Myth #4 : Turnover gives a correct measure of the size of operations of a real estate company
Also published in CNBCTV18.com
Purpose of Myth Series :
While real estate is amongst the fastest growing businesses in India, it rarely finds respectable space in curriculums of business schools. Also, there are hardly any case studies available to explain the intricacies of the sector.
For these reasons, many facts and theories floating about real estate follow a ‘common sense-ical logic’. Unfortunately, many of these are misconceptions, myths or even downright false.
The purpose of this series, therefore, is to take one real estate myth in each blog and provide insights on the real issues.
The ten myths have been classified into three categories – Finance, Marketing and General Business Reading. So the finance category will interest people associated with real estate and also people associated with Finance. Similarly, with other categories.
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The size of any business, in general, is measured by its turnover. Larger the turnover, larger the size of the operations. However, applying the same logic to the real estate business is inappropriate.
To understand this one needs to revisit the definition of ‘turnover’. Turn-over in any business is the measure of the rate at which the goods are ‘sold’ and ‘replaced’ by other goods i.e. the rate at which the inventory is ‘turned over’. So, in a retail store, a garment is sold and is typically replaced by another garment resulting in turnover for the store. The rate at which it is done measures the scale of operations of the store. Essentially, turnover is not just about revenues but also about the ability of the business to replenish the sold stocks.
In real estate, it is not easy for the replenishment of inventory to immediately follow the sale. Inventory is sold every month but the land purchase has a very long lead time. Opportunities to buy land are not available off the shelf, the process of land buying is very time-consuming.
In businesses like manufacturing, no sooner finished goods are sold, the raw material is replenished to produce more goods - classifying the activity as turnover. A similar phenomenon is seen in the retail business. And therefore, in these businesses, turnover ( i.e. sale receipts) provides a good measure of the scale of operations. In real estate, the sale figure tells only half the story about the size of operations. The unsold inventory/land bank, which is the engine for next year’s revenues, is also very critical for measuring the size of operations.
Secondly, since developers generally recognize revenue when the project is complete, the turnover gives a measure of projects completed in that year and not the size of the overall business. Accordingly, turnover in a particular year may have no relation to cash flow or to the actual amount of business activity in that year. In most other businesses, cash flows and sales, generally have a high co-relation, hence for these businesses sales (or revenues) remains a good measure of the scale of operations as well as of cash flows.
However, in special cases, revenues of a real estate company could give a good measure of the size of operations. For example, when the company derives most of its income through rental business the cash flows and revenues have a very high correlation. Also, inventory Replenishment is hardly an issue; property once available for rent will also be available during the next month.
So those of you, who find it challenging to analyse balance sheets of real estate, should now be happy. You are not the only ones J
Many me
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