This was the last sentence of an article written by the celebrated American real estate investor Samuel Zell, in which he described his strategy of profiting from distressed real estate.

Zell, nicknamed "The grave dancer" after the title of his article, has the reputation of being one of the most successful real estate investors, without ever venturing into the real estate development business himself.

In India, going by the dynamics of the real estate markets, many an investor holding real estate stocks in his portfolio would aspire to get close to Zell. Along with being a smart investor, one also has to be adept at predicting real estate trends to be as successful as Zell.

Investing in real estate has not been too different on this side of the planet either, when it comes to the basics. But it is the basics where we are most likely to falter, while valuing realty businesses � and the pitfalls are plenty.

The haves...

The mad rush to invest in realty businesses due to the rapid appreciation of real estate prices witnessed across the board, has been a mixed blessing of sorts for both real estate developers and investors.

Real estate players found an opportunity to raise money to fund their businesses and investors made a quick buck from the steep appreciation in real estate stocks. The real estate stock rally over the past two years was mainly driven by the skyrocketing real estate prices due to the high demand which in turn was fuelled by easily available home loans.

...and the have-nots

Since the real estate industry is at a nascent stage of getting itself organised, there is hardly any credible historical information available in terms of the demand-supply scenario and prices.

Further, with the vast geographic expanse over which a number of developers have their operations spread, analysts find it difficult to ascertain a precise valuation on their own and are compelled to go by the claims made by companies.

Taking into account a company's land reserves and the market value of its ongoing projects, analysts therefore, estimate a net asset value (NAV) of the business at the prevailing market price, which is then discounted to arrive at a per-share valuation of the business.

"As the industry is yet to mature, the conventional price-earnings ratios or profitability ratios would be of little help (See table: Old timers). Therefore, a net asset value (NAV) based approach is taken which gives a fair idea of how much the company is worth at the time the NAV is estimated," says Ritesh Vohra, director - investments, Saffron Asset Advisors, a real estate fund. 

OLD TIMERS
	CMP (Rs)	EPS (Rs)*	P/E (x)*
Ansal Housing	165.95	29.04	5.54
Ansal Properties	234.35	12.01	20.57
Mahindra Gesco	573.05	97.10	6.14
Unitech	353.60	7.75	40.25
* Trailing 12-month

"However, this approach is fraught with risks of subjectivity in discounting and many other blind spots," he adds.

The method...

The NAV method ascertains the value of a realty business by summing up the present values of its assets which are in the form of land bank, existing and ongoing projects � all these translated into a saleable area.

"The assumption of the saleable area could differ from two analysts' points of view because both may differ on the assumptions of the floor-space index (FSI), the developable area over the given acreage and that of the prevailing market price of the assets," says Sirshendu Basu, associate vice president - research, IL&FS Investsmart Securities.

Manisha Grover, head- strategic consulting and research at the real estate consultancy Jones Lang Lasalle Meghraj (JLLM) adds, "There is no standard practice prevalent to carry out valuations. Different valuers may follow different surveying and valuing standards."

� and its madness

The biggest pitfall of considering a company's valuation is the time-sensitivity of the NAV. The NAV of a real estate firm may change every day, as assets are added or sold, or as market prices change. Again, there is no prescribed guideline for realty companies to report the changes in their NAVs at regular intervals. This leaves plenty of room for guesswork on analysts' part.

Developers too, could misuse the NAV in a number of ways. Ramesh Jogani, managing director and chief executive officer, IndiaREIT Fund Advisors throws some light: "Going by the trends in India, a realty business commands a money market multiple of around 1.3-1.5 times on the value of its land bank, that of 8-10 times on projected profits, 10-12 times for the yield from rentals and income from service and maintenance contracts each."

Jogani further explains, "Even if a real estate company buys land where it does not plan immediate development, the company's valuation is pumped up by 1.5 times the value of this land. Again, the profit estimates of realty companies are vulnerable to execution risks, but the estimates could result into an immediate gain of 8-10 times the projected profit in the company's valuation."

Perhaps, this is the reason why Sebi has barred realty businesses from mentioning their NAV in the red herring prospectus while coming up with an initial public offering.

However, for the curious ones, the draft prospectus, in which most realty companies have mentioned their NAVs so far, are available publicly on the Sebi website.

Is NAV indispensable?

Until the realty industry matures, the conventional valuation metrics of price-earnings multiples, operating profit margins or return on equity will remain weak or unreliable. Till then, there is no alternative but to depend on NAV. "At least the method gives a starting point," says JLLM's Grover.

