There has been general buoyancy of valuations in the market. So, the quest for value often takes us to neglected corners of the market.  One such place for me has been Real estate sector; so I set about understanding the dynamics here.

Throughout the global history, Real estate has shown remarkable consistency in exhibiting cyclical patterns. One primary reason for this has been the time lag between demand and supply(It takes long time to add new inventory to real estate market once when its needed, and then developers not giving weightage to cyclicality tend to keep erecting buildings till there is a widespread recession).

Other significant driver for this cyclicality is Interest rates and credit supply.

One of the early works to demonstrate the characteristics and phases of real estate cycle were published by Henry George in late 19^th century. His findings were as follows :

Phase I RECOVERY  ….. Land prices are at depressed lows, Unmet demand for residence and business needs is increasing. Interest rate cycle has already peaked and maybe trending downwards.

Phase II EXPANSION…. Occupancy begins to exceed the long term average ,Increase in rental growth and real estate prices, Pace for new development increases.

Speculators then jump in to profits from change in prices, also there is surge in volume of credit, written on land being collateralized at higher values.

Investors believing current rates justifying future growth keep on buying at inflated prices and developing new projects.

Phase III HYPERSUPPLY… Abundance of supply in the market, Early signs of trend reversal with rise in unsold inventory,rent growth rates drop lower and lower. Huge expansion of credit in previous phases may lead to increase in interest rates consequently higher mortgage payments.

Phase IV RECESSION… Rate of growth of unsold inventory accelerates, rising interest rates, lower profits for developers on account of lower rents than anticipated and high unsold inventory.

Homer Hoyt,  a leading land economist of 20^th century believed a typical real estate cycle to be around 18 years using data of land prices and volume of transactions in many cities of USA. But, In India, Asia, Middle East etc empirical evidence from past 3-4 decades suggests cycles have been shorter and in the range of 8-10 years.

Owing to this inherent cyclicality, it is imperative for a real estate player to act with prudence and keep track of certain factors that affect demand and supply. This in turn will help them to calibrate their strategy and resource allocation.

A.Demographic factors…shape demand because of population growth, migration, household size, age distribution and change in family structure

B.Economic factors… household purchasing power, interest rates, foreign investments etc

C.Regulatory factors… have an impact on providing transparency and increasing confidence of the buyers

D.Political factors… such as an unstable region may cause buyers to shun investments and look for liquid instruments. (Think Regions of Telangana, especially Secunderabad/Hyderabad)

To survive a market downturn a developer should have robust risk-management framework in place. This business has volatile revenue streams and its necessary to balance the portfolio with certain recurrent revenue streams(leased assets) to meet cash needs during recessionary times. Also, a level of risk be defined with which stakeholders are comfortable and consequently  a debt/equity limit be set. And, too often during expansionary phase, it’s seen, developers start taking all kinds of projects across value chain/segments perceiving low risks and future profits and wander away from core expertise(Think Shopping malls during last real estate boom in india ,Also this month’s cover story in Business Outlook). The management’s aim shouldn’t be to profit the most during Boom times but to create sustainable value for stakeholders.