Idea Book On Investing In Real Estate Developers

09 
 
September 

Idea‐Book on 

Investing in Real Estate Developers 

Rahul Deodhar 
Investors  got  fantastic  returns  investing  into  real  estate  developers.  However,  as  times 
become difficult, it is important to separate the grain from the chaff. I present some bits of 
knowledge  I  collected  while  analysing  real  estate  developers.  These,  I  hope,  will  help 
investors identify the great developers and thus make better investment decisions. The list is 
to be read in addition to prudential investment and valuation principles and practices. 

RAHUL DEODHAR

Investing in Real Estate Developers –An  ideaBook 

 

Introduction 
Real estate developers have been a significant part of value creation for investors. And 
they will continue to be. However, as times get difficult, it is important to pick the right 
developers to invest in. While these are logical, they are often ignored in my experience. 

I  believe  first  thing  a  developer  must  be  sensitive  to  is  business  cycle.  Irrational 
optimism leads to a fatal failure in preparing for eventual slowdown. 
Similarly,  land  bank  quantity,  quality  and  cost  determine  the  future  earning  potential 
and growth of the developer.   
Developers’ also need an ability to manage through‐cycle earnings for the company. In 
search of quick profits, developers often condemn the company to future revenue de‐
growth and lower or negative profitability. 
Cash flow management and debt structuring is other critical part of real estate business 
that can make or break the company. 

Lastly, I mention some ways in which real estate developers prevent value realisations 
for the listed entity. 

I  hope  these  learning’s  will  be  helpful.  These  do  not  comprise  the  complete  list  and 
must  be  used  in  conjunction  with  standard  investment  and  valuation  procedures  and 
practices. 
 
 

License  
The  work  can  be  shared  for  noncommercial  use  through  proper  attribution  as 
explained  in  Creative  Commons  AttributionNoncommercialShare  Alike  3.0 
Unported License 

  2 
 
© Rahul Deodhar 2009 
www.rahuldeodhar.com


Understanding Business cycles 
Real  Estate  Industry  cycles  lasts  10‐13  years  peak‐to‐peak.  Over  this  period  prices 
decline to troughs and start improving again. The volumes, generally, start picking up 
as  prices  pick  up  and  peak  volumes  occur  when  prices  are  roughly  80‐90%  of  their 
peak value. 

Cycle in growing city  Cycle in declining city 

  

The actual prices and volumes at peak and trough depend upon the state of the city’s 
economy.  In  a  growing  city  the  through‐cycle  average  prices  tend  to  move  up  (as 
represented by dotted line) whereas they decline in a city with declining economy. At 
the  country  level  certain  cities  tend  to  lead  the  growth  whereas  certain  others  lag. 
Beijing is an example of growing city, while Detroit, US is example of declining city. 
The good developers understand the cycle and where their cities are within the cycle. 
The best developers adjust their businesses to become structurally sound as we will see 
further.  

  

  3 
 


Land Bank 
Countercyclical land bank aggregation 
In most cases, land prices are in line with final real estate prices. Therefore, land bank 
aggregation  needs  to  be  counter‐cyclical.  In  established  cities,  this  creates  structural 
advantage difficult to match. Those developers buying land at peak cycle will lose out. 

Land bank aging 
Land bank is usually bought for next cycle. So a established developer has land bank for 
10 years. In other words, if land is bought today, construction will start in after 5 years 
and the next 5 years the project will be complete. In the last few years, the developer’s 
land  bank  holdings  shrank  to  2‐3  years  worth  construction.  This  typically  happens 
around peak of the cycle. 
However,  redevelopment  lands  in  central  locations  are  difficult  to  hold  for  longer 
periods. This land is turned around very quickly. 

Debt free land bank 
Given the above conditions first principles dictate that developers use own capital for 
land  bank  purchases.  Debt  for  land  purchases  severely  hinders  the  ability  to  capture 
value.  Hence  developers  financing  land  bank  purchases  through  debt  will  be  under‐
perform in the longer term. There is also a risk of default depending on total leverage. 

