The current article aims to highlight the critical aspects of the business of real estate companies. After reading this article, an investor would understand the factors that impact the business of real estate developers/builders and the characteristics that differentiate a fundamentally strong real estate company from a weak one.
Key factors influencing the business of real estate companies
1) Real estate is a fragmented industry with intense competition:
The real estate sector, which comprises residential, commercial (office & retail) and industrial (warehouses) segments, faces intense competition in all the segments.
The key reason for severe competition in the real estate sector is the presence of numerous small and large players both from organized as well as unorganized sections competing with each other for business. As a result, the industry is highly fragmented and each of the players is only able to control a small market share.
Rating criteria for real estate developers by CRISIL, June 2023, page 5:
The real estate sector is marked by a high degree of fragmentation, given a large number of small regional players with small market share.
The fragmented nature of the real estate industry is a global phenomenon because even the developed world like Europe, North America and Japan has small players dominating the sector.
European real estate rating methodology by Scope Ratings, January 2023, page 3:
European real estate industry is highly fragmented. Market participants often have smaller market shares
Key credit factors for the real estate industry by Standard and Poor’s (S&P), February 2018, page 5:
The real estate industry is fragmented, with most commercial real estate owned by individuals and small-scale operators.
The real estate industry is dominated by small-unorganized players because it has low barriers to entry for new players. If an individual/entity has required capital, then it can easily enter into real estate development because most of the key functions like construction, marketing, designing, procurement etc. can be easily outsourced.
Rating methodology for real estate by Rating and Investment Information, Inc. (R&I), Japan, September 2021, page 3:
barriers to entry are low because many of the functions required to manage the business can be outsourced.
The entry of new players is very easy, especially in the office leasing space where any entity with money can enter the field by acquiring any existing building.
Key credit factors for the real estate industry by S&P, February 2018, page 5:
There are few impediments to entering the business through acquisitions, other than capital.
Moreover, getting financing in the real estate industry is comparatively easy because the players have assets like land and buildings, which are considered high-quality collateral assets/security by lenders. Therefore, individuals/real estate players with land/buildings can mortgage them to banks and get money, which increases the competition in the industry.
European real estate rating methodology by Scope Ratings, January 2023, page 6:
entry barriers are lowered by the high industry fragmentation and generally good access to credit due to the collateral-eligible assets.
Global methodology for rating entities in the real estate industry by DBRS Morningstar, April 2023, page 11:
the deep pool of capital and long- established history of liquidity available for real estate entities to pledge core stabilized real estate assets as a source of funding that typically does not exist for other corporate industries. This source of funding has been demonstrable even at low points in the cycle in the case of institutional quality assets.
Due to the high-ticket size of real estate purchases, if the cost of any property exceeds the budget of the customer, then she looks for alternate options even though each real estate property is unique in terms of location and available views. Therefore, except for some large established players, most of the real estate players face a low pricing power and price-based competition is also present in the industry.
Rating methodology for real estate by R&I, Japan, September 2021, page 3:
competition among major companies is intense, and price frequently becomes a critical factor. Even when highly individual characteristics and little interchangeability of properties are taken into account, R&I evaluates the competitive environment to be somewhat challenging.
Nowadays, office and retail properties are facing further competition from trends of work-from-home (WFH) as well as online/e-commerce. As a result, large customers especially corporate clients put very strong pricing pressure on real estate developers.
This is especially true for retail malls where anchor tenants (large occupants that pull most of the crowd to the mall) usually pay very low rent than other tenants in the same property. At times, real estate developers even agree to rent out space to the anchor tenant for free so that they can easily lease the remaining area of the mall.
Global methodology for rating entities in the real estate industry by DBRS Morningstar, April 2023, page 4:
the fact that larger tenants pay little to no rent, and competition from non-traditional points on the value chain (e.g., direct-to-consumer retail from distribution channels) can be issues
It is not only the anchor tenant who negotiates very strongly with the retail mall developers. Other smaller tenants force the developers to put co-tenancy clauses in the rental/lease agreements. As per co-tenancy clauses, if the anchor tenant or other key tenant vacates the mall or a significant area of the mall is vacated (dark area), then these smaller tenants can reduce their rent payments significantly or simply terminate their agreements.
DBRS Morningstar North American commercial real estate property analysis criteria, September 2023, page 16:
Retail leases often have co-tenancy provisions that permit lease termination or significant rent reduction if certain tenants are no longer open for business at the property or a certain percentage of NRA (net rentable area) goes dark.
Due to such hard negotiation by tenants, regional/smaller mall developers end up offering a significant portion of vacant space in the malls to MTM tenants who pay very little rent. This is only to avoid the visibility of large vacant areas (dark areas) in the mall. As per DBRS Morningstar, at any point in time, a mall may have up to 15% tenants as MTM tenants.
DBRS Morningstar North American commercial real estate property analysis criteria, September 2023, page 22:
Regional mall operators typically fill vacant spaces with either MTM tenants or tenants on one-year leases. These tenants are often local businesses that invest little into their space and pay a fraction of the total rent and reimbursable expenses are paid by permanent tenants. Operators put these tenants in place to avoid substantial amounts of dark vacant space throughout the mall, which makes for a negative visual impression. Depending on the quality and performance of a mall, these tenants typically represent anywhere from 0% to 15% of total occupancy
Therefore, an investor would appreciate that the real estate industry faces intense competition in each segment be it residential, commercial, or retail primarily due to the presence of a large number of unorganized players.
However, recently, with the implementation of the Real Estate Regulation and Development Act of 2016 (RERA Act), the regulators have started enforcing stringent laws, which has created problems for small-time developers who are not able to comply with tough regulations. Therefore, now, the real estate industry has started witnessing signs of consolidation.
Rating methodology – real estate by ICRA, November 2022, page 3:
Real Estate Regulation and Development Act of 2016 (RERA Act), have resulted in consolidation of the industry, in turn benefiting larger developers.
Also read: How to do Business Analysis of a Company
2) Cyclicity in the performance of real estate players:
The real estate sector is highly influenced by the macroeconomic state of the market i.e. factors like interest rates, gross domestic product (GDP) growth rates, employment levels, availability of surplus income with customers etc. All these factors are outside the control of the developers and significantly influence the demand for residential, commercial, retail as well as industrial properties.
Rating methodology – real estate sector by CARE, March 2023, page 2:
The real estate sector is cyclical having direct linkage to macroeconomic scenario, interest rates and income levels.
The commercial segment of real estate also faces significant cyclicity because its customers i.e. office space occupants are corporations from different industries, which also get affected by economic downturns. As a result, reduced demand for office space from corporations hurts business prospects of commercial/office buildings.
European real estate rating methodology by Scope Ratings, January 2023, page 6:
commercial property companies face higher cyclicality due to their exposure to industries that are vulnerable to changes in demand.
The cyclicity in the real estate sector is a global phenomenon. Due to a combination of cyclicity and intense price-based competition, real estate prices may decline even up to 50% during an economic downturn, for example, in Hong Kong from 1997 to 2003.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 2:
Selling price competition can be intense, varying over the course of the cycle. So-called real estate bubbles have occurred at times…At the extreme, the U.S. market has seen peak-to-trough price declines of more than 30%. Moreover, prices in the Hong Kong market declined by over 50% during 1997 to 2003
The cyclicity in the demand for real estate properties creates significant problems for builders because real estate projects have a long gestation period of about 3-4 years. A builder may have launched a project during the upcycle phase of the economy; however, as the project progresses, the economy may change to a downcycle hitting the demand and financing for the project, which may even impact the economic viability of the project and the builder.
