Is the property boom already a bubble?

property prices across the country have gone sky high, raising fears of overheating, and property stocks are getting astronomical valuations. Are we seeing 'just the tip of the iceberg' as the bulls say or is this already a bubble?

"Buy land, they are not making it any more" — Mark Twain

One of the biggest beneficiaries during most periods of sustained economic expansion is the property sector. Real estate prices firm up initially on genuine demand for new commercial space, production facilities and housing. Then, as always, speculators take over and prices soar to unrealistic and unsustainable levels which trigger a collapse later on. As veterans in the property sector say, in real estate gravity always comes into play.

It has been no different in India over the last few years. After the crash in property prices in late nineties, the sector was in a limbo for many years. Property development was one of the least fashionable businesses as inventory of unsold properties piled up. That has all changed in the last few years and some of the new entrants to the country's list of dollar billionaires are property developers.

The RBI has been warning banks about rising real estate prices and asking them to be prudent in lending to the real estate sector for quite some time now. Even so, property prices in the big cities have only gone up - in some cases the growth has been around 40 per cent annually for the last few years. The developers have already moved into smaller cities, where the rise in prices have been nothing short of phenomenal.

Behind the boom
Every boom, irrespective of the sector, is based on very sound economic logic of demand and supply conditions. As the good times extend further, future projections take the place of real demand and supply conditions and the rally is stretched further. In this phase, the rise in prices would be very fast and it attracts a lot of speculators who do not have the staying power. The rally becomes a full blown bubble which breaks at some point, taking down even genuine investors.

The current boom in real estate started when service sector companies started seeking more space to service the outsourcing boom. Service sector salaries and corporate spending started rising, which lifted other sectors and led to rising demand for housing in the metros. Later, manufacturing also started picking up and pushed up property prices even further. The housing market got a further boost and the boom spread to smaller cities and towns.

Housing finance has been one of the big growth areas for commercial banks in recent years. As income levels continue to rise, borrowers are willing to take bigger mortgages to finance large houses and apartments. New financial products like reverse mortgage, where a person receives a fixed monthly payment from the financier who takes possession of the property after the borrower's death, have been introduced.

As the boom picked up, institutional funds started flowing into the sector. The country saw its first property fund floated in 2005 by housing finance major HDFC, followed by many others. Real estate investment trusts (REITS) are preferred investment vehicles for high net-worth individuals these days and real estate mutual funds may be on their way. Foreign institutional investors and hedge funds have also invested heavily in domestic property.

Domestic property developers are now raising money from overseas markets. Mumbai based Ishaan Real Estate, part of the Raheja group, has raised $340 million on London's Alternate Investment Market (AIM). An overseas associate company of Unitech has announced a $700 million issue in London, while Hiranandani Constructions, which built a huge residential township at Powai, is planning to raise $750 million.

Promising but cautious future
It is very clear that if the country has to lift the remaining millions out of poverty, it has to sustain the current growth rates at least for the next few decades. This would mean increased urbanisation in future as migrants from rural areas shift to the cities to satisfy the demand for cheap labour. Increased urbanisation would lead to further expansion of both large and small cities.

Can the sector continue to grow at this pace in future? If the economy continues to grow at this rate, it is most likely. But the rate of growth would most definitely slow down and some areas may even see modest price corrections. But at the first signs of a slow down, the speculators may exit the market and cause a deeper correction.

The housing sector still suffers from gross under supply. The sector needs to build millions of new homes to satisfy the demand from the emerging middle class who would see their incomes rising steadily if the economy stays on its growth track. Even the release of large tracts of land like the mill land in Mumbai and some areas in Delhi has not helped much in easing the supply constraints.

True, if interest costs rise further, the housing market may slow down. But rates are most likely to remain around the current levels as global growth rates and interest rates are expected to decline next year. Strong domestic growth would prevent the RBI from contemplating a rate cut, but the central bank may not hike rates much either.

Commercial property segment is bound to benefit from higher infrastructure spending and industrial investments over the next few years. Infrastructure development would invite more investments into major cities and push up demand for commercial space. As cities expand even further, more commercial space would be created in the suburbs to feed demand. City centres may also see more construction as the transport network improves with wider roads and metro railway systems.

