How to approach the real estate sector now?

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How to approach the real estate sector now?

The hottest space in the market for the last 12-15 months has been real estate. Manish Chokhani, Director, Enam Securities and Arvind F Pahwa, MD, JPMorgan Asset Management gives their views on how to approach the real estate sector now.

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Q: For those who are into development or rentals, do you accord a premium in terms of geography or location in those that focus on tier I cities or maybe even have a more pan-India presence versus the others?

Chokhani: Yes of course, for some one who is very region specific may tend to go through a boom in the cycle if a particular region gets over built. To step back a bit - think of this as a cement business. In theory, you can build out a cement plant for USD 60-70 million per million tonne.

But the reality is that the stock market seems to be valuing this at USD 150-200 per million tonne. This is happening because like real estate, there is a period of shortage and probably '06-'07 are bonanza years in terms of profits. One almost inevitably knows that in 2009, you will see oversupply here and if one is valuing it today or not.

So those are the set of dilemmas that one deals with and like a cement company, if you are only operating in Andhra Pradesh, as opposed to someone who is operating all over India, surely your valuations will be different.

Similarly if you are going to operate one plant and not expand as opposed to someone who is going to expand and build more capability and thereby become a larger leading player in the business, surely your valuations will differ as well.

So it is exactly the same valuation principles - it just seems to look like a new asset class. But I am sure markets will get its hand around it very quickly and it is probably in a simplistic sense a very easy sector to value.

Q: But if you had to look at investing in the listed stocks without naming any specifics, how do you marry the two? Do you think that it will move in tandem with the stock markets cycle or do you think it is part of the longer multi year run on real estate and hence invested it and hope to see even higher levels?

Chokhani: It is a multi year run and though one cannot agree with all the price, but again I want to just give you big picture here and not specific numbers right now. Our market cap for India is about USD 800 billion and one knows if you look across the region and across what is happening to our country and our GDP and so on, it is a very reasonable bet to say that 10-15% of market cap will belong to real estate type companies.

This is very much the way one could take a view very early on telecom or power and so on that these would be large significant portions of market cap. So in theory, there is USD 80-100 billion of market cap available for this space and there is appetite certainly from the capital markets side for people like that.

Today, probably, there is just Unitech , which is about USD 10 billion and the rest are really much smaller companies. A lot of this gap will get filled up by issuance but a couple of people, who like Arvind said earlier, if you are able build the right brand image and the right pan India presence, these people will get valuations, which are going to be disproportionate to what the rest of the pack will do.

Again very similar to the cement sector, you always have Gujarat Ambuja at a premium as opposed to somebody else. Similar things will happen here. I am not suggesting that the valuations today makes sense. It probably is the first burst of euphoria, where a sector has opened up - no one knows how to value it really and a lot of things are getting overdone.

As a value buyer, are you seeing margin of safety in most of these names? I would think not. Having said that, you don't need to necessarily look at listed ones because there are a whole host of companies, which are going to approach the market and that maybe another way to get into this space.

Q: A quick thought from you on how some of these listed companies are valued today because as we were discussing earlier some of these seem to be priced for a completely perfect scenario because they are getting market caps which are better than the land banks that they own at current market prices and at very high market prices, would you agree with those kind of valuations?

Pahwa: Real estate is the flavour of the month. So obviously, it is getting much more visibility compared to many other sectors. Again having said that, it goes both by the stock markets sentiment and as well as the basic demand in real estate.

For the real estate sector, both the things are doing very well today; the stock market sentiment is very positive, the sector variables are very positive. So looking at both these things, as on today, the valuation seems to be reasonable. But with one dip happening, how these valuations would change, I really cannot make any judgment on that.

But as I said earlier, being a cyclical business, there is bound to be some kind of an oversupply, which is again good and healthy for the market because till now you had a situation where vacancy rates in most places were practically zero or negative.

Buildings were pre-leased even before they were completed. Now, you will have a situation where the tenant has a choice to take the buildings on lease, you already have situations in many micro markets where there are lease free periods being made available for doing the interiors.