Q1FY24 Review: Real Estate: Office REITs: Chugging along in a tough milieu; valuations compelling

23 Aug 2023 , 11:53 AM

Indian Office REITs have been able to maintain their quarterly distributions, despite no meaningful improvement in occupancy levels and rising interest rates for the last few quarters. While delays in SEZ amendment continues to be a key impediment; growth in hiring from global captives and healthy non-SEZ demand offers hope. Analysts of IIFL Capital Services see FY24 distribution to be flat YoY, with rental income increases being offset by higher interest outflow. Beyond FY24, changes to the SEZ law and policy rates are likely to drive operational and stock price performance, in their view. Office REITs are trading at compelling valuations. Analysts of IIFL Capital Services see 25-30% total return across the three Office REITs; retain BUY on EMBASSY and ADD on MINDSPCE/BIRET. 

Q1FY24 performance muted: 

Office REITs reported flat-to-marginal decline in their distribution for Q1FY24, even as the NOI saw flat to marginal growth on a QoQ basis. Distribution growth lagged NOI growth due to higher interest costs and working capital led outflows. NOI margins declined meaningfully for EMBASSY and MINDSPCE QoQ. During Q1FY24, occupancy levels have been a mixed bag. EMBASSY and BIRET witnessed a decline of 100bps/240bps QoQ respectively; while MINDSPCE reported a 350bps increase. Overall, occupancy levels continue to hover between 82% and 87% — ~1,000bps below the preCovid levels of ~95%. Physical occupancy (employee attendance) has been improving albeit at a slow pace, with steady improvement seen on a QoQ basis. Physical occupancies stand at 66% for BIRET, 57% for MINDSPCE and between 52% and 55% for EMBASSY. Blended rental (on LTL basis) has seen a 3-6.5% rise on a YoY basis for the three office REITs. However, this has been offset by interest costs that have risen 400/400/1040bps on a YoY basis for EMBASSY/MINDSPCE/BIRET, respectively. Over the next three years – EMBASSY will witness ~62% of its debt coming up for maturity, while it is 36% for MINDSPCE and ~5% for BIRET.

Continuing to pursue growth, both brownfield and inorganic: 

Office REITs continue to pursue growth through a combination of: 1) Brownfield expansion – 7.9/4msf of assets under-construction for EMBASSY/MINDSPCE respectively. 2) Inorganic growth too, with BIRET just having completed the 6.5msf acquisition of sponsor assets in Gurgaon and Mumbai. High interest rates (to raise acquisition debt) and unit pricing at steep discount to NAV (for raising equity capital) are making inorganic route difficult (EMBASSY has put Chennai ROFO on hold for now, due to this), even as some developers continue to pursue these acquisitions with a long-term view in mind. Net Debt-to-GAV has been increasing for EMBASSY and BIRET at 29% and 34% respectively; while MINDSPCE remains stable at 18-19%. 

Fresh expiry notices continue; but increased hiring from GCCs offers hope: 

Over the last two quarters, EMBASSY and MINDSPCE have been reporting increase in expiries for FY24 – EMBASSY increased its expiries guidance for FY24 from 0.9msf to 2.8msf over the last 6 months, while Mindspace also raised expiry guidance to 2.1msf as on Q1 vs 0.8msf at Q3FY23-end. This is partly linked to IT service providers like Cognizant/Accenture having announced recalibrating their space requirements in India. However, hiring at GCC (Global Captives) has picked up, and that is likely to see that translating into leasing demand over next 2-3 quarters. For EMBASSY, ~70% of leasing demand in Q1 came in from the GCCs. 

No progress on SEZ amendment a key impediment to growth: 

Listed SEZs account for 55-80% of the REITs portfolio, and ~58-80% of the total vacancy of the listed REITs (EMBASSY 3msf of 5.1msf vacancy is SEZ and MINDSPCE 2.3msf of 2.9msf is SEZ). While the DESH Bill has apparently been put on a backburner, an amendment to the 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 the next two 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.