REITs Q2FY23 review: Stable quarter; near-term headwinds emerging

21 Nov 2022 , 11:02 AM

Return to office has been slower than expected, and concerns around slower demand are likely to weigh in the near term, even though leasing pent-up demand remains strong. With high exposure of SEZ’s in the REIT portfolio, progress on DESH (new SEZ bill) remains the key to occupancy improvement. Occupancy ramp up could be protracted, and distribution growth could lag recovery in occupancy. Analysts at IIFL Capital Services build in 5.8-7.0% pre-tax yield for FY23 and 22%/9%/9% upside for EOP, M-REIT and BIRET. Retain Buy/Add on EMBASSY/M-REIT; upgrade BIRET to Add on valuations.

Q2FY23/H1FY23 operational performance stable

EOP/M-REIT/BIRET reported flat sequential per-unit distribution of Rs5.5/4.8/5.1, respectively. NOI growth was largely in line with EOP/ M-REIT/BIRET, reporting 3.9%/3.9%/2.9% sequential growth. Blended occupancy levels were also largely flattish sequentially. M-REIT reported a modest 70 basis points/130 basis points improvement in occupancy/committed levels. For EOP and M-REIT, tax-free distribution stood at 84.2%/92.4%, while clocking at 53% for BIRET. Net Debt-to-GAV has been broadly stable for EOP, M-REIT and BIRET at 26% (versus 27% QoQ), 17% (versus 17% QoQ) and 31% (versus 32% QoQ) respectively. At the Industry level, Q2FY23 net absorption came in at 9msf (2X YoY, flattish QoQ), driven by Bangalore that accounted for ~40% of overall absorption. For 9MCY22, net absorption is ~25msf (almost 2x vs 9MFY20 and 9MFY21) and CY22 is now expected to be between 32- 35msf (similar to last five-year average absorption before COVID-19).

Physical occupancies still low

Listed REITs and top CRE developers have witnessed only modest improvements and are currently witnessing 30-50% of daily physical occupancy (versus 50-70% employees back on hybrid mode) with regional disparities (Mumbai, Chennai higher attendance versus lower in Bangalore/Hyderabad). In the US (currently physical occupancy ~45-50%), many companies have issued mandates for employees to return back to office on hybrid basis after the Labour Day. Steady increase in physical attendance will drive leasing demand, since a number of places have hired employees more than the seating capacity of the premises.

H2FY23 Outlook — Headwinds emerging, DESH Bill critical

While the leasing momentum till Q2FY23 had been robust, recent concerns on weakening economy in developed countries has had an impact on the leasing momentum in India as well. According to EOP and M-REIT, many large RFPs (>1msf) have slowed down/have been put on hold; the expectation is that they will be pushed out by at least a quarter or two. However, smaller RFPs (40,000-50,000sqft) continue to remain active and there is strong demand in that segment.

Further, REITs high exposure to SEZs, and any delays in clearing the DESH Bill is likely to have a near-term impact. IT-SEZ accounts for ~25% of Commercial Real Estate of top eight cities and is witnessing rising vacancy levels (~13% in Q1CY22), post the end of tax benefits in 2020. However, the listed REITs have nearly 60-87% of their portfolio as SEZ, much higher than industry; hence analysts at IIFL Capital Services see a meaningful positive impact in leasing momentum once the bill is cleared in the Parliament. Post the clearance of the Bill, developers being able to attract a wider set of occupiers in such premises. Analysts at IIFL Capital Services expect occupancy levels to improve modestly, or remain flat over H2FY23.

Expect stable distribution in H2 – Rising interest rates to offset NOI growth

Office REITs in the US/SG/HK are down 42%/12%/23% YTD and down 23%/15%/15% in last three months, while REITs in India have outperformed (+7% YTD/ -9% in last three months) with softness seen in prices only in last three months.
Overall, REITs have delivered total annualized return of 11-17% since their listing. For FY23/24, IIFL Capital Services see REITs yielding 5.8-7.0%, while forecasting stronger growth for FY24 leading to yields of 6.5-7.6%; EOP/M-REIT/BIRET trade at 18%/8%/8% discount to NAV. Analysts at IIFL Capital Services have upgraded their recommendation on BIRET to Add on valuations, and retain Buy/Add on both, EOP and M-REIT.