Affordable housing finance companies (AHFC): Small caps with big valuations

The financial sector can be broadly demarcated as lending and non-lending entities. When it comes to the lending space, banks occupy the top position in terms of advances and market value followed by non-banking finance companies (NBFC), small finance banks (SFB) and micro finance institutions (MFI) at the bottom.  In NBFCs, there are many subcategories and affordable housing finance companies (AHFCs) is one among them.

Affordable housing finance companies (AHFC): Small caps with big valuations

The affordable housing segment generally comprise of homes with price below Rs.45 lakh. As per the data from real estate consultant PropTiger, 43% of the total housing sales in India’s eight leading housing markets was within the price bracket of Rs 45 lakh in 2021 while this was 48% in the previous year. 

The Indian government has encouraged the growth of this segment with tax sops and incentives. Under Section 80EEA of the Income Tax law, the government offers first-time homebuyers an additional tax deduction of Rs 1.50 lakh if the unit costs below Rs 45 lakh. Such a borrower can also claim subsidy under the government’s Pradhan Mantri Awas Yojana Programme (PMAY).

While we generally look at lenders by their book size (advances) and network, the market has a different take when it comes to valuation and that has a significant impact on shareholder returns. 

AHFCs have become the market darlings in recent times over their conventional, broad based home lending counterparts, as reflected in their market valuations. So, what makes AHFCs market favourites? 

For this discussion we will take the top three AHFCs by market value that cater to lower income segments in the salaried and self-employed categories with average ticket size of around Rs.10 lakh.  

Below is their brief financial profile:

When you look at the above PBV and PE of the companies please compare it with the average P/BV and PE of 2.42 and 19 times respectively for lending NBFCs and 1.04 and 8.14 times respectively for top 5 standalone housing finance companies with market value above Rs.5,000 crore. You will see the significant premium that the above AHFCs command.

What’s behind the rich valuation of AHFC stocks?

The first determinant of valuation for a lender is RoA. A high RoA will in turn lead to high RoE. The second determinant of valuation is the growth which will translate to high PE ratio.

If we look at the previous table, the top 3 AHFCs have generated superior RoA, upwards of 3.5%,  while they were growing their book at 25% CAGR over the last 5 years, higher than industry average.

To give a broader perspective on valuation of AHFCs vs. other lenders, let’s look at the same metrics as taken above for the top 5 lenders from different categories such as banks, NBFCs and HFCs.

Looking at these financial metrics along with that of the top 3 AHFCs, a stand-out observation is that the market is giving rich valuation to those lenders generating superior RoA and RoE.

Valuation is a factor of RoA and RoE and not necessarily the size of the advances or the branch network.

A high RoA and RoE can be achieved only in two ways;

  1. Having a robust deposit franchise that provides a significant source of low-cost funds, even though lending yields are not high, while maintaining control over costs and asset quality.
  1. By building specialised lending portfolios that offer high lending yield along with control over costs and asset quality.

In the first case, banks (including SFBs) are at an advantage and if they achieve control over costs and asset quality, that will translate to high RoA and in-turn high RoE. If growth also follows, there is nothing that prevents a bank from quoting at superior valuations.

NBFCs, on the other hand, decided to take the second path, as they cannot compete with banks, and focused on developing competencies in specialised lending segments like consumer finance, used commercial vehicle loans, affordable housing loans, gold loans and microfinance.  They identified segments that banks were reluctant to serve and that gave them the advantage of pricing the loans higher to cover for the risk. Over a period of time, some of these NBFCs were able to grow their book with sound asset quality while delivering robust RoA and RoE as well. This led to few of them becoming market favorites in different segments. 

The same story seems to have played out with AHFCs, where valuations are at a significant premium thanks to  high RoA and RoE, even while growth continues at a healthy pace. 

(Please note that at present, their RoE may appear depressed due to high capital adequacy ratio (or low leverage) of 40-50%).

But what is driving such ROA and growth? We will discuss that next.

What’s driving high growth and RoA for AHFCs?

#1 Differentiated model

AHFCs, with their focus on low-ticket size loans, have become the forerunners to help realize the dream of Housing for All under the Pradhan Mantri Awas Yojana (PMAY). With their differentiated capabilities to assess customer incomes, AHFCs play an important role in providing financing to the customer segment which are under-serviced by banks. 

Their model is quite differentiated in the following ways, when it comes to assessing borrowers and lending to them:

  • One, they generally focus on low-income groups from both salaried and self-employed categories. This is a category underserved by traditional banking channels.
  • Two, they often take into account the total family income from all sources rather than individual borrowers’ income. This expands the universe they serve. 
  • Three, their average ticket size is low at around Rs.10 lakhs.  This enables them to price housing loans much higher compared to prime or organised sector salaried employees and earn higher yield on their loans.  The top 3 AHFCs that we are discussing here have managed to maintain robust asset quality in the last 5 years while maintaining high yield on loans with operating costs around 2.5-3.5% of the AUM.