Rating methodology – real estate sector by CARE, March 2023, page 2:
A typical real estate project has a gestation period of three to four years and any adverse change in the macroeconomic factors in the interim period can affect the cash flows of the developer.
A real estate project is heavily dependent on sales/customer advances for its financial closure. Customers’ advances may constitute up to 70% of the total financing required for the project.
Rating methodology – real estate by ICRA, November 2022, page 11:
a large share of the funding mix in real estate projects being met through customer advances (typically 50-70%)
Therefore, when sales in any real estate project slow down, it creates a serious funding crunch for any real estate developer. This slows down the construction progress of the project, which further impacts the sales as customers tend to avoid buying in projects, which are facing delays. As a result, a vicious cycle of deteriorating financial position of the project starts.
Rating methodology – real estate by ICRA, November 2022, page 5:
Any delays in project execution can negatively impact collections from customers (which are generally linked to construction milestones) and saleability of projects, leading to a vicious cycle of lower funding availability that further constrains execution progress.
Apart from lower collections from sales, an economic downcycle affects debt funding for the project as well. Two factors play their roles here. First, banks usually disburse existing sanctioned debt to the project in proportion to the promoters’ contribution and sales’ collections i.e. if bank debt is 25% of the project cost and balance 75% is from promoters’ contribution and sales collections and the bank has already disbursed half of its loan amount, then it will stress on disbursing the remaining part of the debt only when the promoters’/sales collections have contributed their share in the project.
Rating methodology – real estate by ICRA, August 2019, page 7:
Weak sales levels can impact debt funding, given that banks and institutions usually disburse monies in proportion to the equity infusion and customer collections received, and hence delays/inability in bringing in the above could impair the ability of the project to draw down even the sanctioned debt.
Secondly, during an economic downturn, banks tighten their lending criteria and as a result, builders find it difficult to raise money from other banks. In addition, declining property values in the economic downturn further decrease the amount of money that a builder can raise by mortgaging its assets.
At times, the reduced fund availability has been so severe that it has led to the bankruptcy of builders.
Rating methodology by sector – real estate by Japan Credit Rating Agency, Ltd. (JCRA), June 2023, page 3:
When the market is stagnant, in particular, financial institutions tend to tighten their loan restrictions, and reduced fund availability has caused a series of bankruptcies in the past.
Therefore, a direct linkage to the economic cycles presents a very tough business environment for real estate developers. During the upcycle, the demand is booming and many new players enter the market and launch numerous projects. Most often, by the time these projects proceed to the implementation stage, the economic cycle changes to downcycle, and customers’ demand and funding slows down and the projects face a liquidity crunch leading to many builders becoming bankrupt and abandoning their under-construction projects.
Rating methodology by sector – real estate by Japan Credit Rating Agency, Ltd. (JCRA), June 2023, page 2:
High market volatility, however, results in an increase in new entrants when the market booms. When the market is sluggish, on the other hand, small and medium-sized companies whose finances are unstable tend to be ousted from the market, and continuing this business is considered difficult
Many times, investors may believe that commercial office/retail space developers with long-term lease agreements with tenants are protected from economic downturns. However, if the lease agreements stipulate regular rent increases whereas the business of the tenant is hurt due to the economic downturn, then there is a high probability that the tenant will resist rent hikes/renegotiate lower rent or refuse to renew the lease. This is especially true if the market rentals for new lease agreements have declined in the vicinity.
Rating criteria for commercial real estate and real estate investment trust by India Ratings, September 2023, page 4:
Long lease durations with the clients whose businesses face greater business volatility, may however suffer if the rental cost does not trend with economic conditions, and may result in higher tenant delinquency or forced breaking of leases if the rents are too different from the open market.
In addition to cyclicity, real estate developers also face seasonality in their business due to the preference of customers to buy properties during certain seasons/festivities and refrain from buying properties during certain other periods leading to fluctuating demand and business performance.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 4:
Apart from cyclical fluctuations, in certain regions demand is subject to a high degree of seasonality, and weather conditions can have a significant short-term effect on sales levels.
Real estate transactions are very high-ticket and most of the customers only purchase over their entire lifetime. Therefore, real estate developers do not benefit from repeat sales to existing customers and have to mostly find new customers to sustain their sales. In addition, during commodity price upcycles/high inflationary situations, when property prices are high, customers downsize their requirements/quality expectations and switch to other developers/locations as per their budget.
Therefore, this low customer continuity hurts real estate developers’ business and increases the impact of economic cycles on their performance.
Rating methodology for real estate by R&I, Japan, September 2021, page 3:
transactions are one-time sales to individuals and rarely lead to a continuing relationship…Because there are no definitive differences in the products and services provided, and there is little to prevent a customer from turning to another real estate company, on the whole customer continuity and stability appear to be somewhat low.
Therefore, cyclicity in the business of real estate developers due to linkage with the state of the economy as well as seasonality affects their business significantly.
Therefore, those real estate developers who have been in the business for a long period and have managed the business through multiple economic cycles definitely have a big advantage over new entrants in the industry.
Rating methodology – real estate sector by CARE, March 2023, page 3:
companies that have been through various business cycles are generally better placed when compared to peers with limited experience.
Also read: How to analyse New Companies in Unknown Industries?
3) Capital-intensive nature of real estate business:
Real estate projects are highly capital intensive as they require a large investment in land acquisition as well as for obtaining approvals that include payment of numerous costs and development charges to govt. authorities. This is in addition to an equally significant investment in construction expenses for the properties.
European real estate rating methodology by Scope Ratings, January 2023, page 3:
real estate industry is capital-intensive, with significant investment needed to buy or maintain properties.
Executing a real estate project requires deep pockets from developers because most of the spending at the initial part of the project i.e. land acquisition and getting approvals must be funded by the developer on her own/via equity funding because lenders usually do not fund land acquisition making debt unavailable at this stage.
Rating methodology – real estate sector by CARE, March 2023, page 6:
real estate business is capital intensive in nature and the entities require huge capital during various phases of project construction. The acquisition of land for a project is more often funded through the promoter’s contribution, while the construction of projects is funded through external sources.
In fact, most of the costs of a real estate project like land, approvals costs and construction materials are fixed and developers cannot change a lot in the cost dynamics without impacting the underlying quality of the project making real estate projects’ cost structure inflexible.
As a result of rigid and high-cost structure, improving sales efficiency and selling price is more important for improving profitability instead of obsessing about cost controls.
Rating methodology by sector – real estate by JCRA, Japan, June 2023, page 2:
the industry generally carries a heavy burden of fixed cost…Because most such costs are determined by the start of a project, ensuring adequate sales is more important in terms of profitability than controlling costs.
In fact, it has been observed that those real estate developers who claim to spend a lower amount of money on construction costs, ultimately, end up spending a higher amount due to cost overruns later on; thereby, impacting the financial health of the project.
Rating methodology – real estate by ICRA, November 2022, page 8:
construction costs for projects with similar specifications are typically comparable. Lower-than-comparable costs could also imply a risk of cost overrun at the later stages and lower eventual profitability.
A real estate project involves numerous counterparties transacting with the developer like multiple customers (many times, going into thousands), vendors etc. Therefore, once a project is launched and starts the execution phase, any failure on the part of the developer in correctly estimating the financial viability puts the money of so many counterparties at stake that it becomes very difficult to sort out the messy situation that results.
Moreover, most of the projects that are funded by lenders stipulate an escrow mechanism where lenders control the usage of sales receivables and typically use a part of sales receivables for their loan repayment. Therefore, when builders face a financial crunch and their projects’ execution is affected, lenders tighten their control on escrow accounts and start using a higher share (sometimes 100%) of cash inflow from customers for their loan repayments.
