Near term headwinds for REITs on FY22 lease expiry, weak demand

Strong base of technology sector tenants and valuations may provide support

Listed real estate investment trusts or REITs have been underperforming their peers in the real estate space over the past year on worries of falling occupancies, increasing lease expiries and lower new leases and its impact on revenues.

The stock of the largest listed player in this space, Embassy Office Parks REIT (Embassy) is down 4 per cent while the BSE Realty has more than doubled investor value (106 per cent) since May last year. Even Mindspace Business Parks REIT (Mindspace) which got listed in August last year has delivered a return of -8.2 per cent since then. 

In addition to the trends and management commentary post Q4, lease expiries in FY22 and demand recovery once business activity returns to normal will be key triggers for the REITs. Embassy and Mindspace reported March quarter numbers in line with their FY21 guidance; Brookfield India Real Estate REIT (Brookfield) which got listed in February this year also put up a resilient performance in FY21. Office rental collections have been 99 per cent for all three players in the quarter with rental escalations for a portion of their leased assets. 

Near-term worries are reflected in the vacancies of the larger players. For Embassy, which has a lease portfolio of 32.3 million square feet, the occupancy levels at the end of March was 88.9 per cent down 390 basis points over the year ago period. For Mindspace, occupancies are down 350 basis points over the December quarter to 81.8 per cent on a completed asset base of 23.9 million square feet. 

In addition to this, other challenges for Mindspace in FY22 according to Manish Agrawal of JM Financial are likely leasing delays in vacant areas and possible expiries of 1 million square feet in the first half of FY22. Including the FY21 rollover, Brookfield has 1.1 million square of expiring area, though it expects to renew about half of the area. 

For Embassy, 1.9 million sq ft of space is coming up for renewals (of which 0.5 million is committed) while the rest could see churn. Though the company has not given any guidance for FY22 given the pandemic related uncertainty, it expects the medium to long term growth story to remain resilient, driven by core tenants comprising technology companies and captive centres. Analysts at Morgan Stanley however, have maintained equal weight on the stock citing a delay in new leasing recovery due to Covid-19 resurgence in India, forthcoming interest-rate up-cycle, and potential unwinding of income support in the medium term. 

A positive for the REITs is falling borrowing costs. Embassy raised Rs 5,200 crore of debt in FY21 at 6.9 per cent and refinanced Rs 3,280 crore of debt resulting in 336 basis points of interest cost savings. For Mindspace, on a total gross debt of Rs 3,800 crore, cost of loans has come down from 7.3 per cent in the December quarter to 7.1 per cent at the end of March quarter. 

While the near term outlook remains tough, IIFL Research, which has a buy on all three listed REITs, believes that long term outlook is attractive. A strong tenant mix with technology sector accounting for 45 per cent is a key positive as the sector maintains a robust outlook on revenue growth and hiring. As the situation normalises, demand for leases could move up. Mohit Agrawal of the research firm highlights declining borrowing costs, improving distribution mix (higher share of distribution tax exempt) and attractive valuations has key positives for the sector.