Indian Real Estate-Under Debt Stress (Sell) Macquarie

Sector news flow remains weak

Inflation has surpassed all expectations and reached a seven-year high of 8.75% last week. The recent hike in fuel prices (10% for petrol and 8% for diesel) may further fuel inflation given the direct impact on the cost of transportation. Our regional economist, Bill Belchere, expects no monetary easing until later this year at the earliest.

This view is supported by the low base effect, which is likely to remain in place until October 2008. Note that we are also now in the run-up to central government elections in May 2009. We suspect that last week’s 25bp rate hike by the Reserve Bank of India (RBI) may not be the last.

Is there a ‘Centro’ lurking out there?

In December 2007, Centro Properties (CNP AU, A$0.28, Underperform, TP: A$0.50) announced a reduction in earnings projections as a result of its inability to refinance short-term debt obligations on a long-term basis.

We believe the situation is ripe for a similar scenario to emerge in India. The domestic markets and the Singapore REIT markets remain soft. Debt capital was already in short supply given targeted tightening by the RBI over the last two years.

Our channel checks suggest that certain developers have raised bridge finance (at 18–25% interest rates) until October. They expect the lull in activity due to the monsoon to end with the festive buying season in October.

Given the interest rate scenario, we believe there is a higher than 50% probability that the recovery in sales volumes will be weaker than expected. This would lead to under-cutting on product prices and asset sales/equity injections at distressed valuations.

Focus on the two C’s: ‘cash’ and ‘commercial’

‘Cash is king’ are the three sweetest words in the current scenario. This ensures timely project launches and delivery. Importantly, it also opens the door for opportunistic asset acquisitions over next 6–12 months.

‘Commercial’ sub-segment is the most attractive given stable (locked-in) cashflows in a volatile pricing environment. It derives benefits from limited upcoming grade ‘A’ supply, continuing economic growth and moderate prices.

The hard part! Identifying winners

We ‘shock’ our financial models and perform an analysis using scenarios – from the realistic to the grim (liquidation). Mid-sized players are trading at deep discounts to NAV. Meanwhile, individual companies (such as Ansal) are trading near their liquidation value (Figure 1). However, investors are unlikely to get excited as realisation of the value is unlikely given the lack of triggers.

Within our coverage universe, we expect the outperformers to have the two important characteristics: access to capital and exposure to commercial real estate. Indiabulls Real Estate and DLF Ltd stand out. Unitech is a player which we believe should survive the liquidity crunch by raising fresh venture and private equity funds.

What should one keep an eye on? We believe the possibility of positive 12-month returns in the sector is higher than 50%. The next data points we would watch out for are signs of any pickup in sales during the festive season in October. Purchases of distressed assets by capital-rich developers could prove to be NAV accretive