheeler story. The results were a bit disappointing on the two-wheeler side. Ten years back we were probably the first one to point out that Bajaj Auto’s return on operating assets was getting clouded over by the huge cash on its balance sheet. It’s a good thing that it is getting separated out.

The market never values an operating-cum-holding company and values it much better when it splits. Currently, some parts of the valuation for Bajaj Auto would be somewhere in the Rs 2,800-2,900 range.

Q: Are you a bit disappointed like the rest of the market on the whole insurance call option business because that is what lead to a Rs 400 sell-off from Thursday?

A: That means you cannot capture the entire upside. What would have also worked on the market are the results themselves on the operating side.

Q: What is the call on the market from here; this week it has been quite strong for it?

A: Some time back our call was that the market would touch a new high before correcting. Then in the middle, we were unsure whether the new high would come. Now, it looks like new highs would be made, but the bias still remains towards softness thereafter.

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