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| Real estate blues |
| Devangshu Datta / New Delhi Jun 06, 2010, 00:49 IST |
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The fate of real estate is dependent on the economy’s recovery. But setting price targets is an exercise in futility.
Exotic derivatives are blamed for the US real estate bubble. Derivatives did exacerbate problems but the issues started with lending irregularities. Due diligence was pathetic and rating agencies gave bad loans higher ratings than deserved.
Most derivatives were extensions of securitisation, which is a well-established system. A loan can be reduced to a net present value (NPV) at an agreed discount rate. For example, a one-year loan of Rs 100 is made at an interest rate of 10 per cent, when the fixed deposit rate is 9 per cent. The NPV of that future Rs 110 is Rs 100.92 at a discount rate of 9 per cent (100.92 at 9 per cent =110). The riskier the loan, the higher the discount rate. Note that the NPV of a bad loan is zero since the future cash flow is zero.
A loan portfolio can be parcelled using NPV. Bonds may be issued against aggregate cash flow. If the parcelled loans have different ratings and rates, the holders of more secure loans (senior tranches) receive less interest while the holders of high-risk tranches receive more interest.
If subscribers to such securities want protection, they can take out credit default swaps. The counterparty to a CDS works out the odds of default, puts up collateral and collects a premium to insure against default.
The US real estate industry built impressive sand castles upon these concepts. Collateralised debt obligations (CDO), as the securities issued on bad mortgages were called, were covered by CDS. If the loans had been honestly rated, the CDOs would have been priced close to zero. But CDOs weren’t traded on exchanges. So, there was no price-discovery.
Abandoning all derivatives as a result of elementary lapses in due diligence is silly. If CDOs had been standardised into lots and exchange-traded, the problems would have come to light earlier. Information would have been widely available and exchanges would collect margins from traders. So prices would have crashed but defaults would not have cascaded.
Off-exchange derivatives (misleadingly called over-the-counter instruments) are often non-standard because they are customised for specific needs. Take typical currency and interest rate swaps. An importer needs a specific amount of a given currency this month and undertakes to return that amount next month. Or, somebody wishes to convert a fixed interest rate to a floating rate. A customised swap makes most sense. So regulators will have to find ways to allow normal business transactions while preventing lunacies.
The bubble burst in the US before the Indian real estate sector could even think about emulation but Europe is headed there with Hungary's CDS market exploding last week. India doesn’t have a secondary debt market and lack of timely legal recourse in case of default makes lenders extra cautious. This is not cause for self-congratulation. If liquid debt markets existed and lenders were more assured of debt-recovery, financing would be easier and that would enable faster growth.
Indian real estate developers are permanently cash-strapped. For a brief while, they found it relatively easier to raise money before the US crash. In the past 12 months, housing finance loan volumes have shown some levels of recovery but this has happened more in tier 2 and tier 3 cities and in “affordable housing”.
Both FIIs and domestic institutions have increased their stakes in commercial complex developers more than in housing developers. This market still seems fairly soft and it has potential oversupply. But there seems to be faith that the economic recovery will trigger a need for more office space and the bets have been spread across regions.
The global slowdown also meant project slowdowns so there won't be too much action immediately. Revenues are only booked when a project is completed and sold. As such, many developers will show significant revenue only in 2011-12.
We're back in the loop of NAV-based valuations. Most developers have projects on hand but those will be delivered in 2011 and 2012. Using assumed prevailing prices at the time of delivery, the NAV per share of a real estate developer can be calculated. Then a multiple of the NAV can be assumed to get a handle on the “fair price” of the share.
Share valuation methods all depend upon assumptions. But this system has so many fuzzy valuation aspects that it’s probably best ignored. If the economy picks up, real estate will make a recovery. In that case, stocks are under-valued over a 2-3 year time-frame. But, setting price targets is an exercise in futility.
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