Office REITs Q2 review: Occupancy levels close to bottoming out

20 Nov 2023 , 01:58 PM

Office REITs reported stable distribution for Q2 even as blended occupancies declined QoQ, on higher-than-expected expiries in IT/ITES. With Global Captives witnessing pickup in leasing demand, SEZ de-notification around the corner, and return-towork picking up — analysts of IIFL Capital Services see enough tailwinds for leasing demand to turn around from hereon. High interest rates and the lag between leasing and cashflows will continue to keep DPU growth for FY24 and FY25 benign. Analysts of IIFL Capital Services see strong growth coming in from FY26. Valuations remain inexpensive at steep discount to NAV and they see occupancy pickup as the key trigger. Reiterate BUY for EMBASSY and upgrade MINDSPCE and BIRET to BUY (from ADD). 

Insipid performance over Q2 and H1FY24: 

Office REITs reported broadly flat distribution (on adjusted basis) for Q2 despite NOI being meaningfully higher, offset by higher interest cost. For H1FY24 too, distribution has broadly been stable. However, occupancy levels declined QoQ (by 200-300bps) for Office REITs, while those for DLF (DCCDL) improved. Over H1FY24, the fall in occupancy levels has ranged from 0.4- 4ppt for Office REITs, which as per mgmt is because of weak demand from the IT/ITES companies who continue to drive fresh exits. Industry data from Cushman and Wakefield (C&W) also echoed the weak demand YTD, Q2FY24/Q3CY23 absorption was 9% lower YoY, 9MCY23 absorption is also down 7% YoY with cautious approach by occupiers towards largesized transactions. 

Occupancy levels to turn net positive over next 1-3 quarters: 

Industry experts and REITs mgmt have guided to a positive outlook, highlighting that demand from global captives and Indian corporates is expected to outweigh the weak outlook from IT/ITES from hereon, reflected in increase in RFP’s in the market. EMBASSY shared that active RFPs in the market have increased from 8msf as of July’23 to 20msf currently (~60% for Bangalore). While REITs continue to report healthy gross leasing, fresh expiries have led to a decline in net occupancy levels. This is set to change over the next one to three quarters with DLF already witnessing a pickup, and EMBASSY/MINDSPCE/BIRET guiding that over the next one to three quarters, net leasing will be higher than the exits through fresh expiries. 

Return-to-office (RTO) likely to pick up: 

Physical occupancies have been improving, albeit at a slow pace, and now stand between 50% and 70% for the industry. IT/ITES segment remains a laggard, while the Global Captives, Indian Corporates as well as BFSI segments have largely been able to bring back their employees to office. Indian IT companies are now driving the RTO trend with TCS mandating 5-day office; and Infosys/Wipro mandating partial return. Since Covid, hiring across these companies since covid has been meaningfully higher than the space additions (eg. Infosys >40% hiring vs ~10% space add), which will drive an immediate need to add space.