This further reduces the cash inflow available to the developer to manage its financial situation to come out of it. Therefore, once a developer mismanages its real estate project, then it is very difficult for it to revive the situation and come out of it.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 4:
costs associated with suspending construction in progress may be substantial.
In India, there have been multiple cases where real estate developers failed in proper planning and execution of their projects and when they abandoned their projects, then due to innumerable litigations and disputes, they ended up in prison. Promoters of Unitech group and Amrapali group are a few of the prominent names who are currently in jail due to mismanaging their real estate projects.
ED arrests Unitech promoters Ajay, Sanjay Chandra in money laundering case: Economic Times
SC sends Amrapali CMD, 2 directors to police custody for cheating homebuyers: Times of India
Each real estate project involves an investment of significant capital and in addition, it leads to sales/revenue only for a couple of years until its inventory is fully sold. Thereafter, a real estate developer has to launch and execute new projects so that it can maintain a continuous supply of saleable units.
As a result, real estate companies need to continuously invest in land acquisition as well as keep a pipeline of projects at different stages of construction so that they can continue to sell units and generate revenue. Otherwise, once a project is completed and sold, the business of a real estate builder may come to a halt.
This requirement of continuous investment in land and under-construction properties makes the real estate business further capital intensive especially increasing the burden of working capital i.e. inventory of units and receivables.
Carrying a large amount of unsold inventory of real estate units exposes the builder to the risk of inventory loss if the economic cycle changes to a downturn.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 4:
To meet demand, homebuilders and developers must maintain sufficient land inventory (through direct ownership, purchase agreements, or the use of options) and work-in-progress inventory. This requires significant investments in working capital…In a sudden downturn, it also exposes homebuilders and developers to valuation losses and burdensome carrying costs related to unsold land and properties.
Many times, builders consciously decide to hold on to the unsold inventory in order to sell it later when the project is nearing completion so that they can sell it at a higher price to increase the profitability of the project. However, at times, this may prove counterintuitive because, if by the time the project is complete, the economic cycle turns to downcycle, then the high unsold inventory will put an immense financial burden on the builder who will be forced to sell it at a discount leading to reduced profitability or even losses.
Rating methodology – real estate sector by CARE, March 2023, page 6:
often the intention is to hold the inventory in order to take advantage of rising prices; however, at the same time huge unsold inventory imparts pressure to sell the inventory at lower prices in order to secure the payments thereby exposing the developers to pricing risk.
A real estate developer needs to continuously keep on spending money on expensive physical assets irrespective of its segment i.e. residential or commercial.
Rating methodology for real estate by R&I, Japan, September 2021, page 5:
To maintain and strengthen the earnings base in the leasing business, continuous, new investments are indispensable.
Also read: Operating Performance Analysis: A Simple & Complete Guide
4) A large size of operations helps real estate developers:
Developers who have a large size of operations enjoy numerous advantages like economies of scale where they are able to spread their administrative costs over a large number of real estate units. They also enjoy a higher negotiating power over suppliers due to the large size of their orders and in turn, get lower prices.
Property industry – key success factors by Pefindo, Indonesia, November 2022, page 1:
company with strong market position tends to have stronger bargaining power to contractors and customers.
Due to their large size of operations and financial strength, large real estate companies can get access to large land parcels whose development can require enormous capital. Other schemes like large redevelopment projects also favour large developers because an enormous amount of resources is required for their execution.
Rating methodology by sector – real estate by JCRA, Japan, June 2023, page 3:
In public tenders for large redevelopment projects, large companies having rich experience and expertise in development that are ranked high in the industry have a more competitive edge
Similarly, large real estate companies provide an investment opportunity for equity investors (private equity etc.) as well as large lending opportunities for banks etc. Therefore, they are able to get access to cheaper capital/sources of funds.
In addition, large real estate developers attract better employee talent as well as better contractors for project completion.
Additionally, large developers usually have a presence in many different segments like residential, commercial, property management & services, brokerage etc. Therefore, they have a better understanding of the end market, which helps them make better strategic decisions.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 6:
Companies with greater scale and market shares may be better able to attract capital to support growth, garner economies of scale, enjoy better access to well-situated land parcels, garner some pricing advantage, retain access to the best sub-contractors and vendors, maintain better sales performance amid adverse market environments, and support investment in systems to enhance sales effectiveness and better understand its target end market.
At the same time, many large developers have unencumbered/non-mortgaged land and properties, which they can offer as collateral to lenders and get money even during an economic downturn, which increases their financial flexibility to better handle economic slowdowns.
Rating methodology – real estate by ICRA, November 2022, page 10:
Financial flexibility could arise from factors such as an entity’s large scale of operations with strong financials, large, unencumbered cash flows, unencumbered assets and the flexibility to borrow against such assets
Even though large-sized developers enjoy numerous advantages at a company level; however, at the level of sales in individual projects, the advantages of a large developer are not very high because, in the real estate industry, each project competes individually for customers based on its location, configuration, ticket size etc.
Rating methodology by sector – real estate by JCRA, Japan, June 2023, pages 2-3:
Each business in the real estate industry competes individually in each area or property, and particularly housing sale and agency business do not necessarily require a high market position to be competitive.
So, a large size of the real estate developer may not give it an exorbitant pricing power.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 10:
scale may afford the company only limited pricing power
Similarly, a real estate developer with a large size and presence in multiple geographies may not enjoy a very high competitive advantage at the level of sales in each individual property/project. This is because in real estate customers’ preferences are highly specific in each small micro-market and many times, regional developers display a better understanding of local preferences than large national players.
In addition, the focus/preference of customers on a specific location makes it necessary that developers see each micro-market separately for demand and supply instead of clubbing the supply of entire nations/large regions.
Rating methodology for real estate entities by Infomerics Ratings:
real estate business is a regional game and hence, regional demand-supply dynamics is very important.
Rating criteria for real estate developers by CRISIL, June 2023, page 3:
As the real estate segment is typically fragmented, market share in the relevant micro market is taken into consideration instead of the industry as a whole.
Nevertheless, large real estate developers enjoy advantages like the ability to gain premium and large corporations as customers due to their specific needs for high-quality (grade A) and large-sized units.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 3:
A larger scale is normally indicative of better financial flexibility, access to capital, track record and ability to attract marquee clients, which typically have a requirement for large areas.
In addition, due to a large scale of operations, large real estate developers are able to achieve better diversification across many parameters like geography, and business segments: residential, commercial, retail etc.
European real estate rating methodology by Scope Ratings, January 2023, page 7:
Large size often goes hand in hand with solid diversification in terms of geographies, sectors and tenants.
Therefore, in the real estate industry, even though the large size of operations provides many advantages to the developers; however, at the same time, due to the regional nature of the industry, smaller players with a strong presence in the micro-market also enjoy strong business positions.
Also reading: Margin of Safety in Stock Investing: A Complete Guide
5) A strong brand and market position is a strong competitive advantage for real estate developers:
A real estate developer with a well-established market position and a strong brand benefits in multiple aspects.
The first advantage of strong brand equity is that the developer is able to achieve large sales in its projects quickly i.e. at an early stage of project development. As a result, it can meet a significant portion of its project cost using receivables from sales that it had already done; thereby reducing its reliance on future sales and, in turn, lowering the funding risk for the project.
Rating methodology – real estate by ICRA, November 2022, page 4:
With a large share of the funding mix in real estate projects being met through customer advances (typically 50-70%), a superior market position can translate into relatively faster sales and hence, reduced funding risks for the project.
As customer advances are the lowest cost of funds for real estate developers, a higher proportion of customer advances in project cost also improves the profitability of the project.
