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Since Jan’23, global macro headwinds in the form of rising interest rates and tech MNC hiring slowdown (MNCs account for 67% of Indian office space demand) have led to a slowdown in large leasing decisions for the moment. Further, delayed implementation of the DESH Bill (related to SEZs) along with fresh exit notices for FY24 by a few large tenants in Jan-Mar’23 period has dampened the mood further. As a result, the office REIT managers under our coverage universe (Embassy and Mindspace REIT) have refrained from giving distribution guidance for FY24 given the uncertain near-term outlook. Our distribution estimates for FY24E assume flattish to marginal YoY DPU growth considering all these factors. However, we are of the view that while REITs may underperform in the near term, the very factors which are driving this underperformance may reverse from FY25E with 1) increased outsourcing to India by global captives (MNCs), 2) interest rate cycle possibly peaking out, 3) the DESH Bill being implemented or partial denotification of individual floors in SEZ spaces and 4) clarity having emerged on capital return taxation for unitholders. REIT managers on their part are managing the headwinds by focusing on small to mid-sized leasing deals, conversion of SEZ to non-SEZ space and speeding up capex to drive NOI growth. We remain constructive on REITs as they provide a stable cash flow profile with 6-8% distribution yields over FY24-25E along with long-term capital appreciation. Embassy REIT is our preferred pick among Indian office REITs.

* Headline supply to remain strong, focus to remain on micro-markets: We estimate pan-India Grade A net absorption of 31.0msf in CY23E (13.9msf achieved in H1CY23) vs. 36.4msf in CY22. Going forward, we are of the view that with headline supply of 156msf scheduled for completion over H2CY23-25E (Jul’23 to Dec’25) and assuming annual net absorption of 30-35msf, headline vacancy levels at pan-India level may rise further over the next 24-30 months. However, the focus would be on individual micro-markets and Grade A institutional supply in respective cities/micromarkets. We believe that with supply-demand equilibrium remaining stable in preferred micro-markets such as Sarjapur/Whitefield in Bengaluru, Madhapur in Hyderabad, Cyber City in Gurugram, Kharadi in Pune and pre-toll OMR in Chennai, vacancies in these markets may rise marginally even as overall vacancy levels may trend higher.

* Embassy REIT commentary and leasing outlook: Owing to early termination notices of 1.6msf given by tenants in Q4FY23 (1.0msf in Manyata, Bengaluru and 0.5msf in Galaxy, Noida) of which 1.1msf is SEZ space, FY24 expiries now stand at 2.5msf as of Mar’23 vs. 0.9msf as of Dec’22. With the passage of the DESH Bill related to take up of vacant SEZ space by non-SEZ tenants (3.3msf of SEZ space vacant in REIT portfolio as of Mar’23) likely being delayed till H2FY24 along with global macro headwinds leasing to delay in large leasing decisions by GCCs, the REIT manager has chosen not to give any NDCF guidance for FY24.

* Mindspace REIT commentary and leasing outlook: Overall portfolio occupancy as of Mar’23 was at 83.4% (decline of 30bps QoQ) with committed occupancy at 89.0% (up 70bps QoQ). While large leasing deals continue to see delays owing to global macro headwinds, the REIT manager has indicated that the estimated portfolio exits for FY24E as of Mar’23 now stand at 1.6msf vs. 0.8msf at the end of Dec’22. Of the 1.8msf of FY24 exits, 0.5msf is in the Airoli East, Mumbai asset and 0.6msf in the Madhapur, Hyderabad asset. Vacant SEZ space of 1.6msf across the portfolio continues to pose a challenge (0.4msf of this is being converted to non-SEZ under existing regulations).

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