Why do real estate companies mostly operate on debt.If we go on to observe the books of real estate companies we can find that the real estate companies are levered to a great extent as compared to the other sectors. I have tried to intuitively reason out few of the possible sector specific nature of the business.
Sector specific reasons
Collateralized loan – Banks and other lenders will be ready to give their loans when there is a collateral against the loan (called as collateralized loan). So if we can observe companies which contains low capital assets in their balance sheet also will have less debt. Also lenders will be wary of providing loans to R and D related activities, service business (observe the balance sheet of Infosys.Zero debt!! …It can’t get cleaner than that).This helps the companies go in for more debt rather than equity (This is just a theoretical argument and hence we are not getting into arguments regarding CDO, MBS, Lehman and the other reasons of financial crisis)
Premium Requirements according to CAPM: Real estate prices are highly volatile and it is hugely driven by the economic scenario. Hence even if the investors try to diversify their risks by buying a portfolio of real estate stocks (Portfolio theory), they cannot get away with the undiversifiable (also called as the systematic risk).As per the CAPM model investors expect a premium for the undiversifiable risk (risk of the individual stock that is correlated with the market) and in this case it is quite high . Hence we observe the Beta of the real estate stocks to be on the higher side. So the premium required on the real estate stocks compared to other stocks is quite high. This implies cost of equity for a real estate stock is quite high. This drives the real estate companies to look for private placements or to look for debts at affordable interest rate (either collateralized bank loans or commercial papers depending upon the length of the project or based on the cash flows associated with the project).
PS: One reason for high beta is due to the fact that these companies take huge debt .But we can safely ignore that assumption because the changes in beta because of increasing levels of debt is quite negligible compared to the other risks associated due to the macroeconomic changes and associated changes in the market returns .
Easy to manipulate : One important ratio which the banks observe while they give loans is the interest coverage ratio(There are other profitability measures like Operating profit margin , Net profit margin which is being looked at, but interest coverage ratio is all the more powerful way of looking at a debt serving capacity).This ratio is given by the formula
Interest coverage ratio = Earnings before interest and tax/Interest expense
The cash flows of the real estate companies can easily be manipulated. The revenues as reported in the balance sheet essentially does not means cash is flowing into the company (Accrual method of accounting).Hence real estate companies will use different methods such as percentage completion method , cost recovery method to report the earnings in the balance sheet . These figures depend upon the discretion of the management. (How much can a auditor question when the management says it is very sure about its cash flow!!). Hence Interest coverage ratio can be inflated to higher levels so as to get higher and attractive loans.
Note: One way the lenders try to avoid this trap is to see the operating cash flow to the Net income ratio. If this ratio has been consistently less than one, then there is certainly something wrong with the company and its business
Loss of management control: By pumping in more money, the promoters have to forego some of their control and for each and every decision they have to be approved by the shareholders. Hence in order not to lose the control of the management, the promoters normally try to go in for debt rather than equity. Though this fact is common to every other sector, this assumes even more significance in the case of a real estate company because their corporate governance and their pricing policies have not been the best(Take the case of DLF , Unitech which has been bombarded with corporate governance issues for some time now) . Hence they would want to avoid all the regulations, investor questions regarding policy decisions and the likes (Ouch, am I making a bias here by considering only few real estate companies??!!)
PS: My next article will be a study on the corporate governance policy across the real estate companies in India, which will give clarify whether my last argument is just a bias or is it real.
Sector specific reasons
Collateralized loan – Banks and other lenders will be ready to give their loans when there is a collateral against the loan (called as collateralized loan). So if we can observe companies which contains low capital assets in their balance sheet also will have less debt. Also lenders will be wary of providing loans to R and D related activities, service business (observe the balance sheet of Infosys.Zero debt!! …It can’t get cleaner than that).This helps the companies go in for more debt rather than equity (This is just a theoretical argument and hence we are not getting into arguments regarding CDO, MBS, Lehman and the other reasons of financial crisis)
Premium Requirements according to CAPM: Real estate prices are highly volatile and it is hugely driven by the economic scenario. Hence even if the investors try to diversify their risks by buying a portfolio of real estate stocks (Portfolio theory), they cannot get away with the undiversifiable (also called as the systematic risk).As per the CAPM model investors expect a premium for the undiversifiable risk (risk of the individual stock that is correlated with the market) and in this case it is quite high . Hence we observe the Beta of the real estate stocks to be on the higher side. So the premium required on the real estate stocks compared to other stocks is quite high. This implies cost of equity for a real estate stock is quite high. This drives the real estate companies to look for private placements or to look for debts at affordable interest rate (either collateralized bank loans or commercial papers depending upon the length of the project or based on the cash flows associated with the project).
PS: One reason for high beta is due to the fact that these companies take huge debt .But we can safely ignore that assumption because the changes in beta because of increasing levels of debt is quite negligible compared to the other risks associated due to the macroeconomic changes and associated changes in the market returns .
Easy to manipulate : One important ratio which the banks observe while they give loans is the interest coverage ratio(There are other profitability measures like Operating profit margin , Net profit margin which is being looked at, but interest coverage ratio is all the more powerful way of looking at a debt serving capacity).This ratio is given by the formula
Interest coverage ratio = Earnings before interest and tax/Interest expense
The cash flows of the real estate companies can easily be manipulated. The revenues as reported in the balance sheet essentially does not means cash is flowing into the company (Accrual method of accounting).Hence real estate companies will use different methods such as percentage completion method , cost recovery method to report the earnings in the balance sheet . These figures depend upon the discretion of the management. (How much can a auditor question when the management says it is very sure about its cash flow!!). Hence Interest coverage ratio can be inflated to higher levels so as to get higher and attractive loans.
Note: One way the lenders try to avoid this trap is to see the operating cash flow to the Net income ratio. If this ratio has been consistently less than one, then there is certainly something wrong with the company and its business
Loss of management control: By pumping in more money, the promoters have to forego some of their control and for each and every decision they have to be approved by the shareholders. Hence in order not to lose the control of the management, the promoters normally try to go in for debt rather than equity. Though this fact is common to every other sector, this assumes even more significance in the case of a real estate company because their corporate governance and their pricing policies have not been the best(Take the case of DLF , Unitech which has been bombarded with corporate governance issues for some time now) . Hence they would want to avoid all the regulations, investor questions regarding policy decisions and the likes (Ouch, am I making a bias here by considering only few real estate companies??!!)
PS: My next article will be a study on the corporate governance policy across the real estate companies in India, which will give clarify whether my last argument is just a bias or is it real.
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