Developers with a strong market position enjoy a higher bargaining power with all the counterparties. They are able to attract better customers, investors, and lenders as well as easily tie up with financiers for home loans for their projects. The real estate sales channel i.e. brokers are happy to sell units in projects of such developers due to a strong demand from customers.
Rating methodology – real estate by ICRA, November 2022, page 4:
positive correlation between the market position of a real estate player and its ability to attract customers/brokers, engage with key lenders/investors, and get projects approved for home loans from banks/housing finance companies.
Due to strong demand from customers, builders with strong brands are able to maintain sales even during stagnant markets/downturns and can better handle economic cycles.
Rating criteria for real estate developers by CRISIL, June 2023, page 6:
Developers with strong market reputation tend to have better capability to withstand cyclical downturns and ensure higher degree of business stability. This allows them to sell projects or lease inventory even when the industry outlook is tepid
The higher brand equity of a developer results in its properties selling at a premium price over competitors within a micro-market.
Rating methodology – real estate by ICRA, August 2019, page 3:
The brand equity enjoyed by the REE is reflected by the premium earned over the market rate and customer preference for the REE’s projects over similar competing projects.
However, still, developers with an established brand are also not fully protected from the vagaries of the real estate industry. This is because customers tend to prefer location and budget constraints significantly while making real estate purchases. Therefore, if a well-known developer launches a project in a less-desired location, then it may not see a great response whereas another developer with a lower brand positioning may see a good demand for its project if it is in a prime location. This is because in real estate, at the end of the day, each property competes for itself.
Rating methodology by sector – real estate by JCRA, Japan, June 2023, page 2:
Meanwhile in condominium sales business, while brand power and product planning capabilities are important, property locations and selling prices are more important in terms of competition…Any advantage based on company size and brand power, therefore, is not necessarily absolute, and competition develops for each individual property
Also read: Credit Rating Reports: A Complete Guide for Stock Investors
6) Diversification brings strength to a real estate developer’s business model:
The real estate business is highly cyclical due to the linkage of its demand with the economic growth cycle. As a result, the earnings and cash flow performance of real estate companies witness significant volatility.
To reduce the impact of cyclical fluctuations, reduce risks and smoothen out business performance, real estate entities tend to diversify their operations along different aspects like geography, segments, customers, land acquisition strategies etc.
Global methodology for rating entities in the real estate industry by DBRS Morningstar, April 2023, page 8:
A high degree of diversification tends to help a company mitigate its exposure to cash flow volatility caused by a concentration in geographic regions (e.g., regional market dynamics, climate, and weather risks), subsectors, or in specific subcategories, properties, and counterparties (i.e., tenants or industries).
6.1) Geographical diversification:
Real estate developers who are present in multiple markets/geographies are in an advantageous position because they are protected from slowdowns, changes in customers’ preferences, and social, political, and weather-related risks limited to any single geography. This strengthens their business model.
Rating criteria for real estate developers by CRISIL, June 2023, page 7:
Geographical diversity becomes important as demand-supply dynamics in real estate tends to be local in nature. A developer operating in multiple geographies will, therefore, be better protected against slumps than the one limited to a single geography, irrespective of the type of properties.
6.2) Diversification in multiple business segments:
Real estate companies, which operate in diverse business segments like residential, commercial (office and retail), industrial (warehouses) etc. are able to reduce the impact of demand slowdown in any single business segment along with benefiting from the unique characteristics of each segment.
For example, commercial projects generate regular cash flow via rental/lease income whereas cash flows from residential projects are lumpy, and clustered with the launch of units for sale. At the same time, residential projects have the benefit of generating cash flows even before the project is completed whereas commercial and industrial projects generate cashflow only after completion of the project.
Rating criteria for real estate developers by CRISIL, June 2023, page 6:
Commercial real estate projects have a consistent revenue stream in lease rentals, whereas revenue from residential real estate projects can be lumpy…Commercial projects generate cash flow after project completion, whereas sale proceeds from residential projects start pouring in during the construction phase.
Within the commercial segment i.e. office and retail, the cashflow income from office properties is comparatively more stable with a fixed rate of income whereas in the retail segment, cashflow is volatile as they are mostly linked to sales of tenants via revenue sharing agreements.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 2:
Cash flows from office properties are usually seen to be more stable and predictable, given the longer lease terms, stickiness in lease renewals, fixed rate agreements and relatively lower vulnerability to general macro-economic trends. On the other hand, leases in the retail segment are subject to various additional risks such as variable rent rates (due to revenue share arrangements), shorter lease terms
However, if a company focuses on commercial (office, retail) properties on the “for sale” model, then the saleability/market risk is higher than residential projects because commercial units are typically high-ticket and have a lesser number of target customers. Therefore, unless the builder has tied up its commercial units in advance i.e. presales or is making a building customised for a client, it has a higher risk than residential projects.
Rating methodology – real estate by ICRA, March 2017, page 3:
market risks associated with commercial real estate properties tend to be higher on account of the narrower target customer segment and larger ticket size per transaction.
There is another business segment of real estate, industrial segment properties (warehouses), which require less capital and are more profitable because their operating costs are lower when compared to residential, office and retail buildings.
Global methodology for rating entities in the real estate industry by DBRS Morningstar, April 2023, page 5:
industrial segment tends to be less capital intensive, with lower land and construction costs…maintenance and operating costs are low and lead to relatively high profitability
Therefore, a presence in different business segments helps the real estate developer reduce the risks of any single segment. During the Covid pandemic, while recovering, office, industrial and residential segments recovered earlier than the retail segment; thereby, benefiting the developers present in multiple segments.
Rating methodology – debt backed by lease rentals discounting by CARE, March 2023, page 7:
stability of cash flows can also vary depending on the industry segment (i.e., retail, office or warehouse) which was observed during COVID-19 wherein the retail segment recovered at a slower pace compared to other segments.
Also read: How Companies Manipulate Cash Flow from Operating Activities (CFO)
As a result, those developers who are present in multiple business segments (residential, commercial, industrial etc.) can recover their business by focusing on segments that are doing good at any point in time.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 9:
ability of a developer to switch its focus between property segments–between residential and office properties, for example–to adapt to changing market conditions can be an important source of competitive advantage.
Similarly, there are real estate developers who are also present in ancillary services like property management, brokerage/sales channel, investment management (real estate investment trusts, REITs) etc., which lead to fee income. These business activities mitigate the cyclicity in their business model as well as allow the developer to get more insights into customer behaviour and market trends that help it make better strategic decisions in core real estate activities.
Rating methodology for real estate by R&I, Japan, September 2021, pages 4-5:
“fee type” operations including brokerage, property management and fund management…being involved in a wide range of businesses strengthens a firm’s ability to gather information…This leads to improving the accuracy of investment decision-making and enhancing land purchasing and property leasing and sales skills as a result, and helps to mitigate business risk.
6.3) Diversity of projects at different stages of completion:
Real estate projects especially residential ones have a limited revenue-generating life. Once all the units are sold, then there is hardly any future revenue visibility for the developer. Therefore, developers that have a pipeline of “for sale” residential and commercial projects are ready at different stages of construction to maintain sales visibility.
Rating criteria for real estate developers by CRISIL, June 2023, page 5:
healthy balance between projects in the under-construction stage and the cash flow generating stage are critical indicators of the overall operational efficiency of developers.
In addition, even after completion, commercial projects take about a year to achieve reasonable occupancy rates and thereby, stable cash flows. Therefore, developers who focus on leasing office/retail properties also need to have a pipeline of properties at different stages to consistently grow their rental income.
Rating methodology – lease rental discounting (LRD) by ICRA, August 2019, page 3:
New properties may take up to 6-12 months for stabilisation of operations, during which time occupancy may be sub-optimal.
