· Non-transparent and illiquid market with significant regulatory controls that impede capital flows;
· Non-availability of quality data about the economy and the industry; and
· Professional and ethical standards, etc.
Segregation of real estate is depicted in the diagram given below.
In the residential division, liquidity is easy and low funding is required as most of the companies take money in advance. Commercial space is mostly leased out and fund requirement is high. In the hospitality division, operational freedom is mostly passed on to the user.
The increasing popularity of real estate in India has drawn the attention of both practitioners and academicians towards the intricacies of real estate and its valuation aspect. A wrong estimation of value of business may prove to be economically disastrous for either the buyer or seller. Some valuation models lay emphasis on accounting parameters (e.g. P/E multiple), some value firms on the basis of future cash flow (e.g. Shareholder Value Approach) while others attempt to value a firm on the basis of economic profit (e.g. EVA method). The basis of valuation is normally past performance and future prospects.
For old firms having sufficient past data and acceptable bases to estimate future growth prospects, valuation becomes less troublesome. But for Industry like real estate, having relatively no past record, no comparable data, no industry history and volatile growth prospect, are very difficult to value. Valuation on the basis of future earning capacity (e.g. Profit earning capacity value) or on net asset basis is fraught with criticism. P/E based valuation have three basic limitations:
a) Market price (P) of share is forward looking, whereas the EPS (E) is historical;
b) The relationship between EPS and market price has not yet been satisfactorily established; and
c) The EPS is subject to accounting distortions.
Of course the first criticism can be countered with an estimated EPS. But the typical way of valuing a firm on the basis of its own P/E or comparable P/E is not justified because this assumes the continuance of P/E multiple. The P/E itself undergoes frequent changes and hence using the past P/E or comparable P/E to find out future market value is not justified. Valuation of the firm on the basis of replacement value of its assets is used when the firm is liquidated. This method may be used to find out the break up value of the firm (i.e., if the firm ceases to continue its operations in the future). Another limitation of using asset based valuation model is that the value of a firm is not driven by market value of assets it owns but by the future cash generating capacity of the assets.
The biggest fallacy while valuing real estate companies is to look for common parameters to value these companies. Each company has a different business model and its own core competencies and skill set. Each company should be valued independently to ascertain the value of the assets and overall competency of the business model. Business models are unique for all companies.
· Location of Land Bank
· Low land cost
· Construction capability
· Product offering
A DCF-based NAV valuation seems more suitable than the P/E based valuation method which neither captures the value of the land bank (most critical resource in the industry), nor its high growth potential. Also, near-term profits (next 4-8 quarters) are largely determined by recent real estate prices and historic land costs and hence don’t fully reflect the future outlook. A DCF-based NAV methodology is better suited as it addresses these issues; it understates the value of the developer as it excludes terminal value (while all developers aggressively add to their land banks). As many companies have land parcels with development horizon of more than three years, their full value is not showcased in an earnings-based valuation. Moreover, the business models of companies are not similar, with each having its own mix of developmental formats (residential, commercial, malls, SEZs, construction, townships, hotels), rental incomes and price positioning. Ascribing similar earnings multiples would not justify the valuations of these companies. The valuations are further complicated due to want of proper management disclosures, lack of clarity on land banks and status of payments and receivables. In more developed markets, P/E and asset valuation methodologies are used for valuing real estate companies. P/E multiples can be used in developed markets as the business models are robust and the companies have an extensive track record. However, asset valuation still remains the underlying benchmark, given that globally, real estate investment trusts (asset owners) have larger market-cap compared with real estate developers having higher earnings.
P.S.: This article was contributed by Nitesh Kumar, an MBA from IMT Nagpur with dual specialization in Finance and Marketing. He will be joining Syntel, Pune in the near future. If you too want to see your articles in this space, then please mail me your work @ varun.parwal@gmail.com .. Looking forward to your contribution and Nitesh, thanks for helping me out so generously!
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