A young analyst armed with a laptop assumed his new workplace with a real estate fund in the year 2007. The fund brought foreign capital into real estate ventures in India and the analyst was the backbone of decision making. He felt his quantitative skills and MS Office’s superior computation abilities will soon catapult him into the big league – being a Partner at the fund. And thus began the journey.
In about two months he was the master of running simulations on the excel sheets pertaining to real estate investments primarily residential projects. Sounds cool, right, just that it isn’t. All that one needs to do to make excel sheets is to come up with a set of ASSUMPTIONS!!! Let me not demean the spread-sheet business because I simply love doing numbers, more so when the zillion circular references throw up interesting scenarios, you feel no less than being an Einstein. So what does it take to prepare a spread-sheet in order to assess the merits of a residential project –
- Date of investment (thus begins the pressure to deliver on the funds)
- Date of commencement of work (your funds are being put to use)
- Sales commencement date and phasing of sales (collections begin against the bookings)
- Construction costs and phasing of them (spending pattern)
- Schedule of other costs, income and other taxes etc
Residential project investment has a finite life i.e. ideally one can exit upon complete delivery of the project. Now compare this to the FMCG industry, where demand and supply variables are plenty because these businesses run for perpetuity and have multiple products being produced at several locations. Real estate analysis is comparatively simple, right!
If it was this easy foreigners would have reaped huge multipliers on their investments in the joint ventures with real estate companies. Sadly just a handful of examples exist to demonstrate the merit of pouring FDI into India. Why then the anomaly?
The above mentioned five parameters seem easy to assess on an excel financial model however it is not the case. Let me pick on the second one from these “commencement of work”. A real estate project can take off only after all building approvals are in place. Buying land or development rights is just a raw material, for this raw material to be turned into a product a developer needs to approach local and central bodies for several clearances. So much so that some of the approvals are redundant in several cases and there is a lot of duplicity in others. In our experience we found it took anywhere from six months to several years before even the excavation could start at a site. While approvals in Gurgaon or Bangalore are easier to obtain, Mumbai and Chennai are known to be notorious in this regards.
Our budding analyst proposed an investment in January 2008 and project commencement date of July 2008. A good six month gap from the initial investment date. He also felt that a 500 apartment project will be completed by December 2011, four years in all. That’s long when compared to speed of execution by Chinese. However it doesn’t hurt to be conservative, in fact it was very prudent of him to be reasonable in assumptions around project completion. At the end of it all he found that the fund will make an internal rate of returns of 25% net of taxes. Now this is huge, kudos to him as the limited partners of the fund would love him. However, reality bites! It was September 2008 and approvals were nowhere in sight and in the same month it felt as if the financial world was crumbling, Lehman caved into pressures of staying solvent. Real estate demand in India was robust till early 2009 and our analyst hoped the fund will encash on Indians new found love for apartments. The pressure to perform was mounting – simply put – the 25% return for an year wasn’t realised, which meant the project had to deliver a higher number over the remaining three years to stand true to the assessment on the excel sheet. The real estate demand started to taper off, general elections were being held in India and local bureaucracy wasn’t clearing the project files. Eighteen months later the approvals finally arrived, our friend was ecstatic as the project was launched without further delays. All the earlier assumptions needed to be revised to highlight the delay, weak markets and rising input costs. Our young analyst wasn’t impressed with the results but he had no choice. The reality of Realty was here to sting him.
Even without factoring the risks pertaining to poor corporate governance of real estate companies, there exist several challenges in conducting realty business – red tape, business cycles and land aggregation.
I will sign off this note with a word of caution to all analysts and fund managers
“Spread-sheet results are just as good as the Assumptions you make”.