Moreover, a developer needs to pay attention that its project portfolio is not concentrated in either early-stage projects or near-completion/late-stage projects. A concentration of early-stage projects where sales activity has not picked up will lead to high funding/execution risk because sales activity that will bring in customers’ receipts will pick up as construction progress is visible.
On the other hand, if most of the projects are nearing completion, they may see good sales; however, these sales will be only for a limited period until all the units are sold.
Rating criteria for real estate developers by CRISIL, June 2023, page 8:
A project portfolio skewed towards early-stage projects means the developer is exposed to significant implementation and funding risks. On the flip side, a project portfolio skewed towards near-complete projects ensures stable cash flows in the near term, but compromises on cash flows in the long term.
Once all the near-completion projects are fully sold, to generate revenue growth, the developer might be inclined to launch a lot of new projects simultaneously, which will lead to an increase in execution risk in addition to leverage because, at the initial stage, projects may not see good sales response.
Rating criteria for real estate developers by CRISIL, June 2023, page 8:
Besides, the developer would have to launch several new projects in a short time to build an inventory to sell, which can lead to a sudden spike in project-related risks and leverage. A steady pipeline of projects across multiple stages is most favourable.
Also read: Inventory Turnover Ratio: A Complete Guide
Therefore, real estate developers who have a mix of projects at different stages have an advantage. Such a situation also helps the builders in supporting poorly performing projects with low sales responses by utilizing money from good-performing projects. Nevertheless, with the implementation of RERA, developers can only use 30% of the money of a project for other projects as the law mandates that 70% of sales receipts of any project must be used for the same project.
Rating methodology – real estate by ICRA, November 2022, page 5:
Operational cash flows in projects that are performing well can be a source of cash flow to support relatively weak ongoing projects. However, the RERA Act of 2016 imposes a cash flow ring-fencing mechanism, with 70% of the collections to be received in the project escrow account and withdrawals permitted on the basis of the cost incurred on the project.
6.4) Diversity in the customer base/profile:
Real estate developers who have multiple clients in their office/retail properties benefit from relatively stable earnings and lower vacancy risk when compared to the ones relying primarily on one or a handful of tenants for rental income.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 5:
The higher the degree of concentration, larger would be the reduction in occupancy ratio and debt coverage ratio, should the tenant vacate after expiry of the lock-in period. A diversified and reputed client profile reduces the dependence of cash flow on a few tenants, thus mitigating the risk of a delay in rental receipt from any of the tenants.
Even within multiple customers in office/retail properties, those developers whose customers are from diverse industries are better placed than the ones whose customers are from single/limited industries (called solid sector diversification). This is because different industries are affected differently during phases of the economic cycle and therefore, all the customers may not suffer in their business at the same time.
European real estate rating methodology by Scope Ratings, January 2023, page 8:
Solid sector diversification (measured by the percentage of revenues generated by a specific tenant’s industry…) is also a positive rating driver for a property company. Since the economic cycle affects sectors differently, spreading activities across various sectors tends to reduce cash flow volatility.
Diversity in the underlying industry in tenants helps developers of commercial properties because due to their nature of business, different tenants become profitable at different levels of footfall/occupancy, which influences the vacancy risk in the commercial property. For example, in retail malls, movie theatres in addition to being one of the major crowd pullers, are profitable even at 20%-30% occupancy levels.
DBRS Morningstar North American commercial real estate property analysis criteria, September 2023, page 21:
movie theaters, which can be successful at occupancy costs between 20% and 30%
Movie theatres in retail malls are usually tenants with a low vacancy risk because before commencing their operations, they invest a significant amount of money in customizing the place as per their requirements, and do fit-outs. Therefore, they tend to have long-tenure lease agreements to recover their costs.
As a general rule, among commercial properties (office, retail etc.), the ones that are offered bare shell by the developer in which the tenant has to invest a lot of money for fitouts etc. see lower vacancy risk than warm shell/fully fitout properties.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 4:
Facilities let out on a fully fitted basis with no investment made by the tenants entail larger vacancy risk in comparison to the facilities wherein the tenants have made substantial investments towards fit-outs and interiors.
It is essential for a real estate developer to have customers/tenants from diverse groups because in commercial properties especially retail malls, developers have to remove those tenants/outlets that are not getting sufficient traction/footfall. The presence of outlets, which do not get good footfall hurts the image of the mall as well as is a financial loss to the developer who relies on revenue sharing with tenants of its mall.
Rating criteria for real estate developers by CRISIL, June 2023, page 6:
In case of retail malls, the track record of churning tenants is also assessed; as malls usually have revenue share agreements with tenants, they tend to push out non-performing tenants to effectively manage revenue and footfalls.
Similarly, real estate developers that target customers from diverse groups like different income groups are better placed because demand from high-income group customers as well as demand for premium properties (grade A) is relatively stable during downturns.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 2:
In some markets, higher-priced end-market segments have experienced less cyclicality in demand and pricing than lower-priced segments
European real estate rating methodology by Scope Ratings, January 2023, page 9:
A high-quality asset, such as a ‘grade A’ or ’core’ building located in the central business district of an internationally significant city, tends to achieve higher occupancy rates, more stable cash flows, higher profitability and, therefore, less peak-to-trough price volatility compared to lower-quality assets.
Along similar lines, investors who focus on diverse groups of customers like financial investors and end-users are also able to benefit from higher profit margins from investment properties and relatively stable demand from end-user-focused properties. End-user-focused properties face relatively lower volatility than investor-focused properties.
Rating methodology for real estate by R&I, Japan, September 2021, page 2:
volatility of the property investment market targeting investors is greater than that of the market for properties sold for residential purposes.
Rating methodology – real estate sector by CARE, March 2023, page 2:
mix of customers into end-users and investors is also assessed as these have bearing on the overall cancellations. Higher proportion of end-users in a project is viewed favorably.
Also read: Receivable Days: A Complete Guide
6.5) Diverse land aggregation strategies:
Real estate builders usually follow two approaches for aggregating land for their projects. The first is the outright purchase of land and the other is the joint development agreement (JDA) model where the landowner is made a partner in the project and is paid in the form of a share of built-up area/residential units in the project.
The JDA model does not require the developer to make large financial payouts for the land at the early stage of the project; thus, it is an asset-light strategy with a lesser risk. On the other hand, outright purchase of land requires large capital investment; however, it also brings in a higher profit margin to the builder in the project.
Rating methodology – real estate sector by CARE, March 2023, pages 4-5:
Asset light models, through joint development agreements (JDA), enable developers to significantly increase the scale of operations without excessively leveraging their balance sheets, while land aggregation on the other hand ensures that the developer does not have to share part of the revenue/profits with a third party, albeit at the cost of considerable investment for the acquisition.
In addition, when a builder follows a land aggregation strategy by outright purchase of land, then it ends up creating a large land bank where many land parcels are not developed for many years/decades. In such cases, as land prices appreciate in the region, the developer ends up holding many land parcels bought in the past at very low costs. This gives the developer the advantage of low costs in the projects where it has a lot of pricing flexibility to beat its competition from nearby developers who might have bought land recently at high prices and thus do not enjoy low costs.
Rating methodology – real estate by ICRA, November 2022, page 6:
Other factors which are important while assessing the land banks are their historical cost as the developers that would have acquired land at relatively lower costs would have had a higher flexibility in pricing the final products.
Also read: Asset Turnover Ratio: A Complete Guide for Investors
7) Significant regulatory risk faced by real estate companies:
Developing a real estate project requires numerous approvals for planning and construction from different regulatory authorities like changing of land use, local municipal corporation, airport authority, environment ministry, heritage department, fire department as well as various other utility offices.