A combination of three factors – high yield, control over cost and control over asset quality – have helped affordable housing finance companies earn high RoA which in turn led to high RoE*.

#2 High yield on advances and robust asset quality

Below is the average yield on advances of various categories of lenders that give a picture of how much AFHCs earn compared with other lenders.

On the asset quality front, the top 3 AHFCs have maintained robust asset quality with Gross Stage 3 assets (NPAs) within 1-1.25% of advances in the last 5 years. There has been a spike recently pursuant to tighter norms by RBI on NPA classification. But the NPAs based on 90 days (3 months) past dues remain around 1% to 1.25% only.  

#3 Fastest growing among HFCs

Apart from earning high yields along with robust asset quality, AFHCs are also the fastest growing among housing finance companies. India’s housing finance sector has expanded at a 15% CAGR over the past five years, despite having a low mortgage loan to GDP ratio of 10.4%. The range for wealthy nations is between 30% and 60%. The AHFC segment, on the other hand, has grown at a CAGR of 25% during this period. The top three AHFCs we have taken here have grown their book at over 30% CAGR in the last 5 years despite a slow-down in FY22.  

According to a recent report by India Ratings and Research, AHFC segment growth has slowed down a bit to 20% in FY22 on account of rising inflation, interest rates and construction cost while the segment is still expected to grow at 18% in FY23, higher than industry average of 13-15%.  As per a recent Assocham report, AHFC’s target segment comprising of Low-Income Group – I* and Low Income Group – II** households represent 161 million households comprising 66% of the population. This leaves a significant runway for AHFCs to continue growing at above the industry growth rates as income levels of the population grow. 

Note: *Low Income Group – I – Annual income of Rs. 90,000 to Rs. 2 lakhs represent 106 million households. **Low Income Group - II – Annual income of Rs. 2 lakhs to 5 lakhs represent 55 million households.

How long can the valuations sustain?

This is the most difficult question to answer because we don’t have a history of rich valuations sustaining for housing finance companies as a whole for a prolonged period. There are just a couple of outliers, though.

#1 Only few outliers historically

A rare case of such rich valuation for a housing finance company previously was that of Gruh Finance which was trading at 12 times book value and at 52 PE before it merged with Bandhan Bank in October 2019. 

At the end of FY2019, GRUH Finance had a loan book of close to Rs.17,000 crores but was absorbed by Bandhan at a market cap of Rs 23,300 crore.

Other than that, the only other NBFC that has had sustained rich valuation for a longer period of time is Bajaj Finance. Cholamandalam Finance has started enjoying high valuation in recent times. If we look at the previous table, we can see that Bajaj Finance, at this size, is still maintaining superior RoA and RoE – and these remain the key drivers of its valuation.

Whether these AHFCs will continue to enjoy rich valuations after attaining a much bigger size on advances will be something to wait and watch for now.

If AHFCs can sustain this combination of high growth along with superior RoA and RoE, then these valuations may sustain.

#2 Competition emerging

Strong growth notwithstanding, one cannot ignore the competition that is emerging as this too will have a bearing on valuation. Close to 90 AHFCs are registered with the National Housing Bank (NHB is a  subsidiary of RBI) while only a few of them are listed. Besides, listed NBFCs like IIFL, Manappuram, Muthoot and leading housing finance players such as PNB Housing have set their eyes on this niche segment. 

This apart, the big daddy of lending, SBI, has stitched co-lending deals with home finance subsidiaries of NBFCs such as IIFL home, PNB housing, Shriram housing, Edelweiss housing and Capri global housing. Though banks have stayed away from this space due to high operating cost, the new co-lending model seems to be giving them some direct participation in this space.

#3 Lessons from other lending segments

And we also have the lessons from the gold loan space! Valuation of gold finance NBFCs went through the roof in the aftermath of Covid as demand soared while they also had a robust financial performance track record prior to that. Top gold finance NBFCs built a robust network and their customer base of low-ticket borrowers enabled them to price loans significantly higher.

While competition from banks and other NBFCs capped the growth in the high ticket segment, their bread-and-butter low-ticket segment was hit badly by Covid. This was also reflected in the high auctions they had to do in the post Covid period. These two factors led to a double whammy of falling yields and slowing growth, which hit their valuations hard.

All said, for the time being, the party seems to be ON for AHFCs!

This article should not be construed as a recommendation of stocks mentioned here. One of the stocks mentioned here is part of PrimeInvestor Financial Disruptors smallcase.

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