Valuing Real Estate Companies

Last few years saw real estate property prices go through the roof. Three factors that impact property price are property cost, interest rate and income levels. Given the fact that in India, shortage of residential units is approximately 19 million, demand side will never be an issue. Reduction in interest rates and tax incentives for home loan repayment drastically increased the affordability and demand of residential properties after 2005. And as supply lags behind the demand for residential properties, prices logically rose drastically. Similarly, growth in IT and ITES sector and organized retail sector resulted in increase in commercial property prices.

Driven by soaring commercial and residential property prices, valuation of real estate companies also increased dramatically. Some investors consider size of ‘land banks’ as a key parameter for investing in real estate companies, and give little importance to margins and execution time taken to complete these projects. The major pitfall of this approach is that even loss making realty companies will be valued highly, despite having poor fundamentals.

While size of land banks held do provide indication about expected growth of a real estate company’s revenue, investors should also consider certain ratios specific to this industry. Operating margin and Return on Capital Employed should not be ignored as they provide valuable insight into a realty company’s operating efficiency. Also, since realty projects have long gestation period, it is important to understand how the company is financed. Hence, debt to equity and working capital to sales are very important ratios to be applied while analyzing real estate companies.

Investors who value real estate companies based on the total land held use ‘best price per square foot’ method to value the land size, experts opine that since it tends to ignore the risks involved, using ‘normalized price per square foot’ or ‘profit per square foot’ are more appropriate methods. According to some experts, Price to Earnings ratio and Price to Sales are appropriate methods for valuing real estate companies.

One major shortcoming of valuing land banks for determining the value of real estate companies is that there is no standard price which can be used. Moreover, land prices defer widely from location to location. Using higher values per square feet will tend to overvalue companies.