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The Indian Commercial Real Estate (CRE) office market saw Q3CY22 (Jul-Sep’22) net absorption of 8.7msf vs. Q2CY22 (Apr-Jun’22) net absorption of 9.6msf. 9MCY22 (Jan-Sep’22) net absorption stands at 24.2msf vs. the Covid impacted years of CY20 and CY21 which saw 20msf of net absorption each at pan-India level. We estimate net absorption of 31.7msf in CY22E and 33.5msf in CY23E with the Bengaluru market likely to lead the way with annual net absorption of over 10msf in both years. While vacancy levels for India REIT office portfolios have increased by 600-900bps since Q1CY20 (Jan-Mar’20) in line with rise in industry vacancies, the key monitorable for REIT office portfolios over the next 12 months would be REIT managers’ ability to buck the trend of rising vacancies at industry level and recover the lost occupancy (getting back to pre-Covid levels). We remain bullish on office asset developers and reiterate our positive stance on DLF, Embassy REIT and Brigade Enterprises. Key risk to our call is the emergence of further Covid waves and global/domestic inflation related risks.

* Recovery on track: While CY20 and CY21 were weak years with 20msf of net absorption each owing to Covid-19 impact, with net absorption rising from Apr’22 – Q2CY22 net absorption of 9.6msf and Q3CY22 net absorption of 8.7msf at pan-India levels – we now estimate net absorption of 31.7msf in CY22E (9MCY22 net absorption of 24.2msf) and 33.5msf in CY23E. While the presence of hybrid working models and overall global macro slowdown may not result in annual net office absorption reaching levels seen pre-Covid in CY19, we believe that annual net absorption of 30-35msf annually concentrated in preferred micro-markets and Grade A institutional supply will be the way forward.

* Focus on micro-markets/REIT portfolios rather than cities will be crucial going forward: Going forward, we are of the view that with headline supply of 133msf scheduled for completion over Q4CY22-CY24E (Oct’22 to Dec’24) and assuming annual net absorption ranges between 30-35msf, headline vacancy levels at pan-India and individual city 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/micro-markets. 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.

* Environment of rising interest rates coincides with improved leasing activity: During the Covid impacted years of FY21-FY22, the listed REITs in India have demonstrated resilience with almost 100% rental collections even with portfolio occupancies having declined by 6-9% over the same period. This was also a period when interest rates have been at record lows in India and REIT managers have utilised this window to refinance debt at lower costs to cushion impact of falling occupancies. In FY23, with interest rates rising globally and in India, there is a possibility of expansion in cap rates for Indian office assets to adjust to higher yield expectations. However, this rise in interest rates also coincides with an expected improvement in office leasing and inflationary impact translating to higher market rentals which have remained stagnant for the last 24 months. While near-term distribution yields for Indian REITs over FY23-24E may appear low at 6-7%, we remain constructive on the long-term prospects of the Indian office leasing market.

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