THE WEIGHT OF EXPECTATIONS
How an IPO will redefine the real-estate sector in India.
By Abe De Ramos

A statue of the elephant god Ganesh stands at the lobby of a tenth-floor office in Gurgaon, an urban sprawl an hour away from central Delhi. Beneath the stone image kneels a man in white kurta, chanting prayers from a tattered notebook, while another lays marigolds on a carpet that barely fits them both. In this Hindu ritual called puja, the Brahmins are invoking favors for the new occupants of the sloping tower, which an imaginative worker says resembles the top half of a breaking Titanic. Some employees of DLF are moving in, and CFO Ramesh Sanka knows the company, which owns the building, could use the blessings. Come November – or as soon as a battle with shareholders is over – India’s biggest landlord will sell its shares in what could be the country’s largest initial public offering. But not only would the deal change DLF’s fortunes; it could also give rise to a role model for a ragtag industry that badly needs one.

Back in Delhi, Sanka is besieged by his staff with spreadsheets and letters and the constant ringing of his phone. He handles the hubbub with monkish composure, unperturbed by the delay in his IPO. The family-owned DLF planned to raise 136 bn rupees (US$3 bn) in June from selling just 12.5% of its shares – effectively valuing itself at US$24 bn – but a complaint from minority shareholders put it off. That may in fact have worked in DLF’s favor. In the four months since the company filed its draft offer document, the Indian stock market has crashed and strongly recovered, while DLF added new assets to its portfolio. “We have 14 new projects, acquired lots of land, and signed two major joint ventures,” says Sanka, who is now updating the financial data in DLF’s prospectus. “The market is in a better position now.”

In short, DLF might command an even higher valuation. DLF is one the most attractive names in corporate India today, credited with transforming Gurgaon from grassland into a scrubbed-up city. Since 1946, the company single-handedly developed more than 8,800 acres of land. What was then called Delhi Leasing & Finance, selling houses to refugees displaced by the Indo-Pakistani War, is now known as a provider of offices for multinational corporations such as IBM, Citibank, and Coca-Cola, and a developer of condominiums and malls for the new yuppie class arising from the outsourcing boom. The IPO will allow DLF to grow beyond Gurgaon, with plans to also build hotels and special economic zones across India.

“DLF is a sought-after brand name,” boasts Sanka. “Our products command a 10-15% premium over our competitors’.” But for that premium to translate into IPO success, Sanka has to convince investors that his valuations make sense. Fears of a property bubble are growing, as housing prices in Gurgaon, Delhi, and Mumbai have in some cases doubled in the last two years. Investors are also more discerning of new issues in light of the failure of recent high-profile IPOs such as that of low-cost carrier Air Deccan, which now trades at half its offer price. “There’s been a good amount of debate lately on IPO valuations,” says Jigar Shah, head of research at brokerage firm KR Choksey. “The response to DLF will probably be good, but not great.”

PROPERTY VALUES

Whatever the response, the IPO’s benefits may go beyond DLF itself – it could change the way India’s real-estate companies operate. For a country with vast amounts of land, property companies make up less than 1% of the stock exchange. The reason? Archaic land-ownership restrictions are natural barriers to growing a property firm to a considerable size, and so discourage potential long-term players. Naturally, those who get around the law choose to stay under the radar. DLF’s listing ups the ante on the competition and could encourage other developers to raise funds in the open market. By ripple effect, this could force them to improve transparency and drive consolidation in the highly unorganized sector.

To be sure, developers have a huge demand for capital. India has a shortage of 20m houses, according to the government. Property-management firm Jones Lang LaSalle says India also needs up to 70m square feet of office space in the next two to three years to meet demand from the outsourcing industry alone. In retail, consulting firm Ernst & Young says 220 malls are expected to be completed in India by end-2007. “We’re in a sunrise industry,” says Sanka, adding that the property sector could grow 20% a year if GDP grows 8% – as it is poised to do in the next five years.

Over the last two years, some developers have received funding from venture capitalists, including foreign ones, since the government relaxed investment rules. But even now, most still largely fund their projects with private debt, and in the case of residential developers, advance payments from customers. “Customer advances are funding as much as 90% of the project, followed by bank borrowings and equity,” says Akash Jyoti, head of corporate ratings at rating-agency firm Crisil. Rashesh Shah, CEO of Edelweiss Securities, says public equity should add to the mix once DLF is listed. “In the next three to four years, we expect real-estate companies to make up 8-10% of the stock market,” he says. “Forty to 50 real-estate companies are now waiting in the wings.”

That is, waiting to see how investors value DLF, which earned US$44m on US$280m of revenues last year. The US$24 bn price tag thus means investors would pay a mind-boggling US$545 for every dollar of profit. What explains the lofty valuation? Property valuator Cushman & Wakefield valued the land DLF currently owns (about 5,230 acres) at US$24 bn. Coincidence? Not for Shah of Edelweiss. “Land bank holdings drive a large part of the valuation,” he says. “But land is only as valuable as what you could do with it. The asset will take time to be converted into earnings, and a model needs to be established on how to value them.” The IPO is thus an opportunity for the real-estate sector to finally have a benchmark – and for DLF to get it right.

