It may sound strange, but realty firms are perhaps still not good value despite 90 per cent price decline.
Military strategists often make plans to fight previous wars all over again in the future, overlooking technological advances and changed circumstances. For example, the French thought the fixed defences of the Maginot Line would help them win WWI-style battles of attrition in 1940. They ignored the impact of armour and air-power and forgot that improved road systems allowed faster troop movements.
Policy-makers and management thinkers are also frequently guilty of the sin of looking backwards in planning for the future. When, discontinuities arise as in the current situation, businesses that treat it like a normal if large, cyclical downturn may be wiped out.
One key factor is inter-connections between national economies and different sectors. Imbalances have meant rapid changes in trade balances and violent currency fluctuations. These will continue. There has already been an obvious negative impact on exporters in general, and on the IT/ITES industry in particular.
Another Indian industry that squarely faces discontinuity is real estate. Realty is not debt-free unlike IT. Of course, its exposures and consumers are domestic. But the sector has been completely caught on the wrong foot.
Most companies are over-leveraged. They started scaling up between 2004-08, and expected overseas capital inflows (now unavailable) to help complete ambitious projects. Most have murky balance-sheets since that is innate to the business.
The BSE Realty Index has corrected by about 85-90 per cent from its all-time highs. Not surprising since majors like DLF and Unitech have seen profits erode 70-95 per cent in October-December 2008.
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Anecdotally, the vast number of stalled project sites across the country is evidence of how cash-strapped realtors are. The increasingly desperate deals being offered in both commercial and residential segments also suggests demand has evaporated.
Prices have eased by 30-40 per cent. But to put it bluntly, prices may need to revert to 2004-2005 levels and mortgage rates may also need to drop back to 2004-05 levels before there is strong demand revival. That means about 300 basis point cuts in home loan rates and another 30-40 per cent reduction in real estate prices.
Quite apart from what such deep cuts would do to realtors, lenders could face a potential problem. Loans are generally up to 70-80 per cent of the value of secured assets. Hence, loans disbursed in 2007 and 2008 against real estate at valuations prevailing then, may need review if prices fall by 50 per cent or more. There would be "negative equity" if asset values drop below the value of disbursed loans.
The UK and the US saw tailspins in the late 1980s when such situations arose. Defaults became rational and endemic in negative equity situations. The US banking industry was almost wiped out in the so-called "Savings & Loan" crisis.
India is better-protected because ironically, it has a relatively larger black economy. The actual value of most land is more than that shown on lenders' books. But rising defaults are a possibility and given the Indian legal system, foreclosure will be a nightmare.
There are also basic problems with valuations of real estate companies. Future profits cannot be predicted from trends in P&L accounts. Realtors' viability depends on land banks. The costs of land development is less variable than cost of land acquisition.
A realtor with a large cheaply-acquired land bank is viable even if current profits are low. A company, which generates high profits by selling off most of its bank, may struggle to replace those assets if there's been price appreciation.
This is where the murky balance sheets come into the picture. It's tough to know how credible the stated land banks of listed companies are. That means difficulty in assigning credible valuations and in turn, difficulty in raising capital.
All this means that, horrifying as it may sound, real estate companies are perhaps not decent value even at 90 per cent price declines. There could be much more pain in store for the sector over the next year or two. This is why rumours of insider selling in DLF have caused panic in the recent past.
Whatever happens, the Indian real estate industry will never be the same again. It was hit with this drastic crisis at a point when it was over-extended. The survivors will be the one who emerge with newer, more robust business models. But it will be very difficult for outsiders to predict who those survivors will be.