Monday, 5 September 2016

How to analyze real estate developers

How to analyze real estate developers

Real estate stocks make up a significant number of companies in Asian stock exchanges and many of them are among the the most volatile stocks. Whether the real estate developer is listed or not, they are influenced by a host of cyclical factors ranging from government policies, interest rates, unemployment rates, affordability, etc. Hence, it is important to understand how real estate companies can be analyzed.

Profit Model

Real estate industry can be separated into the following sub-industries or types of real estate developers:

  1. Residential real estate developers
  2. Commercial and mixed use real estate developers
  3. Industrial real estate developers

Profit model of residential real estate developers

Residential real estate developers are more dependent on economies of scale than ever because of increasing land prices and declining rate of increase in residential property prices. In many developing countries, developers used to be able to acquire land at cheap prices and hope for rapid increase in home prices to make huge profits. In developed countries, land prices are higher, and price increases are more muted. Hence, brands and good management are playing an increasingly important role.

Profit model of commercial real estate developers

As prime real estate for commercial developments become more scare, commercial real estate developers tend to prefer to have rental incomes rather than selling units so that they can have consistent income and manage the properties. These developers are also more likely to sell their commercial properties to real estate investment trusts to free up capital and many are REITs that also develop properties.

Profit model of industrial real estate developers

Industrial real estate developers operate more like commercial real estate developers as they seek to have stable rental incomes and also sometimes selling their properties. Some industrial estate developers might even have a fund to invest in promising industrial companies so as to achieve higher profits.

Factors that Affect Value

1.  Land bank - the value of a real estate developer is directly influenced by its land bank. As the larger the land bank, usually means the developer can make more profits from developing the land banks later. Hence, the land bank that a real estate company has is always disclosed in detail in the listed companies' reports.

2.  Inventories - Real estate inventories can be separated into a few categories. Usually increasing values of construction-in-progress and land held for development will translate to higher future earnings for the company:
  • Completed developments - properties whose construction has been completed
  • Construction-in-progress - means the value of properties under construction.
  • Land held for development - value of land help for future developments.
  • Investment properties - properties held for rent or sale

3.  Customers deposits - for residential projects, it is often that developers will collect customers deposits or even prepayments of entire houses prior to completion of the units. As these properties are pre-sold and their profit and loss have yet to be recognized in the income statement, growing customer deposits could signal increasing revenue and most likely profits in the coming years ahead.

4.  Housing prices - the profits from real estate developers that primarily sell their developments come from selling the units at above costs. Hence, the moving of housing prices have direct impact on the profitability of residential real estate developers. Usually the stock price of real estate developers have high correlation with the anticipated housing price direction.

5.  Rental rates - Rental rates are especially important for commercial and industrial real estate developers as most of them do not sell all the units that they developed but they keep these units for rental returns. Rental rates have direct bearing on stock prices of such developers and REITs.

6.  Industry consolidation - as economic difficulties mount and economies of scale becomes more important, mergers and acquisition activities will also drive prices of real estate companies as the merged entities might be more efficient given a larger land bank.

7.  Macro economic factors - government policies play a huge role in controlling property prices as the following factors will determine the direction of property prices. We have listed

Factor                 Movement      Likely Effects
Interest rates         Up                Negative
Land supply          Down            Positive on short term price but will affect future
                                                  profitability if land bank dries up
Loan Quantum      Up                 Positive
Reserve ratio         Up                Negative
GDP                     Up                Positive
Unemployment      Up                       Negative

Valuing Real Estate Developers

A common method to value real estate developers is using the Revalued Net Asset Value ("RNAV") approach which basically determines the net asset value of a real estate developer by adding up

  • the change in value of the investment properties held by the company, 
  • the surplus value of properties held for development using Discounted Cash Flow method and 
  • the net asset value of the company with any other adjustments that are deemed necessary.

Usually a discount or premium percentage is multiplied with the RNAV base on the developers other qualities such as management capabiltiies, branding, track record, etc. A smaller developer with poor record of continuously generating consistent income is usually given a significant discount to its RNAV.

Using the RNAV approach only takes into account of what the developer can earn with the assets that it has in its books at the time of the valuation. If properly applied, it is usually more conservative than the market approach such as P/E multiples.

However, to use this method, it requires a lot of work in revaluing the properties held by the developer, making it difficult to implement by most people as information needed to determine RNAV needs some skill in obtaining.

The price earnings ratio method could also be useful to cross check the RNAV method.


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