Commercial Real Estate: The party isn’t over yet
Along expected lines, the Indian Commercial Real Estate (CRE) office market has seen a 49% YoY decline in H1CY20 net absorption at 10.5msf. While the COVID-19 induced slowdown is expected to result in a 40-50% YoY contraction in demand and supply in CY20E, green shoots are gradually emerging. Developers in our coverage universe have reported over 90% office rental collection between MarchJune 2020 and have seen pickup in leasing enquiries from June 2020 onwards with few large pre-COVID deals also being honoured. Rents also continue to sustain at pre-COVID levels for large, institutional landlords. With a limited number of 8-10 large pan-India office developers capable of building quality assets, India continuing to have affordable rentals of under 1 USD/psf/month and an abundance of STEM talent, we remain bullish on office asset developers and reiterate our BUY ratings on DLF, Embassy Office Parks REIT and Brigade Enterprises.
* Office space demand and supply to contract 40-50% YoY in CY20E: Until the global COVID-19 concerns reduce, corporates will relook at their space requirements in CY20E and expansion or consolidation plans will be put on the backburner. We have built-in net absorption of 25msf in CY20E which is a 40% YoY reduction in demand. At the same time, whereas 149msf was the expected cumulative supply as of March 2020, this number has already shrunk by 20% to 118msf as of June 2020 with ~30msf expected to be completed in CY20E.
* Q2CY20 showing a few green shoots: All office asset developers in our coverage universe have surprised positively with office rental collections of over 90% post the lockdown in mid-March 2020. While there has been news flow of few corporates deferring/renegotiating rentals, this has been limited to standalone buildings and sectors which have been adversely impacted by COVID-19. However, large institutional landlords with a significant percentage of technology focused Global InHouse Captives (GICs) continue to hold fort on rentals with rental escalation clauses also being honoured by tenants and pre-COVID leasing commitments coming through.
* India’s long term advantages remain as a high-quality office hub: While near-term news flow may be negative, our view is that the Indian office market retains many positives such as: 1) Limited number of 8-10 pan-India developers capable of building quality rental assets; 2) India remains one of the more affordable office markets in the world, with average rentals for Grade A office markets in peripheral/suburban micromarkets hovering around 1 USD/psf/month or Rs70-75/psf/month; 3) India leads in STEM (Science, Technology, Engineering, Mathematics) talent for technology assignments with over 2 million students graduating each year; 4) numerous representations by industry stakeholders has prompted the GoI to rollback the proposed Dividend Distribution Tax (DDT) on REITs in March 2020 on the condition that REIT SPVs will not move to the new tax regime (of lower tax rate).
* Listed annuity players expected to weather the storm: We expect annuity asset plays in our coverage universe to weather the storm even in an environment of delayed leasing decisions and 5-10% correction in rentals. We continue to reiterate our BUY ratings on players with a large office portfolio such as DLF (rental income of over Rs30bn and over 30msf of operational assets), Embassy REIT (rental income of over Rs22bn and 26msf of operational assets) and Brigade Enterprises (Rs4.6bn of exit rental income in FY21E). Key risk to our call is the wide-scale adoption of a Work from Home (WFH) model by corporates in the long term.
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