Why stocks of listed REITs are risky bets in the near term

Global macro headwinds in the form of rising interest rates and hiring slowdown by technology MNCs could blight the sector in the near term.

Ram Prasad Sahu reports.

The stocks of listed real estate investment trusts (REITs) are down 9-12 per cent from their peak in January to their low earlier this month.

In addition to the negative sentiment as a consequence of changes announced in the Union Budget 2023-24 concerning tax treatment for debt repayment distribution, concerns about hiring slowdown and its leasing impact, as well as higher interest rates, could blight the sector in the near term.

What is exacerbating uncertainty for the sector is the delay in the clearance of the Development of Enterprises and Services Hub (DESH) Bill, which will replace the Special Economic Zones (SEZs) Act.

The DESH Bill was expected to improve occupancy levels, factoring in the relaxation of regulatory restrictions governing SEZs.

In the near term, the Street will focus on the operational metrics of listed players and the outlook, given that some companies have been holding off on leasing decisions.

Research analyst Adhidev Chattopadhyay of ICICI Securities points out that the global macro headwinds in the form of rising interest rates and hiring slowdown by technology multinationals (MNCs) — they account for 67 per cent of Indian office space demand — have led to a slowdown in large leasing decisions and a delay of at least two quarters (January through June).

However, demand for smaller and mid-sized deals for non-SEZ space up to 100,000 square feet remains strong, he observes.

Occupancy levels in the October-December quarter (third quarter, or Q3) of 2022-23 (FY23) have been stable or have marginally improved for companies.

The largest listed player — Embassy Office Parks REIT (Embassy) — reported fresh leasing and renewals in Q3 and superior occupancy levels, notwithstanding higher-than-expected exits.

Analysts Samar Sarda and Ashutosh Mittal of Axis Capital expect the REIT to exceed the gross leasing guidance of 5 million square feet (msf) for FY23, regardless of higher-than-expected exits, reflecting some improvement in net leases.

Mindspace Business Parks REIT (Mindspace) saw a healthy quarter, led by steady leasing momentum and lower expiries.

Committed occupancy increased to 88.3 per cent, compared with 86.9 per cent in the July-September quarter.

While this is encouraging, interest costs are expected to move up, bearing in mind the higher cost of debt.

Mindspace indicated that 2 msf of projects (Airoli and Pune) will be completed over FY23 and will add Rs 150 crore of rental income over 2023-24 (FY24).

However, an increase in interest cost by 50-75 basis points over the next few quarters and normalisation of excess debt drawdown could largely offset the same, says IIFL Research.

Similarly for Embassy, which has Rs 4,100 crore of fixed cost debt maturing in the second half of FY24, the same will be refinanced at higher rates, compared to the current weighted average rate of 6.6 per cent.

The increased cost of debt due to refinancing is likely to impact the company’s FY24 estimated net distributable cash flows by minus 4 per cent.

The absence of clarity on the interpretation of changes announced in the Budget is also bearing down on sentiment.

The repayment of the debt component of REIT distribution (the other two modes of payment being interest and dividends) will be taxed from FY24.

IIFL Research says that 37-47 per cent of the distribution for Embassy and Brookfield India Real Estate Trust is to be taxable in hands of unitholders, effectively reducing their after-tax yield by 1 percentage point.

Mindspace unitholders are not impacted, given that 90-93 per cent of distribution is paid out as dividends and the residual 7-10 per cent in the form of interest.

The managements of listed REITs have also mentioned that the delays related to the DESH Bill are leading to partial utilisation of facilities located within an SEZ.

REITs are converting this into non-SEZ space within the ambit of existing SEZ regulations to take the edge off the negative impact.

Given the multiple near-term headwinds faced by REITs, investors should await clarity on regulatory issues and an improvement in hiring trends before considering the listed stocks in the space which offer a combination of steady yields and long-term appreciation.