Can you bet on real estate stocks?

The contraction in consumer demand has affected almost all industries in the last couple of quarters, but the real estate sector has been the worst affected.

The ongoing slump in the aftermath of demonetisation and the implementation of Real Estate (Regulation and Development) Act (RERA) has been further exacerbated due to economic slowdown and muted consumer demand.

The risk associated with real-estate is that it is an extremely capital intensive business with significant needs for upfront investments that necessitates the use of borrowed money. During the past few years, the industry that heavily dependent on borrowing has been dried out of cash due to the ongoing NBFC liquidity crisis and restrictive funding from banks.

The sector is already facing several headwinds -- stricter regulatory environment due to the implementation of RERA and GST has forced the industry to be more formalized. Non-delivery of projects and unethical practices that were prevalent during the last few years have been checked to an extent forcing several real estate developers into bankruptcy.

Real-Estate being a cyclical industry performs well for a few years, with higher volumes, pricing, and margins leading to higher market valuation, followed by a depressing cycle, resulting in lower volumes, prices, margins.

While it is impossible to point out the length and depth of the cycle with any precision, one can’t deny that the sector has been in a negative cycle for a while now.

Data over the last 7-8 years shows that real estate transaction volumes became weak. Flattish to negative pricing trends have been prevalent across key cities, consequently, real estate stocks have widely underperformed and have lost money for their investors.

After few years of oversupply of inventories, there has been a sharp downtrend in new launches and prices have become more competitive, that has aided clearing up of the inventories built-up over the previous cycle and this shall pave the way for the next cycle upwards. Whether that happens in the next year or two remains to be seen; however, the direction seems to be clear.

Though the industry is bottoming out, we can’t expect any near time boom in the sector. Despite the price correction over the last few years, property prices are still elevated considering the rental yields.

This could be a rare opportunity for investors to bet on real-estate stocks, as the developers could do well, even though prices of underlying assets may not move much. This is because the surviving 20% developers will have the opportunities to cater to the entire market and grow volumes exponentially over the next 4-5 years.

When investing in real-estate stocks one should always have a long term outlook, one should scout for well managed listed players who are the leaders in their target geography, and have a track record of credible execution with on-time delivery and do have stellar customer trust.

Among these stocks, investors should look for companies with strong balance sheets and sensible capital allocation history. Some of these companies are currently trading around their book value, implying that investors can get an entry with the same terms as the promoter did decades ago and can derive all the goodwill and potential growth for free.

The sub-performance of the realty stocks over the last few years thus creates an opportunity for the investors to get in with an investment horizon of at-lest three years.

We believe that the sector has bottomed out and a recovery is around the corner. All the well managed real-estate companies will, therefore, be re-rated to discount the market conditions and would lead to handsome gains for the investors.

(The writer is Director, Wealth Discovery/EZ Wealth)