The hottest space in the market for the last 12-15 months has been real estate. It’s been phenomenal the way some of these stocks have moved up, much to the disbelief of most of the observers.

The rise has been absolutely astronomical in many of the real estate stocks from the start of this year. How do you value real estate stocks because most people do not seem to understand how to look at this sector and how to value companies here. While some look at cash flows, others look at land banks. But there is a little lack of clarity in how to look at this sector.

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.

According to Chokhani, offtake rate, selling price, developers' credibility, ability to deliver are key for residential property valuation. It is also important to factor in title issues while valuing property. Chokhani forecasts realty companies to account for 10-15% of market cap in few years.

Arvind F Pahwa believes that one needs to consider quality and the location of land bank for valuation. He feels that the current valuation of real estate companies is reasonable. He expects oversupply in the real estate market due to cyclicality of the business.

Excerpts from CNBC-TV18’s exclusive interview with Manish Chokhani and Arvind F Pahwa:

Q: Some say it's crazy, some say it’s still undervalued and some are just confused on how to do it - what is the best way to approach this sector now?

Chokhani: Well, all three are right. In a way, it's probably among the easiest things to value and if one breaks it down in common sense terms, there is a value for land and there is a land bank therefore, which is NAV based.

Then there is a developer who has a developer margin that normally should be cash flow based or a quick thumb rule that people use is EV/EBITDA. When you are able to lease out the whole aspect eventually into REET (Real Estate Excise Tax), which we still don’t have in India. They will effectively be valued as bonds giving you a fair stream of rentals. So if you break down companies on that basis, it is fairly simple, it is not so complex.

Q: What kind of a market cap or enterprise value would it give a business, which has 1000 crore of land bank. What is the right way - because right now, what the market is probably trying to do is, if you have 1000 crore of land bank, it could arrive at something close to Rs 1000 crore in terms of market cap as well?

Chokhani: Currently, the market seems to be valuing Rs 1000 crore more than it actually is. Let me give you some perspective - think of the cheapest space that any developer or land owner sells in the country. It would probably be an IT park, it’s probably the cheapest rental, probably Rs 35 a square foot for a month, thereby implying about a 4000-4,500 per square foot capital value for developed space.

If you knock out about Rs 1,500 odd for cost of development and about Rs 500 as developer margin, effectively the land acquisition cost to build an IT park, can be upto Rs 2000 per square foot. If you take that Rs 2000 per square foot and divide and make it back to an acre, which is roughly Rs 50,000 square foot an acre, in effect, one can buy land at 2000 times 50,000, which is is about Rs 10 crore per acre and still turn a profit.

Now to put that into context, one can buy agricultural land, which lot of our IT companies have done on the outskirts of Mysore or Bangalore, starting from Rs 10 lakh. So it’s literary a scale of 1:100 from unexplored, undeveloped land to land, which eventually becomes developed.

I am not saying that all the parks will get developed, will get sold and will get filled, so you will have a capacity mismatch there. But how do you value it - do you value it at Rs 1 crore per acre or at Rs 10 lakh per acre or at 10 crore an acre?

That’s really where the struggle is and I think the it's early days for the market. One doesn’t know how many of these will get built like it happened with malls, similarly with IT parks or a lot of townships and residential projects, which are coming up. That’s what everybody is grappling with.

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