Rating methodology – lease rental discounting (LRD) by ICRA, August 2019, page 2:
Real estate projects are subject to significant regulatory risk on account of the various approvals that are required from government bodies for the construction and sale of buildings.
Obtaining these approvals is a highly resource-intensive and time-consuming procedure and generally acts as an entry barrier for new players to enter the industry.
Key credit factors for the real estate industry by S&P, February 2018, page 6:
Barriers to entry by means of development are generally more significant, given the government permitting hurdles that must be overcome
The regulatory oversight of the real estate industry in India has increased since the implementation of RERA in 2016. Now, developers have to register their project with RERA before they can launch it for sale. Moreover, a project can be registered with RERA only after all major approvals are obtained.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, pages 3, 5:
regulatory oversight on the real estate sector has increased significantly with the passing of the RERA Act
RERA registration…is taken after the receipt of all other critical approvals such as building plan sanction, environmental clearance, airport authority approval, fire authority approval, etc.
Therefore, if a developer is not able to obtain govt. approvals in time, then it can have significant financial and reputational effects.
Once the basic approvals are in place, even then, govt. regulators keep tight control on the progress of real estate projects. Construction permissions are usually given in parts as the developer achieves multiple milestones in the project.
The tight regulatory environment in the real estate industry is a global phenomenon. For example, in Shanghai, China, a builder cannot begin sales unless it has reached two-thirds of the planned height in construction.
Key credit factors for the homebuilder and real estate developer industry by S&P, February 2014, page 11:
in Shanghai, China, according to local regulations, developers of high-rise residential buildings need to reach a minimum two-thirds of a building’s planned height before pre-selling can commence
In India, RERA has stipulated sample builder-buyer sales agreements, which stipulate penalties in case the builder is not able to meet project completion timelines. If the builder violates any of the RERA regulations, then it may face hefty penalties of up to 10% of the project cost.
Rating methodology – real estate by ICRA, August 2019, page 4:
Any violations of the provisions of the RERA Act, including delays in handover of the projects, may also invite monetary penalties of up to 10% of the project cost.
In addition, another regulation, the Insolvency and Bankruptcy Code (IBC) recognizes home buyers as lenders in the project and therefore, buyers can now start bankruptcy proceedings against the builder in the court if it delays the project.
Rating methodology – real estate by ICRA, November 2022, page 3:
Insolvency and Bankruptcy Code, provide homebuyers the status of financial creditors, thereby granting them the right to initiate insolvency proceedings against developers who have not fulfilled their commitments under the sale agreements.
Apart from RERA and IBC, there are numerous regulations related to land ownership and usage, which present a tough challenge for real estate developers. Due to complex regulations, many land transactions face disputes and litigations leading to project delays and time and cost overruns.
Rating methodology – real estate by ICRA, November 2022, page 3:
legal status of the title of the underlying land for the project can also be subject to litigation and poses a major risk to developers and buyers in real estate projects
The regulatory costs while dealing with real estate necessitate that even lenders while recovering their money by selling their collateral assets must keep these costs in mind.
European real estate rating methodology by Scope Ratings, January 2023, page 3:
Liquidation costs mainly represent the following: 1. Legal costs, 2. Notary costs, 3. Broker costs, 4. Real estate transfer tax 5. Special servicer
Real estate projects face tough environmental regulations, which are continuously changing and becoming more stringent as time passes. Apart from direct impact in terms of obtaining environmental approvals for the building, developers are also impacted indirectly by tight environmental regulations for its vendor industries like building material suppliers e.g. cement, steel, tiles, wood/furniture etc.
Rating methodology – real estate by ICRA, November 2022, page 12:
The real estate segment is exposed to risks of increasing environmental norms impacting operating costs, including higher costs of raw materials such as building materials and cost of compliance with pollution control regulations.
Also read: How to do Business Analysis of Steel Companies
Ever-changing environmental norms affect not only new applications; they also impact the licenses already obtained by developers for projects, that are in the planning or construction stage. This may have a serious impact on existing projects of developers.
Rating methodology – real estate by ICRA, November 2022, page 12:
Impact of changing environmental regulations on licences taken for property development could also create credit risks.
Real estate developers also face social risks due to labour-intensive construction processes as well as highly people-oriented operations and sales. Developers need to pay special attention to labour relations, strikes, union-related issues, accountability towards customers etc. as adverse events may impact the reputation as well as the financial position of the developer.
Rating methodology – debt backed by lease rentals discounting by CARE, March 2023, page 8:
Real estate being a labour-intensive industry, social risks such as employee welfare, labour relations, accountability towards customers, social responsibilities, etc…short to medium-term impact on reputation, consequently translating into impact on future earnings and cash flows.
8) Funding risk faced by real estate developers in projects:
Real estate projects usually meet their financing requirement from three sources: promoter contribution, customers’ receivables, and debt. Out of this, customers’ receivables form the maximum part of about 50%-70% of the project cost.
Real estate developers face tricky situations in assessing funds from each of these three sources.
The promoter’s contribution is usually required at the initial stages of the project for land acquisition and obtaining regulatory approvals. This is because usually, bank funding is not available for land acquisition. Therefore, either the promoters have to bring in their personal funds or raise quasi-equity from private equity (PE).
PE funds, though might seem like equity, are in the form of high-yield debt where the promoter has to compulsorily provide an exit/buy PE stake at the maturity of its agreement tenure. Therefore, in case, the project does not get a good response from sales, then the real estate company may face difficulties in giving an exit to PE or in refinancing this debt/quasi-equity.
Rating methodology – real estate by ICRA, August 2019, page 7:
The funding in the real estate sector also comes as PE, which may assume the form of debt or quasi debt since an REE may be obligated to provide an exit to investors with assured returns…nature of repayment obligation which may fall on the REE or its promoters, resulting in refinancing risk…any promised coupon/amortisation during construction period may impact the REE’s liquidity as such investments generally carry high coupons/yields
Customers’ receivables form the biggest source of funding for project costs; therefore, if a project does not get a good sales response, then its financial closure comes under question and it faces liquidity constraints that lead to construction delays, which, in turn, lead to a further sales slowdown. The project enters a vicious cycle of liquidity crunch and construction delays.
Rating methodology – real estate sector by CARE, March 2021, page 6:
Higher reliance on customer receipts is generally viewed unfavourably as this could lead to cash flow mismatch and later developer may have to rely on debt/external funding to meet the balance project cost.
In order to generate sales in projects where demand is low, real estate builders come up with numerous marketing schemes in which builders incentivise customers by subsidising the interest cost of their home loans or by deferring the payments until possession etc.
Rating methodology – real estate by ICRA, August 2019, page 8:
Cash flows are also adjusted for the units sold under various marketing schemes such as possession-linked plans, subvention plans, etc. where either the cash inflows are back-ended or interest cost has to be borne by the developer on behalf of the customer.
All these schemes put a burden on the cash flows of the builder and impact its profitability.
In addition, if a project generates lower sales, then the cash inflow from customers’ advances suffers, which, as discussed earlier, may also impact the disbursement of debt tied up with lenders because lenders prefer to release loan amount in proportion to the contribution stipulated from promoters’ equity and customer advances. Therefore, in such cases of slower sales, pressure increases on the promoters to meet the shortfall from their own sources or from high-cost PE funding.
Therefore, real estate companies, which are part of financially strong promoters who can pitch in and bridge the gap created by slow sales by increasing contributions are a great competitive advantage. This is because it ensures that projects get completed in time and in turn, the developer generates strong goodwill and brand equity, which helps sales in its future projects.