Sanka bridles when asked why DLF expected so much from its relatively small profit. “PE ratio in our case is dicey,” he says, explaining that earnings are dictated by how much of the company’s projects are sold or leased. In the year ending March 31, DLF made 9.4 bn rupees from property sales and 422m rupees from rentals. In the two years prior, the latter amounted to 10% of sales income. Going forward, Sanka says DLF plans to lease more of its projects, especially the malls and offices. “People will have to understand which profit is better: a one-time sale or rental forever?” he says. “My rental income will become sizable in the next two to three years. Then people will be able to see our underlying potential.”

LAW OF THE LAND

But DLF can become a benchmark in more ways than just valuation: It is a model of growth. By any measure, DLF towers over competitors, including Delhi-based Unitech, the largest of the few real-estate companies currently listed on the Bombay Stock Exchange. Unitech has so far developed only 1,100 acres of land, according to Morgan Stanley analysts, and last year made half the turnover and a third the profit of DLF. The rest are even smaller, and due to their limited resources, they tend to operate in only one city or property class. “If you ask me if there is one single competitor who covers all areas of our operation, I would hesitate to say yes,” says Sanka,

To understand how DLF achieved its size, consider how the industry became fragmented. In 1976, India imposed the Urban Land Ceiling Act to prevent developers from profiteering from the sudden housing demand from war refugees. Under the law, developers can’t own land beyond a certain size – in some cases as little as 5,000 square feet – under one name. In recent years, some states have repealed the act, although it remains in place in many others including those that hold the key cities of Mumbai, Hyderabad, and Kolkata. Another hindrance to growth is high transaction cost. Stamp duty paid on direct purchases of real-estate assets range from 5% in Mumbai to 10% in Bangalore. “This is a reverse incentive for developers from making as many transactions as possible,” says Jyoti.

DLF got around both restrictions through a combination of luck and corporate structuring. Delhi and the state of Haryana, where Gurgaon is, repealed the act earlier than other states. DLF also used special-purpose vehicles to ring together plots of land acquired under different names. This structure, says Jones Lang LaSalle, brings the purchase cost to as low as 0.5% of asset value. Sanka says DLF has about 70 such vehicles as subsidiaries, and that understanding how these work has been his most challenging task since joining DLF in 2004. “It’s easy to go through the balance sheet of one company, but it’s difficult to understand so many companies,” says Sanka, a mechanical engineering graduate whose prior job was CFO of telecom firm Bharti Mobitel.

But the “number one competitive advantage” of DLF, says Sanka, is its land-acquisition skill. In India, buying land is complicated by a number of factors. For one, most private land holdings have no clear title deeds. Families and individuals are the typical private owners, and as such, organized dealings are restricted and title transfers often disputed. Investors reduce the risk by securing title insurance from insurance companies. “You have to painstakingly do due diligence before buying,” says Sanka. “We have a huge team of lawyers and experts who specialize only in land acquisition.” It helps that DLF is cash-rich; at any given time, Sanka maintains a cash balance of at least US$100m. “If there are problems with land acquisition, we would like to settle then and there,” he says.

Analysts acknowledge the significance of DLF’s IPO. “It would inspire other developers to corporatize,” says Amitabh Chakraborty, head of research at Brics Securities. “The market now understands that if you become a company, you can borrow money from the banking system and even attract foreign portfolio investors.” When more developers list, says Jyoti of Crisil, it would add to the momentum towards better transparency in the sector, which has improved in the last two years following the entry of foreign investors. “Listing on the stock exchange itself, being a trigger for a lot of disclosures, will bring greater transparency,” says Jyoti.

And transparency is needed in every aspect of the business. The ULCA restrictions and high transaction cost have forced many developers to fiddle their accounts. “Payments to land deals are underreported for the purpose of tax concealment,” says Jyoti, adding that payments from clients and to suppliers are also often misstated. That translates to a lack of transparency in pricing. “There is a huge information gap between the buyer and seller,” says Chakraborty. “Two similar properties one block apart can have very different prices; it is a totally negotiated market until now.” As the industry matures, Jyoti predicts a shakeout. “As developers start to operate at a state or national level, competition will increase, small players will be wiped out, and consolidation will follow.”

BEING PAN-INDIAN

For Sanka, a successful IPO simply means that DLF has the official green light to pursue its ambitions. Of the 136 bn rupees it first hoped to raise, 65 bn rupees were allocated for land acquisition, 31 bn rupees for development and construction, and 40 bn rupees for loan prepayment. In the last few years, DLF has been buying land in Hyderabad, Pune, Chennai, Bangalore, and Kolkata, among other cities, to shed its image as a mere Gurgaon player – not to mention to capture growth opportunities. Not only does DLF want to dominate the retail, commercial, and residential property segments in India, but it also wants to be a major player in hotels and special economic zones (SEZs).

