Office REITs: SEZ amendment removes a key regulatory overhang

12 Dec 2023 , 11:09 AM

Analysts of IIFL Capital Services discussions with industry participants reassure them that the recent SEZ amendment allowing floor-wise de-notification, will be a significant positive to improve the overall occupancy levels of the office REITs/CRE portfolio. Also, analysts of IIFL Capital Services do not see the risk of non-SEZ supply rush to hit the markets, due to: 1) upfront costs involved in the de-notification 2) limitation of retaining 50% minimum SEZ area 3) supply-demand dynamics of the relevant micro market. Within the commercial Real Estate space, analysts of IIFL Capital Services expect the larger, Grade A office landlords to benefit more, and will be positive for Office REITs, DLF, BRGD as helping lease up vacant SEZ space (~7-18% of the total area), with demand from global captives having picked up in the last few quarters. 

SEZ amendment removes a key regulatory overhang: 

The rules will be applicable to developers of IT/ITES SEZ zones – Developers will need a permit from Board of Approval (BOA) to convert SEZ into nonSEZ. The permit will be allowed for a complete floor and not for just a part of it. Developers will have to ensure access control mechanisms, screening of movement of persons and goods in & out of SEZ premises. BOA will permit conversion into non-SEZ, on: 1) payment of tax benefits availed earlier, attributable to the area being converted, without interest and without the impact of depreciation on the construction cost. 2) Payment of tax benefits availed on the common areas to be used by SEZ and non-SEZ zones. Developers will have to adhere to the minimum-notified SEZ built-up area – the SEZ area cannot be less than 50% of the total area or less than 0.5msf/0.25msf/0.15msf for category A/B/C cities (all three REITs/ DLF/BRGD have assets in category-A cities). 

Impact: Expect steady improvement in occupancy levels; distributions to improve with a lag: 

SEZ area is 55-80% of the total portfolio for the three office REITs. With a weak demand for SEZ, vacancies have been rising steadily, moved up 2-5ppt over H1FY24. While the amendment has been notified in the gazette, companies are awaiting the detailed guidelines. Broadly, the govt has heeded to the industry demand, although some issues persist: 1) There is no clarity on depreciation being allowed while calculating tax payments — which was an ask from the industry; but it seems that the same has been disallowed by the govt. 2) Clarity on how much area can be de-notified from SEZ to non-SEZ – rules say at least 50% of the total area or a minimum area of 0.5msf should remain as SEZ. This could limit how much area can be de-notified across the IT/ITES parks. 3) Clarity on payment of tax benefits/method of calculation for the common areas in a hybrid building with both SEZ and non-SEZ spaces. 

No meaningful risk of non-SEZ oversupply: 

Owing to the amendment, some investors have been concerned about a rush of supply. However, analysts of IIFL Capital Services highlight the following points: 1) Upfront costs involved in de-notification could be as high as Rs600-800/sq.ft (~20% of Rs3,000-4,000/sq.ft construction cost), so visibility on demand is critical. 2) Limitation of retaining 50% of the minimum SEZ area (of the total area) that could limit the extent to which the de-notification can be done. 3) Supply-demand dynamics of the relevant micro market (eg. some micro markets witnessing high vacancy rates even in the non-SEZ market). 

Discount to NAV’s should narrow; bullish on REITs/DLFU/BRGD: 

REITs have underperformed the broader markets by 10-20% over the last 1 year, given the headwinds in operational performance and elevated interest rates. For REITS, analysts of IIFL Capital Services believe that the worst of operational performance is behind us with: 1) Demand steadily improving from global captives and is expected to outstrip the weak outlook from IT/ITES from FY25 onwards. 2) Steady improvement in work from office trends (companies like TCS, Accenture, issuing strict diktats), even for IT/ITES companies. 3) A probable shift in the interestrate environment in early FY25 acting as tailwinds to the REIT unit prices. Analysts of IIFL Capital Services see FY25 to be a strong year for Office REITs w.r.t occupancy levels; with FY26 to see sharp improvement in distributions. Valuations are cheap with 10-28% upside and 6.5-8.4% pre-tax yield, offering attractive entry levels. Reiterate BUY on Office REITs – EMBASSY, MINDSPCE, BIRET; and on DLFU and BRGD.