Capital management to overcome cycle mismatch 
The  difference  in  land‐bank  procurement  cycle  and  real  estate  cycle  causes  financial 
mismatch.  Developers  are  most  leveraged  at  the  time  when  prices  are  lowest  (or  at 
least should be) and they are cash rich when land prices are at maximum. Developers 
usually  tap  the  equity  markets  during  peak  times  (to  get  best  valuations).  So  a 
mismatch  is  created.  Developers  have  to  manage  this  mismatch  if  they  do  not  have 
capital  to  finance  land  purchases.  Generally  two  ways  are  used.  First,  land‐purchase 
agreements are used to lock in the price. Second, joint development agreements make 
the current landowner partner in the project.  

Strategic Land value inflexion 
Policy  action  or  infrastructure  developments  lead  to  inflexion  in  land  value. 
Aggregating  land  banks  at  strategic  locations  creates  a  structural  advantage.  Great 
developers have in‐house experts to understand and identify such locations.  

  4 
 


Revenue & margins 
At  a  company  level,  revenue  is  product  of  total  area  sold  and  average  selling  price 
(ASP).  To  a  certain  extent,  margins  are  independent  of  the  top  line.  They  are 
determined  by  the  land  bank  costing.  Nevertheless  the  revenue  equation  creates 
unique challenges for the developer. 

Maintaining or managing revenue growth 
To maintain, say, 10% revenue growth, a developer has to expand the volumes by 10% 
or price by 10%. We read this in conjunction with the current position in the business 
cycle. Clearly, in an up cycle it is easier to maintain the revenue growth momentum. The 
problems occur in the down cycle when prices are falling. Here, to maintain our 10% 
growth, volumes will have to grow more than 10%. Real estate prices are known to fall 
by more than 30% over the down‐cycle. So clearly the pressure is huge. But there is a 
way out. 
Developers  adjust  project  mix  to  sustain  the  ASP  level.  This  means  at  peak  cycle 
developers are selling lower ASP projects and concentrate on premium projects during 
lean times. This makes sense otherwise too. Usually lower ASP projects are far out and 
thus  bear  greater  risks.  Premium  projects  are  generally  closer  to  city  centres  where 
ASPs and saleability tend to hold out better. 

Developers  need  to  have  the  land  bank  profile  to  fit  such  strategy.  Conversely, 
developers with high cost land banks tend to lose out. 

Revenue Augmentation – lure of commercial real estate 
With  the  huge  cyclicality  in  revenues,  developers  are  drawn  to  steady  stream  of 
incomes offered by commercial real estate (CRE).  
CRE  acts  like  an  income  source  till  the  valuations  and  cap  rates  become  attractive. 
Thereafter the developer can sell the CRE to a REIT and exit at a handsome profit. But 
on the flip side, it ties up lot of capital. Further, CRE adds to the risks. 
Commercial  realty  has  altogether  different  risk  structure.  The  commercial  realty 
market  is  dynamic  and  demand‐supply  need  to  be  finely  tuned.  Reckless  mall 
development  is  hindrance  for  developers  and  tenants.  Developers  in  India  and  China 
are  still  to  fine‐tune  this  risk  assessment  and  response.  Some  Singapore  real  estate 
consultants  have  made  great  progress  in  this  area.  To  protect  themselves  from  CRE 
cycles,  developers  tend  to  house  them  in  separate  entities  with  asset  itself  as  debt 
collateral. 
There  is  always  a trickle  back  of risk  to the  holder  of the property (the  developer) in 
commercial  real  estate.  Hence,  a  base  fee  +  revenue  sharing  arrangement  is  usually 
considered better compensation for malls and hotels.  
Aside, most potent commercial real estate is car parks. Car park is less analyzed area in 
real estate. 

  5 
 


Cash Flow and Debt management 
Cash flow and debt management differs greatly in residential and commercial projects. 