The SEZ policy has generated enough excitement and even if only a part of the proposed SEZ's take shape, it would see a substantial addition to supply of industrial and commercial space. Since the larger zones would be far from cities - except zones like the Reliance SEZ near Mumbai - the SEZ's would not help in easing the supply shortage in cities. They would become self-contained islands with their own demand and supply.

Unless there is a dramatic change in market conditions, funds flows into the real estate sector from overseas investors would continue for the next 2 to 3 years. Major global fund managers like Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers are all bullish on the Indian realty market and are planning to float offshore property funds for investments in India. Apart from buying into large projects, some of these investors are also picking up strategic stakes in privately-held property development companies in smaller cities.

It is also very clear that property prices in some areas have become prohibitively expensive to make most businesses unviable at those locations. This would ensure a gradual shift of new businesses from these locations, which would mean slower growth in property prices in future, if not a decline.

Property stocks defy gravity
Stocks of property development companies and those companies with large land holdings have been among the best performers over the last one year, when the real estate frenzy really caught on. 'Land bank', or the extent of real estate holdings which can be commercially exploited, has become the new buzz word in stock markets - almost similar to 'unique site visitors' during the last internet bubble.

The frenzy is so much that some of the micro-cap companies owned by dubious promoters have started renaming their companies to reflect their newfound interest in property. Not a day passes without a mid-cap or small-cap company declaring its intent to enter property development business, similar to the mad rush to enter financial services and technology in the previous bull runs.

Delhi-based Unitech has been one of the biggest gainers over the last three years. The company was valued at less than $20 million just three years back at the beginning of the bull run. The stock has had a dream run and was locked in the upper price circuit successively for more than 3 months early this year. The company is currently valued at a staggering $8.5 billion.

Mahindra Gesco, one of the more established companies in the sector which concentrates on developing industrial and commercial townships, has also seen spectacular gains. Other big gainers include Ansal Properties and Ansal Housing.

Stocks of companies which have ventured into development of their own land holdings have also appreciated substantially. Companies like Bombay Dyeing and Godrej Industries have already launched residential and commercial development in Mumbai, while Bata is developing its holdings near Kolkata. Groups like Future - which runs Pantaloon Retail - and India Bulls have launched full fledged property development companies which have attracted significant overseas investments.

Parsvnath Developers, promoted by a small time real estate broker slightly more than a decade ago, had a spectacular listing this week on the exchanges. The company is now valued in excess of $2 billion and would surely earn the promoter - who holds nearly 80 per cent - a place in the Forbes list of dollar billionaires. The IPO of Bangalore based Sobha Developers has just been concluded and was oversubscribed an incredible 100 times.

DLF, the big daddy of all real estate developers in the country, is expected to launch its IPO by January. The company had postponed its issue following the market slump in May-June. The response to issues from Parsvnath and Sobha is enough to make DLF confident to re-launch its IPO.

Once DLF is also listed, aggregate market capitalisation of the real estate sector would easily cross a staggering Rs2 lakh crore. More bullish analysts, including some influential foreign brokerages like CLSA, are very positive on the sector and believe that the total market capitalisation of the sector would be substantially higher in another three years. FII inflows into property stocks over the last few years is estimated at around Rs10,000 crore, which is likely to go up as more and more property companies get listed.

However, investors in real estate stocks should be extra cautious and always keep in mind that the valuations of these companies are dependent mostly on their land holdings rather than their ability to develop and sell commercial and residential property. Most of these stocks are now sitting on highly stretched valuations and can come down hard even if there is a hint of property prices coming down.

Hence, if you are among the lucky few who were prescient enough to invest in the Unitechs of the world when they were cheap, you can afford to hold on as you are sitting on a neat pile though some profit booking is always advisable. Recent entrants in these stocks should limit their greed and look at exit opportunities as the returns have been good enough. Those who remained in the sidelines watching their meteoric rise should wait for a decent correction. Irrespective of which category you fall into, all should recall that property stocks were the worst hit in the May-June market tumble and stick to stocks of established property developers or reputed companies which are developing their own land.
By Rex Mathew