Understanding the ground realty

MARKET INSIGHT: Mere possession of land banks is no yardstick to assess real estate firms.

An analyst with a longer memory than most, recently said that the current love affair with land banks reminded him of the 1999-2000 obsession with techs. On the face of it, it's an absurd comparison. There are few things more reassuringly solid than real estate and few things more virtual than infotech.

Yet, there is a similarity. "Mr Market" has uncritically assigned high valuations to land banks in the same way that he blindly assigned triple-digit PEs to the IT industry not too many years ago.

In 1999, companies in all sorts of disparate businesses multiplied valuations by adding "Infotech", "infosystems" or some such coined word with cyber-connotation to their names.

In 2006, companies derived similar benefits from owning land banks. Never mind that they often operate in sectors with little connection to real estate development.

It is one thing to hold potentially valuable real estate. It is another matter entirely to unlock that value.

One has heard statements that SAIL, for example, is undervalued because it owns the equivalent of several mid-sized towns. People, who buy the stock on that basis, ignore the fact that SAIL is not in the business of developing real estate.

Of course, real estate businesses can justifiably claim that land banks are valuable possessions.

One can even stretch the imagination and concede that Indiabulls' deliberate acquisition of a land bank offers partial justification for astronomical valuation.

Real estate companies ranging from Ansal to Anant Raj to Parasvnath to Unitech have all delivered outstanding returns in the first three quarters of 2006-7. Partly through being able to unlock value through projects; partly through the mere possession of land banks.

But how does one value a land bank? The practical problems render it an opaque, exercise. There are risks explicitly mentioned in draft red herring prospectuses of a rapidly corporatising industry. What's more, most Indian investor knows these problems since they differ only in scale with issues that most have faced.

First, there's an apples and oranges problem. Valuation per square foot differs even within metros - by several hundred percent between upmarket areas and slums. Valuations differ even more when it comes to Tier 2 and Tier 3 cities. When it comes to agricultural land versus urban land, the price differences are still larger.

In most cases, we don't have a clear break up of a given land bank. So, it's impossible to simply multiply acres into average price and arrive at consistent valuations. There is no such thing as an average price.

Then, there's the legal situation. Title is often disputed. Some land banks have been built on partial payments and "byanas" - the right of first purchase. Sometimes, it is through power-of-attorney sales or joint venture agreements between title holder and the real estate firm.

The legal system is clogged with disputes in such cases. Most lawyers make their bread and butter on such cases. This is true when one is speaking of relatively small family properties. Litigation is likely to occur on a gigantic scale when it involves thousands of acres.

Third, there are related financial problems of detailing cost of acquisition, project financing and IRR on projects. In some cases the cost of acquisition is unclear. The land has not yet been acquired or fully paid for.

Project financing isn't easy to come by. The gearing is usually high and the debt is long-term. Working capital needs are also high. What sort of IRR is likely to be generated on a given project? Again, we can't make educated guesses at average IRR though individual projects have generated IRRs of over 50 per cent.

You'll notice the lack of concrete numbers anywhere in this essay. There's a good reason for that. While numbers are available in plenty, most consist of unverifiable guesses.

What is most amazing is that anybody who has ever been involved in a small real estate transaction has grappled with these uncertainties. Isn't it delusional to simply punt and hope that these won't crop up on a larger scale?