Adds Basu of IL&FS Investsmart, "But one has to consider a large number of firm-specific factors while arriving at a final number. These factors range from what proportion of land reserves is owned or is in the process of being acquired to the revenue model proposed by the firm."

He gives examples, "For instance, a developer like Orbit Corporation [Get Quote] aims to sell prime real estate achieving high realisations, while on the other extreme IVR Prime has a business model of providing affordable housing to the masses."

IndiaREIT's Jogani adds, "In addition to the business model, aspects such as the company's cash reserves to fund timely execution, quality of tenants in case the company is in a build-and-lease model, the capital structure and the cost of capital would also change the rate at which one would discount the company's NAV."

The way out

Realty stocks have seen a roller coaster rally up and down over the past few months (See chart: Hide and seek) due to a number of reasons such as the increase and decline of housing loan interest rates, curbs on external commercial borrowings (ECB), high demand in tier-II and tier�III cities, rising cement prices, variations from execution promises and the like.

However, just going by the broader picture of demand-supply mismatch, investor frenzy for real estate IPOs has been evident. The average listing gains of the 16 realty IPOs between August 2006 and August 2007 were 71.5 per cent as compared to 22.6 per cent for all the 134 companies that launched IPOs in the same period, according to the recent FICCI-Ernst & Young report on Indian real estate.

Further, going by the number of issues in the pipeline, the outlook does not appear to be any less promising. However, this does not help investors defy the volatility which has gripped the stocks in this sector. Beyond listing gains, realty stocks are notorious enough to let investors down time and again (See table: Real returns?). So, finally, how should one value real estate business then?
 

REAL RETURNS?
	Market Cap Rs crore	CMP (Rs) 26-Oct	Issue Price (Rs)	Gain since listing (%)	Returns (%)
					1-month	3-month	6-month
Akruti Nirman [Get Quote]	6640.99	1045.20	540.00	4.44	40.84	88.50	151.27
DLF	148023.60	910.35	525.00	8.58	13.36	36.27	NA
HDIL	14130.04	665.40	500.00	11.72	8.32	13.68	NA
IVR Prime	2636.24	421.00	550.00	-23.97	-3.34	NA	NA
Omaxe	5523.00	320.40	310.00	12.89	-4.97	NA	NA
Orbit Corporation	2152.99	597.85	110.00	16.32	13.22	84.20	199.65
Parsvnath Developers [Get Quote]	6377.69	353.85	300.00	75.43	1.83	-7.28	2.54
Puravankara Project	9517.64	444.85	400.00	-9.56	2.25	NA	NA
Sobha Developers [Get Quote]	6639.00	929.50	640.00	51.37	3.55	-0.56	-0.72

Keshav Misra, head-real estate investments, Baring Private Equity Partners attempts to answer: "One could go for a project-wise NAV of a realtor, estimating the cash flows from each project individually and then discount it to the cost of capital.

This is the approach taken by real estate investment trusts (REITs) globally." However, it is possible for REITs to partner with developers at the project level, while retail investors are unable to do so. Further, in India, there are very few companies which operate on a build-and-lease model which entitles the real estate player with a steady stream of rental yields.

In a build-and-sell model, the cash flows are bound to vary according to the completion of projects. Saffron Asset Advisors' Vohra inches closer to the Holy Grail: "One cannot go by execution promises lying too far in the future. One should take a three-five year horizon for the company's ongoing projects, estimate the resulting cash flows and for the rest, consider the market value of the land owned by the company to arrive at a fair valuation at any point of time."

Biting the bullet

For the investor, the real question is what to consider while picking stocks. Analysts and fund managers say there is not just one standard tool to analyse the realty business.

Each company is a unique mix of myriad projects such as apartments, group housing, integrated townships, commercial complexes, technology parks, special economic zones and perhaps more. There are complications of part or full ownership, sale or lease, in-house development or contract development etc.

Among the Indian realty players, many companies have a unique proposition that make them interesting investments. DLF has a potential for significant cash flows through lease rentals and service contracts on an annuity basis, which makes the scrip attractive.

Unitech banks on its vast spread, while Parsvnath has execution capabilities to scale up rapidly. Orbit, Sobha, Omaxe and Puravankara aim to cater to premium buyers - an approach which gives them ample price-elasticity, but asks for robust cash reserves and funding abilities.

Akruti Nirman, HDIL, IVR Prime and Vipul try to walk the path in between, attempting to grab a share from both the extremes, thus balancing their project portfolio. Now, all that one has to do is scan through the numbers, estimate one's own risk appetite and take a pick.