Rating methodology – real estate sector by CARE, March 2023, page 3:
a company with financially strong promoters enjoys an advantage over others as its ability to infuse and/or raise funds in a timely manner is better.
The ability of the developer to secure funding either from promoters or from sales using its brand equity or from lenders is essential because in order to achieve growth, most developers usually launch projects, which is much more than what they had executed until now. Therefore, such aggressive construction plans expose the builder to both execution as well as funding risk.
Rating methodology – real estate by ICRA, April 2015, page 2:
In ICRA’s experience, the development plans of most real estate players are usually aggressive compared with the area developed in the past thus necessitating significant scaling up of their execution capabilities.
Also read: Free Cash Flow: A Complete Guide to Understanding FCF
9) Challenges in the assessment of real estate companies:
Investors face numerous challenges while analysing companies in the real estate sector. Let us try to understand some of the key difficulties faced by investors.
9.1) Transparency/governance issues at real estate companies:
The real estate industry carries an impression of non-transparency because of intricate dealings between promoters and numerous intragroup transactions, which are the norm. In addition, there have been many instances of real estate promoters resorting to unfair/illegal means to get regulatory approvals.
At times, govt. authorities and courts have come down heavily on real estate companies for indulging in fraud, bribery etc.
Noida authority ‘corrupt body’, in cahoots with Supertech: SC – ET Realty
Amrapali conducted serious fraud: Supreme Court – ET Realty
As a result, the image of corporate governance in the real estate industry has taken a big hit.
Rating methodology – real estate sector by CARE, March 2023, page 2:
The sector is impacted by transparency issues…lack of clear land title due to absence of land records, use of unsecured loans from promoters for funding and intra group transactions are generally the norm.
As a result, an investor should be cautious and do deeper due diligence before considering investments in the real estate industry. Moreover, she should pay special attention to the management analysis of the company.
Rating criteria for real estate developers by CRISIL, June 2023, page 9
In real estate projects, management evaluation further assumes importance on account of the opacity in the sector.
Also read: How to do Management Analysis of Companies?
9.2) Contingent and off-balance sheet liabilities:
Real estate companies at times have a significant amount of contingent/off-balance sheet liabilities, which might skip investors’ analysis. These liabilities relate to various guarantees given to banks or govt. departments on behalf of itself or its subsidiaries/joint ventures and even group/promoter entities.
At times, high assured returns promised to private equity players for money raised from them for land acquisition also contribute a significant payment, which might not be evident to the investor; however, it may create a severe liquidity crunch/refinancing risk for the developer.
Rating methodology – real estate by ICRA, March 2017, page 7:
In case there are any other contingent liabilities like corporate guarantees, assured returns / buyback obligations to PE investors, pending liabilities towards Government departments, etc, the impact of the same on the developer’s credit profile is also assessed.
Also read: How to study Annual Report of a Company
9.3) Difficulty in comparing the performance of real estate companies:
Investors face difficulty in comparing the performance of real estate companies both across different companies as well as for the same company in different time periods. This is because of multiple factors like discretions/subjective opinions in accounting practices like revenue recognition, huge differences between revenue recognition/profits and cash flows due to the percentage of completion method of revenue recognition etc.
Rating methodology – real estate sector by CARE, March 2023, page 1:
The sector is unique as direct comparison of financial performance of different players may not be meaningful due to a) different revenue-recognition policies followed by entities b) the profits for a given period may vary significantly from the cash flows and c) the revenue booking may fluctuate widely from one period to other, depending upon the stage of execution of various ongoing projects.
Even though, in the recent past, a new accounting standard (Ind AS-115) has been implemented, which attempts to bring some uniformity in revenue recognition based on the completion of performance obligations; however, still, each company/management gets a lot of scope of subjective assessment while recognizing meeting of performance milestones/revenue without crossing the line drawn by law. Therefore, a comparison between the reported financials of two real estate companies becomes difficult.
Rating methodology – real estate sector by CARE, March 2021, page 2:
with the introduction of Ind AS-115, the real estate entities (on which Ind-AS is applicable) will be required to recognize the revenue on the basis of whether performance obligation is satisfied ‘over time’ or ‘at a point in time’, thus the revenue would be recognized once the company performs all its obligations.
Also read: Margin of Safety in Stock Investing: A Complete Guide
10) Important parameters and ratios for analysis of real estate companies:
Real estate companies are effectively a cumulation of many individual projects; therefore, while assessing the attractiveness of stocks of any real estate company, it becomes necessary for investors to use parameters, which assess the company from the perspective of underlying projects. This requires the usage of certain unique parameters and ratios, which are different from the ones we normally use for other manufacturing and services companies.
10.1) A comparison of the area currently under development with the area developed until now is important to understand whether the company has spread its resources too thin or it has taken up a task, which is too big for it to achieve.
Rating methodology – real estate sector by CARE, March 2023, page 4:
scale of the ongoing projects is compared with the aggregate scale implemented in the past to assess whether the projects currently being undertaken are not very large compared to the past projects executed by the developer.
For this analysis, an investor can simply compare this data provided by real estate companies in their shareholder communications. For example, DLF Ltd, one of the leading real estate companies has disclosed in its investors’ presentation of Oct. 2023 (Q2-FY2024 results) that it is currently executing an area of about 46 million square feet (msf) whereas it has developed exceeding 340 msf until now.
DLF Limited, Q2FY24 results presentation, page 4:
10.2) Another important parameter for real estate developers is checking whether balance receivables from already sold area in the projects is sufficient to meet the balance construction cost and how much the surplus, if any, is in comparison to its outstanding debt.
If a developer can easily meet its balance construction cost of projects from its receivables from already sold area, then it presents a safer position in comparison to the case where a builder might have to generate additional sales to complete its projects, which exposes the developer to high market risk.
Rating criteria for real estate developers by CRISIL, June 2023, page 8:
Advances from sales already made represent the steadiest sources of future collections and, hence, are of high quality.
DLF Ltd has disclosed in its investors’ presentation of Oct. 2023 (Q2-FY2024 results) that its receivables from projects are ₹12,750 cr against the balance construction cost of about ₹6,425 cr.
DLF Limited, Q2FY24 results presentation, page 23:
10.3) Another important parameter for assessing the confidence in the receivables of real estate developers is how much money the customers have already paid out of the total agreement value. If customers have already paid most of the agreement value (say > 60%), then there is high confidence in the receipt of balance money (<40%) in the future when compared to a situation where customers have only paid a small amount (say <10%) and most of the agreement value (>90%) is pending. In the latter case, if customers, who are investors, see that the property prices are not increasing or an economic downturn comes, then they may stop making further payments.
DLF Ltd has disclosed about its receivables in its investors’ presentation of Oct. 2023 (Q2-FY2024 results) that the sold area in the projects had an agreement value of ₹63,629 cr out of which about ₹14,750 cr (about 23%) is receivable.
DLF Limited, Q2FY24 results presentation, page 24:
10.4) One of the important parameters for debt analysis of a real estate developer that has rental/lease income is assessing how much debt it can raise on its annual rental income. This is because debt based on rental income called lease rental discounting (LRD) is self-liquidating i.e. the rental cash flows take care of interest and principal repayments and the developer does not have to sell properties for debt-related payments.
As a result, investors may bifurcate the debt taken by a real estate entity into LRD debt and other debt.
Rating criteria for real estate developers by CRISIL, June 2023, page 3:
CRISIL Ratings separately analyses debt taken for residential and sale model commercial projects, and that taken against lease rentals expected from commercial projects, given the difference in stability of cash flow.