Of these, Sanka is most excited by retail, which is buoyed by the rising incomes of India’s young population. Ernst & Young values the retail market at US$230 bn, out of which organized retailers now make up only 2-3%, but should grow to 10-12% by 2010. For now, kirana shops, or small family-run stores, make up 80% of the 12m retail outlets in India. As the rising middle class aspire for better lifestyles, Sanka says mall developers have a lot of room to grow. DLF is now building 64 malls, including the 3m square-foot Mall of India, the largest in the country. “Indians want their mall facilities to be on par with the rest of the world, and we feel that we have a tremendous opportunity here,” he says.

As malls are still a new concept in India – the first one opened in Mumbai in 1999 – DLF continues to learn lessons from their operations. Shoppers initially shied away from malls as they were perceived to have higher prices. To attract shoppers, DLF introduced bazaars where goods are retailed at bulk prices, charging operators minimal rent. “Indians no longer feel that ‘mall’ means ‘costly’, because in the end, malls also have to compete with the kirana shops,” says Sanka.

But a bigger lesson came when DLF sold retail spaces for its third mall, the Megamall, in Gurgaon three years ago. Although every space had been sold, many shops remain shut and thus turn off shoppers, prompting speculation that competitors bought them as an act of sabotage. Sanka does not identify the buyers, but says the experience exposed a vulnerability in DLF’s develop-and-sell business model. While it may have cashed in on the sales, a failed mall is a blemish on its reputation that could jeopardize future projects. As such, all of the malls the company is developing now will only be offered on a lease basis. “If you sell, the buyers can pull down the shutters, and they may not be bothered whether the shop is open or not,” says Sanka. “If I want my mall to be successful, all shops should be open and this is possible only when I operate it on a lease basis.”

In the offices segment, DLF is on a roll, ready to capture the further growth of the outsourcing sector. (At least 80% of its office buildings are leased to multinationals.) “We have already acquired the land required for us to develop IT parks over the next ten years,” says Sanka. The company has signed up “several million square feet” of office space on a pre-leased basis, which means DLF has to get the premises ready within 18 to 24 months. In the residential segment, Sanka says after providing housing to the mid-range market, DLF is shifting its focus to the high-range to super-luxury market, where competition is less intense and the risk of a bubble less likely. “We would like to cater to the niche market; there is large NRI demand in luxury property,” he says, referring to non-resident Indians who buy property in the country for relatives.

Aware of the competition in each segment, Sanka says DLF is adding value by designing innovative buildings and providing its own power supply to insulate tenants from outages of government-supplied electricity. Its Trinity Towers, which opened early this year, features three separate buildings with a number of floors that can be linked together, giving tenants such as GE Money up to 100,000 square feet of space in a single floor. The building relies on its own power, using seven gas-fired and four diesel-fired generators. Among residential projects, DLF is building luxury residences, such as the high-rise Aralias and Magnolias condominiums, which command up to US$1m per unit and introduce shell units for the owners to design themselves.

Analysts also laud DLF for its after-sales services. “Some developers will build a building, sell it, and move on to the next new project,” says Jyoti of Crisil. At DLF, says Sanka, company representatives remain active in condominium associations even if the property had been sold several years back. “We add value by helping our condominiums forever,” he says. “We don’t sell and go away.” DLF is also the first to introduce a maintenance scheme where owners or tenants of its buildings pay only for services that it rendered, as opposed to the customary fixed monthly fee. “Our morals are different,” says Sanka. “I only charge for how much I spend on maintenance, plus a 20% mark-up. Tenants actually prefer this.”

MISSED OPPORTUNITIES

DLF envisions its future ventures in hotels and SEZs will grow as big as its traditional operations. The company is finalizing a joint venture with the Hilton group, under which it will build 100 luxury hotels in India to be run and managed by the latter. It has also won five approvals and is seeking seven more to develop SEZs in various cities. “These are extensions of our real-estate activities,” says Sanka. Analysts see both as certain future hotspots. Sudhir Nair, head of Crisil Research, says room demand will grow at an average 10% a year over the next five years. Meanwhile, analysts predict that SEZs will boom given the generous incentives they offer (including 100% tax break for the first five years) to private enterprises engaged in technology or manufacturing. “Once the SEZ projects kick off, they will overtake all the other activities” in Indian real estate, says Shah of KR Choksey.

In the meantime, Sanka has an IPO to worry about. The issue has been delayed thanks to the slow process of resolution of a case brought against it by minority shareholders who have kept their shares in the company from the days when it was listed at – and then delisted from – the secondary Delhi Stock Exchange. The shareholders are complaining that they had not received the letter of offer from DLF for them to subscribe to a rights issue between last December and January. DLF argues that the letter had been circulated – as evidenced by some who did subscribe – and that the complainants were those who missed out on the opportunity.

“We know that some of them might not have applied deliberately because they wouldn’t have seen the value in the company,” says Sanka. “Those are the people who lost, and they are feeling the pinch.” To be sure, DLF is too, as the slow motion of the Department of Commercial Affairs over the issue delays its access to much-needed capital, and exposes the company to further speculation. Perhaps another puja will help.