The limited informative value of financial statements in construction and real estate industry and how best to interpret them

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Annual financial statements claim to show a true and fair view of the company's earnings and asset situation. On closer inspection, it quickly becomes apparent that in the entire construction and real estate industry there is a great deal of room for maneuver in the preparation of financial statements, which severely limits the informative value of many classic key figures, at least in the short term.

In the case of construction companies, there is a great deal of leeway in two respects in particular, which makes it almost impossible to analyze a single concrete annual result without "insider information".
Firstly, there is a great deal of uncertainty purely on the basis of the valuation of the construction work performed. On the other hand, the claims or additional cost receivables recognized in the balance sheet are often very large relative to earnings, so that minor errors in the assessment of recoverability would already lead to dramatic changes in earnings.

For real estate developers, the leeway lies in the valuation of projects under development. A valuation at cost can be just as correct or incorrect as a valuation based on an appraisal, in that almost any change in the assumption leads to huge differences in the valuation. If two appraisals are commissioned for the same project, a 40% difference in valuation is not an impossibility.

In the case of real estate funds, on the one hand you have the mixing of renting / selling, which makes an analysis more difficult. In addition, there is the issue of the valuation of the real estate, which has a significant influence on important key figures such as equity.

What can investors do to interpret the results in the best possible way?

First of all, long-term comparisons are of course helpful, since construction sites are completed at some point and properties are sold at some point, at which point the truth comes to light, at least for the "old projects". In my opinion, caution is advisable when companies grow permanently in terms of sales or balance sheet total, but earnings or cash development do not keep pace. There are certainly other explanations, but this could be an indication that optimistic revaluations overcompensate for poor results in old projects.

Second, a qualitative analysis is rarely wrong. Competent managers who lead a company for many years tend to be a good sign, but if a company changes its management team too quickly and restructures every second or third year, this is usually not a good sign.

Of course, this is no substitute for quantitative analysis. In this context, it is advisable to focus more on key figures that are not subject to estimates. These include in particular cash flows and dividends or distributions/withdrawals.

If a construction company has a constant growth in dividends or withdrawals as well as in cash and cash equivalents, it is obviously doing a lot right and the valuation using a dividend discounting model should lead to realistic results.

It is also true for real estate developers that the cash position is incorruptible. Stupidly, large projects can take a long time to complete and only have a cash impact in the exit year.

For flowline developers with many small projects, the same approach as a construction company can be taken.

For developers with few large projects, I recommend a project-by-project evaluation. Important key data such as the location, the NNF in m² and the remaining project duration are usually given. Based on this, it is possible to form your own opinion regarding the sustainable rental income and the exit yields and ultimately calculate the present value of the project.

In the case of real estate funds, further "incorruptible" data such as the rental income and the proceeds from sales made are given in the financial statements. This is valuable insofar as it makes it possible to calculate return ratios.

In my opinion, two approaches make sense.

The first is the calculation of the rental yield of the current portfolio. For this purpose, it is first necessary to exclude the rental income from recently sold projects. If the published figures do not provide more, I recommend using a realistic yield and forecasting the rents of the sold projects in this way. By deducting these rents from the total rental income in the financial statements, a forecast of the current rents of the existing properties can be made, taking into account the time of sale. These remaining rents are set in relation to the market value of the capital employed, i.e. market capitalization + debt. If necessary, the value of land and development projects can be deducted.

A second, even simpler indicator, which I find interesting, is the return on equity before valuations, again based on the market value of equity. For this, I take the annual result, subtract the valuation result reported in the financial statements and divide it by the market capitalization. Mathematically, this ratio is the reciprocal of the price/earnings ratio adjusted for valuation effects.

Both return ratios can be compared with direct investments in real estate, whereby the asset class should correspond to that of the fund.

The informative value of financial statements of construction and real estate companies remains limited, but investors can help themselves somewhat by looking at cash-oriented ratios. Together with the qualitative analysis and taking into account the development over time, a feeling can be built up as to whether an investment is worthwhile.