Even if the developer has not yet raised LRD debt to its full potential; however, the availability of LRD potential provides comfort to investors as LRD debt is usually at a lower cost/interest rate due to comparatively stable rental income from already functional and leased commercial properties.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 1:
most often the real estate entities leverage their commercial or retail assets to raise LRD loans in excess of the construction loans. These surplus funds are typically used for the repayment of other expensive term loans, to fund construction of other commercial or retail properties and other general corporate purposes.
DLF Ltd has disclosed in its investors’ presentation of Oct. 2023 (Q2-FY2024 results) that in FY2023, it collected a rental income of about ₹358 cr. (Please note that this data is only for consolidated results of DLF Ltd and does not pertain to its group company: DLF Cyber City Developers Limited, which had a revenue of about ₹5,400 cr in FY2023 and has its separate debt and other outside liabilities of about ₹24,000 cr).
DLF Limited, Q2FY24 results presentation, page 21:
For a simplistic illustration, if an investor assumes a 10% interest rate and a 15-year loan tenure of an LRD loan, then ₹358 cr of annual rental income (without considering any escalation in rent and also without considering any outflows like tax, property maintenance etc) can service an LRD loan of about ₹2,700 cr.
(The actual loan amount will vary based on numerous factors like whether maintenance payments by tenants are a part of it, how much money needs to be set aside for major renovation corpus, tax payments, future rental escalations, actual interest rate, balance lease tenures and many more).
Nevertheless, this estimation is a good crude estimate that an investor may arrive at for her rough analysis.
Now, the investor may compare it with the total debt of the company to build her confidence about the debt repayment ability of the company.
DLF Ltd, in its investors’ presentation of Oct. 2023 (Q2-FY2024 results) that in FY2023, has disclosed that at the end of FY2023 i.e. at the start of Q1-FY2024, it had a total consolidated debt of ₹3,068 cr.
DLF Limited, Q2FY24 results presentation, page 22:
10.5) Rental competitiveness: While taking comfort in the rental income for a real estate company, an investor needs to assess how the existing rents in its properties are in comparison to the ongoing market rents.
Even though, a higher rent when compared to market rent may indicate the premium/brand equity/pricing power of the developer; however, it also increases the risk of tenants negotiating a lower rent or vacating the property, especially at the time of renewal of agreements if such renewal period coincides with the economic downturn.
Rating methodology – lease rental discounting (LRD) by ICRA, May 2022, page 4:
A property where the average rent rates are lower than the market rates is less vulnerable to risks of renegotiation of rates or non-renewal of leases as they expire.
An investor may get the data of average rents received by the developer in its various rental properties in its investor communications.
For example, DLF Ltd has disclosed weighted average rents in its different commercial properties in its investors’ presentation of Oct. 2023 (Q2-FY2024 results).
DLF Limited, Q2FY24 results presentation, page 28:
Also read: How to do Financial Analysis of a Company
Summary
The real estate industry is a highly competitive business with a large number of unorganized developers dominating the market. The fragmented nature of the industry combined with low customer continuity/brand loyalty puts strong pressure on the pricing power of developers. Even though each property is unique in location and configuration; however, if the transaction size goes beyond budget, then customers are willing to switch to other builders.
This limits the premium that a developer can command in any geography/micro-market and large reputed customers put a lot of pricing pressure on developers. This is especially true in the retail mall segment where anchor tenants who bring the maximum footfall to the property pay a significantly lower rent. Moreover, there are multiple small tenants (MTM tenants) who are accommodated in the mall almost free of cost to reduce the dark/unoccupied spaces, which otherwise will hurt the image of the mall.
The demand for real estate properties is highly correlated with the stage of the economic cycle of boom and bust. During the growth phase, demand increases and many developers enter the business and launch projects. However, by the time these projects are ready in 3-4 years, the economic cycle changes to a down cycle and demand declines leading to oversupply. As a result, many developers face bankruptcy and exit the business.
Real estate is a very capital-intensive business where significant money is needed at each stage of planning and execution like land aggregation, govt. approvals as well as construction. As real estate projects have a limited revenue-generating period until all the units are sold out; therefore, companies need to have a consistent pipeline of projects at different stages to maintain their sales and generate growth.
Real estate developers benefit from a large size, which gives them economies of scale and some negotiating power over suppliers and customers, which when combined with a good market position/brand equity also strengthens their position in front of regulators. Large reputed developers also get preference for limited opportunities like large land parcels in prime locations or redevelopment projects.
However, despite the large size and brand equity, developers are not able to achieve significant pricing power over their competitors as customer continuity is low and due to very high ticket size, repeat purchases are less. In case, a builder is into “for sale” commercial properties, then its position is even weaker because commercial units are of even larger ticket size and have a limited target customer set.
Real estate developers that have a presence in multiple geographies, and different business segments like residential, commercial, industrial etc under a mix of “for sale” and “held for lease” models, have a diversity of projects under execution at different stages, cater to diverse customers with varied profiles belonging to different industries etc. enjoy a competitive advantage. This is because diversification reduces the impact of cyclicity on their business and smoothens its earnings reducing the uncertainty in business performance.
Real estate developers face a high regulatory risk due to numerous govt. approvals required for planning and execution of projects. In addition, complex land-related laws lead to frequent litigations, which at times, delay projects to the extent of making them unviable. Moreover, stringent environmental regulations directly linked to real estate projects and indirectly linked to operations of their vendors also affect the business along with social risk for people-centric dealings with thousands of customers, employees, labour, and suppliers. Real estate developers need to manage all these risks diligently to strengthen their business and reputation.
Builders need to fund land acquisition either from their own capital or from high-cost private equity funds, which at times hurts the profitability of the project. There is a high reliance on customer advances in the financial closure of the project; therefore, any delay/slowdown in the project can affect the project progress, if the promoters are not able to bring in additional funds to meet the shortfall. The situation is further complicated if the bank refuses to disburse the already tied-up debt by stressing that debt will be given only in proportion to the contribution from promoters’ equity and customer advances.
Therefore, real estate projects continuously face funding risk and any liquidity crunch puts it into a vicious cycle of slow sales leading to slow construction progress, which further leads to slower sales. At times, it leads to the developer abandoning the project.
Investors face numerous challenges in analysing real estate companies due to a lack of transparency, numerous transactions with promoters and their entities, presence of contingent/off-balance sheet liabilities. Moreover, at times, the comparison of the financial performance of a developer with its peer as well as its own performance over time may not be meaningful due to different revenue recognition assumptions, huge divergence of revenue/profits and cash flows etc.
Nevertheless, with the usage of certain sector-specific ratios like consistent rental income sufficient to cover a lot of its total debt as lease rental discounting, the sufficiency of receivables from sold area to meet balance construction cost, advanced stage of under construction projects where customers have already paid a significant share of their agreement value are some of the measures that give the investor some confidence in their analysis.
An investor should always keep in mind these multiple aspects of real estate companies to understand their business position.
- Fragmented industry with intense competition
- Significant cyclicity in the business performance
- Capital-intensive nature of operations
- Large size with economies of scale brings in a competitive advantage
- A strong brand and market position is an advantage
- Diversification along geography, business segments, projects, customers, and land aggregation strategies bring strength to a real estate developer’s business model
- Real estate companies face significant regulatory risk and funding risk
- It is challenging to analyse the business performance and financial standing of a real estate developer from reported financial numbers
- Multiple sector-specific ratios help investors in analysis like a comparison of the area currently under development with the area developed until now, whether balance receivables from the already sold area in the projects is sufficient to meet balance construction cost, how much money the customers have already paid out of the total agreement value, how much debt it can raise on its annual rental income etc.
We believe that if an investor analyses any real estate company by keeping the above factors in mind, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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Disclaimer
Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.
