Q4FY23 REITs review: Real Estate: Slow and bumpy ride to recovery

24 May 2023 , 10:34 AM

Indian REITs reported muted operating performance for Q4FY23/FY23; with marginal to flat distribution growth. Occupancy levels have also largely been flat – still down 700- 1,200bps from their peak levels in 2020. Office sector continues to be impacted by volley of negative developments since Covid – latest one being fresh expiries coming in from the IT service providers. Path to recovery could be longer, analysts of IIFL Capital Services see FY24 distribution to be flat YoY with higher interest outflow offsetting any NOI increase. REITs are still to recover from their fall after the budget announcements, despite the tax impact moderated meaningfully.

Q4/FY23 performance muted: 

NDCF Distribution was largely flat/reported marginal growth QoQ for Q4. Reported NOI declined QoQ for both EMBASSY (EOP) and MINDSPCE (M-REIT). For FY23, while the NOI witnessed a robust growth (EOP 11%/M-REIT 13%), it did not translate into NDCF growth (M-REIT: +3.5%/ EOP: -flat) largely due to higher interest costs and working capital-led outflows. Occupancy levels over FY23 have also been largely unchanged materially; while blended occupancy for EOP is down 1ppt; it is up 1.2ppt for M-REIT. Physical occupancy has started to improve meaningfully, with steady improvement on a QoQ basis. Interest costs have gone up 0.5/1ppt YoY for EOP/M-REIT respectively. EOP has guided to a further 1ppt increase in debt cost over FY24.

Pursuing growth: 

REITs continue to pursue growth through a combination of: 1) Brownfield expansion – 7.9/6msf of assets underconstruction for EOP/M-REIT respectively. 2) Considering/evaluating acquiring sponsor assets (EOP/M-REIT – 5/1.8 msf respectively). EOP has recently acquired a 1.4msf office asset (Embassy Hub) in Bangalore, which will be primarily funded through debt. Net Debt-to-GAV has been broadly stable for EOP and M-REIT at 28% (vs 25% YoY), 17.9% (vs 15.9% YoY) respectively.

Increase in fresh expiries amid weak demand concerning: 

EOP and M-REIT have reported increase in expiries for FY24 – EOP increased its expiries guidance for FY24 from 0.9msf to 2.5msf in Q4FY23. Similarly, M-REIT also doubled its FY24 expiry guidance to 1.6msf in Q4 vs 0.8msf, at the end of Q3FY23. This is partly linked to IT service providers like Cognizant/Accenture, having announced recalibrating their space requirements in India (as per media reports). Further, slowdown in the US has impacted large RFPs, even though smaller RFPs between 50,000 to 100,000sq.ft remain in good demand.

SEZ Act amendment critical to occupancy improvement: 

Listed SEZs account for 55-60% of the REITs portfolio, and ~68-80% of the total vacancy of listed REITs (EOP 3.3msf of 4.9msf vacancy is SEZ and M-REIT 2.3msf of 2.9msf is SEZ as on end FY23). While the DESH Bill has apparently been put on a backburner, amendment to existing SEZ act allowing partial/floor wise de-notification is the need of the hour. Management across REITs/CRE cos are confident of this being executed over next 2 quarters. Till then, both EOP and M-REIT are increasingly going through the building wise de-notification route, to convert SEZ buildings into non-SEZ.

Adverse taxation announced in Budget, largely rolled back: 

Finance ministry has relaxed tax implications on ‘repayment of debt’ (relevant for EOP) by pushing the incidence of tax at the time of the unit’s sale, and also lowering the tax rate to capital gains rate vs MMR earlier. However, stocks continue to remain weak and have under-performed markets; EOP is down 7% since February and M-REIT is down 3%.

FY24 outlook weak, but valuations attractive: 

REITs have delivered a total annualised return of 6.5-12% since their respective listing timelines, driven by recent under-performance. For FY24, analysts of IIFL Capital Services see REITs yielding flat YoY distribution, (gross yields at 7.1/6% for EOP/M-REIT, respectively) with NOI increase being offset by rise in interest rates. Despite near-term headwinds, REITs are currently trading at 10-30% discount to NAV and offer an attractive entry point for investors with the long-term view. Analysts of IIFL Capital Services retain BUY on EOP and ADD on M-REIT.