Cash flow through presales 
Residential  real  estate  generates  cash  before  expenses  through  a  process  called  pre‐
sales.  This  is  a  process  where  developer  gets  money  from  customers  who  pre‐book 
apartments. Is cash flow is used by the developer to build the project. Top developers 
are able to generate good quality pre‐sales (sales to last buyers rather than investors) 
and  it  remains  important  source  of  cash.  It  helps  developers  take  lesser  debt  than 
otherwise. 
However,  there  are  groups  of  investors  who  pre‐buy  these  apartments  in  bulk.  In 
return developer increases the selling price as completion nears thereby giving a return 
through  asset  price  appreciation.  In  this  form  it  is  simply  a  form  of  project  financing. 
This  mechanism  is  similar  to  dealer  sales  in  case  of  consumer  goods  companies.  And 
just  like  dealer  sales,  the  goods  can  be  returned  if  prices  crash  drastically.  Equity 
market investors cannot discount this risk, as it is hidden.  

Requirement for Debt 
Real  estate  business  seems  positively  cash  accretive  business.  But  the  cash  flow  is 
spread  as  shown  below.  The  green  zone  represents  sales  period  and  is  usually  cash 
flow positive. Red zone is where land bank accumulation happens and there is a cash 
outflow. In red zone, typically debt requirement is high. The debt burden is carried by 
projects under construction with total interest cost being met by trickle of pre‐sales. 

Business Cycle and cash flow situation (Red = net outflow and 
green = net inflow) 

  6 
 


Frauds 
Despite prudential regulations, investors often wonder if a company is ethically sound. 
There are a few things one can look for in real estate developers. 

Nonarms length parties 
The parties who sell the land bank and those who buy apartments in pre‐sales are often 
under scrutiny.  
Land bank is sometimes held in joint venture companies with promoter as part owner. 
The price paid for land bank, by the parent to the JV, should then be subject to scrutiny. 
Often the land bank agreements are renegotiated at higher prices in peak cycle times. 
Similarly,  apartments  are  often  pre‐sold  at  lower  than  market  rates  to  related  parties 
who thereafter make a profit on further transactions. 
Building  maintenance  is  another  area  of  contention.  It  is  usually  carried  out  by  sister 
concern of developer and there is no bidding for lowest cost provider. So if ownership 
structure of this sister concern is different it should raise a flag. 

Missing addon fees 
Often,  cash  component  in  apartment  sale  goes  unchecked.  Further  the  developer 
accepts cash fees for transfers and other services that are not billed to the company.  
Indian  real  estate  market  has  a  certain  cash  proportion  to  lot  of  deals.  These  are  not 
reported to the company in many cases. 
Developers have a single real estate broker and all deals are routed through this broker. 
Such  transactions  are  actually  treated  as  costs  for  listed  entity  and  promoter  usually 
gets a kickback from the proceedings. 

Misrepresentation of Land Bank 
Land bank, as a rule, is amount of land with clear title and relevant clearance for end‐
use as required by projects.  

Land titles cannot directly be attributed to company. Company often needs to resort to 
legal procedures to get clear title or right to develop the land. Such land should actually 
be ignored from land bank calculations. 
Further,  lands  often  do  not  have  clearance  for  real  estate  development  use.  The 
company  might  be  holding  agricultural  land.  While  most  developers  can  get  the 
relevant  permissions  for  conversion,  the  process  is  time  consuming  and  legally 
uncertain. 

  7 
 


Conclusion & Disclaimer 
The  above  points  are  some  of  the  points  to  be  considered  while  analyzing  real  estate 
developers.  The  list  is  not  comprehensive  and  must  be  read  along  with  general 
valuation principles and practices. 
 

About Me 
I worked as a buy‐side analyst with top hedge fund client of Morgan Stanley.  Prior to 
this, I worked for CRISIL Research doing industry and company research. I have over 8 
years of work experience across various roles starting on the shop floor to investment 
analysis. You can email me at rahuldeodhar@gmail.com. 
 

  8 
 

Idea Book On Investing In Real Estate Developers

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