The office leasing segment of the commercial real estate sector had maintained stable credit metrics over FY2021 on the back of healthy collections, low-to-moderate impact on occupancies, and expectations which had built up in the latter half of the year of a bounce-back in new leasing activity. However, the rising Covid-19 second wave across the country, which has left the metro cities especially vulnerable, may delay the recovery in new leasing activity, thereby putting pressure on operating metrics for the industry on an aggregate. As per ICRA note, the share of employees continuing to work-from-home may remain elevated in the near term, owing to the health risks. Without immediate visibility on a larger number of employees returning to offices, potential leasing transactions may get further deferred.
Giving more insight, Mr. Mathew K Eranat, Co-Group Head & Vice President at ICRA said, “In assets which are already operational, the quantum of lease terminations has broadly been in line with past trends, indicating that such terminations were not entirely on account of Covid-19 pandemic, barring some corporate office occupiers rationalizing their space requirements. However, refilling of such vacant spaces is taking longer time in the post-Covid environment, leading to higher vacancies in operational assets. On the other hand, with a steady pipeline of assets becoming operational in the near term, the demand-supply gap could temporarily widen further. While certain large-sized leasing transactions have been announced even during FY2021, the volumes may not adequately cover the increase in completed stock from the larger organized developers. Nonetheless, long-term demand prospects appear favorable for the sector considering that the broad occupier base in such assets has not witnessed any material business impact due to Covid-19. Recovery to earlier levels of demand can rebalance the current demand-supply mismatch over the medium to long term.”
ICRA notes that in comparison to other segments within the real estate sector, the office leasing segment witnessed the least impact on operational cash flows during FY2021. Collections from existing leases remained largely intact with no major challenges observed in the realization of the rents billed. This was despite a very low proportion of employees returning to the workspaces, with reported employee-occupancy levels between 10-20% at most of the IT and business parks. However, the adoption of work-from-home and travel restrictions resulted in delays in the signing of new leasing transactions, which has resulted in occupancies declining in operational assets, albeit in a gradual manner.
To evaluate the impact of Covid-19 on the occupancies of existing assets, ICRA has analyzed the portfolios of listed companies in the office leasing segment and computed the changes in occupancy level in each of the major markets between March 2020 and December 2020. The analysis shows reasonable levels of divergence in the relative performance of various markets, with Mumbai MR and Delhi NCR showing a 5% and 6% reduction in same-store occupancy respectively, while the Bangalore portfolio saw a reduction by 2%. Assets that are primarily occupied by large IT/ITES or captive delivery centers of MNCs have witnessed a relatively lower impact than city-centric properties occupied by corporate office occupiers.
Exhibit: Change in occupancies for office leasing portfolio of sample set of 7 companies covering 98msf
Prior to the second wave, it was expected that the share of employees in workspaces will gradually improve to the earlier levels, supported by expectations of widespread vaccine coverage. Such a pickup in employee strength at the offices would have been a precursor to recovery in fresh leasing transactions which are driven largely by the expansion requirements of corporate. Without immediate visibility on a larger number of employees returning to offices, potential leasing activity by the corporates will be further pushed back. Moreover, international travel restrictions and potential lockdowns may inhibit travel from the head offices of the tenants who will finally approve decisions pertaining to real estate planning.
CY2020 already witnessed a significant gap between the incremental supply and absorption, resulting in an increase in vacancies across all markets, largely impacting the recently completed properties. Net absorption during the year across the top six office leasing markets was under 20 million square feet (msf), falling short of the supply for the year (over 35 msf) and the five-year average net absorption (around 30 msf). A large share of the absorption during the year would have been on account of pre-leasing tie-ups before the outbreak of the Covid-19 pandemic. Close to 130 msf of the projects are under various stages of development across these markets currently. Even assuming that 20% of such projects may see delays or deferment, the supply pipeline in the next three years would remain stable.
Exhibit: Estimated supply and absorption in the top 6 markets (in msf)
In this context, credit metrics for developers with a relatively large portfolio of assets that have been recently completed or are about to be completed will be under pressure. Barring a sharp rebound in new leasing demand, occupancies in newly completed assets will remain under pressure. Buffers in the form of extended debt maturities or financial flexibility through assets with low leverage will be key supports to protect the credit profile.
Added Mr. Mathew, “Despite challenges, long-term demand prospects appear favorable for the sector considering that the broad occupier base in such assets has not witnessed any material business impact due to the pandemic. Moreover, India remains a very cost-competitive destination for setting up global delivery centers for large MNCs, which have traditionally driven a lot of the demand in the sector. Recovery of leasing demand to earlier long-term trends can rebalance the current demand-supply mismatch which may see vacancy levels continue to build up in FY2022 and moderate thereafter.”.
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