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REITs: On the cusp of a rebound

Indian REITs saw strong rental collections of over 99% in Q1FY22 and were able to achieve healthy re-leasing spreads along with contractual escalations. However, overall portfolio vacancy levels increased by another 100-200bps QoQ owing to continued Work-from-Home and second Covid wave leading to deferment of leasing decisions by occupiers. While vacancy levels may rise further in Q2FY22, we expect this trend to reverse from H2FY22E assuming that the pick-up in vaccinations is accompanied by a gradual return to offices. Factoring in incremental vacancy levels rising by 200-300bps in H1FY22 and building in a recovery towards the end of Q3FY22 (Dec’21), we expect the three REITs (Embassy/Mindspace/Brookfield) to offer distribution yields of 6-9% over FY22-24E along with 12-18% capital appreciation as per current Isec target prices. While a rise in global interest rates is the key risk, cumulative potential returns of 20-24% provides adequate valuation cushion, in our view.

* Vacancy levels rise further by 100-200bps in Q1FY22: Post the onset of the first Covid wave in India from Mar’20 (Q1CY20), pan-India Grade A vacancy levels across India's top 7 cities have risen by over 300bps till June’21 (Q1FY22) to 16.6%. In line with industry trends, portfolio vacancy levels had risen by 400-600bps on same-store basis for Embassy REIT, Mindspace REIT and DLF in FY21 while Brookfield REIT retained flattish occupancy levels in H2FY21. This was owing to exits by tenants for scheduled expiries and early exits as well. In Q1FY22, overall portfolio vacancy levels increased further by 100-200bps QoQ on same-store basis for Brookfield REIT, Mindspace REIT and DLF, while Embassy REIT retained flattish occupancy levels.

* Recovery on the cards from H2FY22: While the second Covid wave may lead to further rise in vacancy levels in Q2FY22, we expect this trend to reverse from H2FY22E assuming that vaccinations pick up accompanied by a gradual return to offices and possible pick up in international travel. Commentary from REIT managers and other large office developers indicate that leasing discussions which were on hold owing to the second Covid wave have now been revived again with existing occupiers talking about potential expansion and tenants who were looking to surrender space earlier looking to retain and possibly expand space.

* REITs offer attractive yields of 6-9% over FY22-24E: We have factored in a fall in occupancy levels of 200-300bps for the REITs in FY22E but expect the same to reverse by the end of Q3FY22 (Dec’21) with a full-fledged recovery from FY23E. We expect the three REITs to offer distribution yields of 6-9% over FY22-24E along with 12-18% capital appreciation as per current target prices. While a rise in global interest rates is the key risk, cumulative potential returns of 20-24% provides adequate valuation cushion, in our view.

* Conversion of ZCBs to coupon bearing debt to optically impact Embassy REIT yields: The Embassy REIT had issued zero-coupon bonds (ZCBs) of Rs36.5bn in May’19 at an annual coupon of 9.3%. While these ZCBs were due for maturity in Jun’22 and the REIT manager’s earlier intent was to refinance these as a ZCB on maturity (amortized cost of Rs47bn), the REIT manager has now indicated its intent to convert these ZCBs into a coupon bearing debt in Nov’21 at ~7% annual coupon. While our revenue/NOI/SPV NDCF estimates remain unchanged, the conversion of Rs45bn of ZCBs (fully amortized cost) to a coupon bearing bond will result in lower REIT NDCF distribution of Rs1.4bn in FY22E (Rs1.5/unit) and Rs3.2bn each in FY23E and FY24E (Rs3.3/unit).

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