Indian Real Estate - a bubble?

This is my first post on investment other than equities. I am living in Pune and for the last two years, I feel the real estate prices in and around Pune are inching stratosphere. The prices in the area I live in were quoting around INR 3000 per square feet in 2006. A 2-BHK (two Bed-room, one Hall and one Kitchen) flat cost INR 3 million + parking space of INR 0.15 million + MSEB charges of INR 0.075 million. The total cost of buying the flat would be INR 3.225 million. On top of that there are 1% registration charges and 5% stamp duty making the total outgo at INR 3.4185 million. Consider the cost of basic amenities mentioned below in the table:

Amenity	Cost (INR)
6 Fans	6500
14 Lights	2000
2 Geyser	8000
Kitchen	65000
Curtains	6500

This and other costs would add another 0.1 million to the cost and the flat would cost INR 3.5 million without any furniture.

Now come to present and the price have moved up to INR 4000 per square feet. The total cost of making a 1000 square feet flat livable comes to around INR 4.6 million.

The average income of a salaried employee across various industries with age of around 35 years (the average age at which an Indian male buys a residence) can be about 0.8 million (just estimate, no official source of this figure available). This makes property prices out of reach of a common man with ratio of property to income at 5.75. Looking at some charts at CR, we can see that in US, it went above 5 and created a bubble during 2006-2008.

Even the rent is not able to justify the price. The rent in the area is around INR 15K per month yielding 180K per year. The rent to price or rental yield is 3.91% and after taxing at the highest slab, it comes to just 3% 2.61%. This is justified provided the interest rate remains at the levels they are right now. A one year fixed deposit provides around 6.5% but after the taxes of highest slab, it comes down to around 5% 4.35%.

All this calculation does not mention about the expenses incurred on maintaining a property. Monthly society maintenance is around INR 1.5K. The property taxes are around INR 6K. And I assume there will be other expenses, like painting every few years, internal maintenance of the flat etc... adding to a total of INR 30K per year. Thus the actual income from rent is not INR 180K but just 150K, which makes the rental yield goes down to around 3.26% and just 2.5% 2.18% after taxes if you count it in the highest tax slab.

Consider the counterexample of a flat in 2002-2003, which was selling for INR 1200 per square feet in the same area. The total cost with all the charges was just around INR 1.5 million. The rent at that time was around INR 75K yielding 5% before tax and 3.85% 3.35% after tax, this compares with the 3.91% and 3% 2.61% respectively that we calculated above. The only difference at that time was that the fixed deposits were earning anywhere around 9-11% per year.

The consequences of the burst of this bubble will be really bad.

Midcap IT ready for shakeout?

Due to intense competition lately, it has become difficult for some of the IT companies to maintain their ROCEs. The companies are increasing their debt at an unprecedented rate for growth but are not able to earn proper returns on their invested capital. Have a look at some of them:

Company		3i Infotech	Geodesic	Core Projects	FirstSource	Cranes
	Year
Debt	2005	141.86	0.23	0.82	91.72	115.56
	2006	315.38	0.26	1.1	120.97	323.73
	2007	546.01	0.19	0.31	72.09	461.42
	2008	1262.1	506.79	167.66	1124.14	572.86
	2009	1520.98	640.97	225.57	1342.74	743.25
ROCE	2005	8.57	34.49	NA	3.16	25.72
	2006	7.1	22.07	NA	8.01	14.5
	2007	6.73	30.68	17.48	8.91	14.04
	2008	7.25	14.36	11.86	5.43	13.71
	2009	9.73	19.23	14.96	5.82	11.7

According to what I understand, anything below 15% for two or more years leads to debt spiral where company keeps increasing its debt to fund growth and the interest outgo will keep eating into profits. Some of the above companies have expanded their debt by more than 10 times in last 5 years. This really is unprecedented and may signal what is coming in the future for IT sector.

Some more EPS

Let's have a look at some more EPS numbers as shown in the table:

Index	Jan 7, 2008	Nov 4, 2008	March 9, 2009	Today
BSE500	8882.28/30.04 = 295.67	3879.58/12.8 = 303.09	2983.02/11.72 = 254.52	5945.36/19.67 = 302.25
SMLCAP	13975.19/23.17 = 603.15	4035.11/6.37 = 633.45	2866.68/5.94 = 482.61	6741.24/15.33 = 439.74
CNX500	5500.15/27.06 = 203.26	2421.25/12.42 = 194.95	1966.85/11.24 = 174.99	3727.45/17.6 = 211.79

From the above EPS numbers it is clear that the biggest variation in EPS was in BSE SMALL CAP index. The EPS went down from 633.45 in November 2008 to 439.74 today, a decrease of 30%. The SMALL CAP index was trading at a P/E of 23.17 in January 2008 and came down to a P/E of 5.94 in March 2009, a correction of 75% in P/E itself. The earnings went down by only 24% from 633.45 to 482.61. But the slide didn't end in March. The earnings declined to 439.74 today. Some of it has come due to changes in index constituents but a lot of it has come from profit declines. The SMALL CAP index went down from around 14K in Jan 2008 to 2.8K in March 2009, a correction of around 80% in around 15 months. If you consider the peak earnings of 633.45, at a level of 2866.68, the P/E came to around 4.53.

Surprisingly, Both BSE500 and CNX 500 EPS have gone beyond what it was in January 2008 but P/E has contracted and so the index values are still 33% below their lifetime high made in January 2008.

Sensex-Nifty EPS after Q2 FY2010

Sensex EPS increased from 771.5 after Q1 FY2010 to 15404.94/19.7=781.98 after Q2 FY2010. Nifty EPS increased from 223.4 after Q1 FY2010 to 4711.7/19.81=230.38 after Q2 FY2010. This compares with Sensex EPS of 10631.12/13.1=811.54 and Nifty EPS of 3142.1/13.76=228.35 on November 4, 2008.

This is a degrowth of EPS for Sensex and growth in EPS for Nifty YoY while QoQ both have seen increase. The reason for growth in Nifty can be attributed to new scrips like JSPL, Axis Bank, IDFC introduced in place of Tata Communications, NALCO and Zee.

Why this company is hesitant in paying dividend?

The company I am talking about is "Compact Disc India".

The company first calls for a meeting on February 20, 2006 to consider dividend. The decision to recommend 10% interim dividend was differed in the meeting till the next meeting on 23 March 2006. The meeting on 23 March 2006 was postponed. That meeting never happens.

The company again called for a meeting on 30 May 2008 to consider dividend. The company forgot to inform about any decision taken on dividend in the outcome of the meeting. The updates were communicated to the exchange that the dividend will be discussed in AGM. The company again called for a meeting on 22 August to consider dividend. The board did declare a dividend along with a Shareholders welfare fund worth 50 lacs which will provide interest free loans for personal use to those shareholders who are holding the shares of the company for last 10 years. There was no mention of the word dividend till the next year.

The company called for a meeting on 20 January 2009 to declare interim dividend. The meeting was adjourned on 16 February 2009 and never happened.

The company called for declaration of dividend again on 28 August 2009. The company declared a dividend in the meeting on 4 September 2009. When the AGM was held, the company deferred the declaration of dividend as "in Agreement executed by the company with its bank (lender), the company has to take prior approval of the bank before declaring the dividend." The company again issued a clarification that the dividend declaration was deferred.

Now the company has called again for an EGM to be held on 30 November to declare a dividend in a notice given on 24 October 2009.

Total Market Cap above GDP

One of the valuation that measures whether the stock market in general is undervalued or overvalued is the ratio of total market cap of all the listed companies to GDP. According to economic survey 2008-09, GDP at current market prices was INR 53,21,753 Crore in FY2008-09. According to the BSE, the total market capitalization of all the listed entities was at INR 58,46,175 Crore on Oct 20, 2009. I am not able to get the data for the FY2009-10, but as far as I can remember, the GDP this year will be somewhere around INR 60,00,000 Crore. This makes the current market cap to GDP ratio at 100%. This is much lower than the ratio of 170% reached at the time Sensex was at 21200 in January 2008 when total market cap was INR 80,00,000 Crore and the GDP in 2007-08 was INR 47,23,400 Crore. At the bottom when Sensex reached 8K in March 2009, the total market cap was around INR 30,00,000 Crore, while market cap to GDP ratio at around 56%.

This is despite the fact that many sectors are still not having a single big company listed. This includes Insurance, Restaurants, Advertising, Railways, and many more. Conclusion? The undervaluation of equities is gone.

How government owned companies work?

I would like to give an example of how government owned companies work. The company involved is MMTC. Looking at the balance sheet of MMTC, it can be seen that the company has fixed deposits worth INR 5762.5 Crore while debt of INR 4305.2 Crore at the end of FY09. Now Annual Report of the company shows that it paid INR 665.869 Crore as interest in FY09 while the interest earned was 782.402 Crore. Thus the interest rate earned on fixed deposit was 782.402/5762.5=13.57% while interest paid on loans was 665.869/4305.2=15.47%. If instead, the company had not borrowed money and utilized its own deposits, the company would have saved INR 81.65 Crore, that's 37.6% of its PBT of 217.11 Crore in FY09. What a waste of money!!!.

Are investors over optimistic?

Let's look at valuation of some of the companies:

ABB, a power equipment manufacturer, has a market capitalization of around INR 17K crore at a market price of INR 800. The company earned a net profit of INR 547 Crore in CY08 and has seen a decline of INR 87 Crore in profits in the first two quarters this year, TTM profit being INR 460 Crore. This makes the company valued at a P/E of 37 with degrowth in earnings. The dividend last year was INR 2.2 and the yield turns out to be 0.275%. It will take 363 years for an investor to get dividend equivalent to price of the share if the dividends do not grow.

BOSCH, an auto component maker, has a market capitalization of around INR 13K crore at a market price of INR 4000. The company earned a net profit of INR 633 Crore in CY08 and has seen a decline of INR 143 Crore in profits in the first two quarters of this year, TTM profit being INR 490 Crore. This makes the company valued at a P/E of 26.5 with degrowth in earnings. The dividend last year was INR 25 and the yield turns out to be 0.625%. It will take 160 years for an investor to get dividend equivalent to price of the share if the dividends do not grow.

Gujarat Gas Company, a city gas distribution company, has a market capitalization of around INR 2500 Crore at a market price of INR 200. The company earned a net profit of INR 160 Crore in CY08 and has seen a decline of INR 4 Crore in profits in the first two quarters of this year, TTM profit being INR 156 Crore. This makes the utility company valued at a P/E of 16.5 with degrowth in earnings. The dividend last year was INR 1.5 and the yield turns out to be 0.75%. It will take 134 years for an investor to get dividend equivalent to price of the share if the dividends do not grow.

Hindustan Zinc, a zinc producer, has a market capitalization of around INR 34K Crore at a market price of INR 800. The company earned a net profit of INR 2727 Crore in FY09 and has seen a decline of INR 129 Crore in the first quarter of this year, TTM profit being INR 2598 Crore. This makes the metal company valued at a P/E of 13 with degrowth in earnings. The dividend last year was INR 5 and the yield turns out to be 0.625%. It will take 160 years for an investor to get dividend equivalent to price of the share if the dividends do not grow.

The conclusion? Wait for better opportunities. Wealth does not build over long term with this kind of valuations.