Indian Commercial Real Estate - Balance sheet 'deleveraging' the new mantra?

THIS IS A GUEST ARTICLE WRITTEN BY: SOBIA KHAN Business Journalist The Economic Times

Current outlook

India’s office real estate market remains buoyant and is expected to revive faster once the global spread of COVID-19 is arrested. The office segment witnessed a strong net absorption in the first quarter of 2020 despite COVID-19 induced economic slowdown and slow decision making by occupiers. The India’s office market witnessed an increase of 64% in the net absorption in the quarter ending September 2020 versus quarter ending June 2020 (Q2). The total absorption for the July-September quarter was 5.4 mn sqft. Even amidst these times, there is an 8mn sqft requirement that has cropped up in Bangalore and this demand is expected to resume after the coronavirus period which could be by April-June 2021. 

The projected demand of 40 mn sft by the end of 2020 and supply of about 45-48mn is likely to come down to 25mn sft and 38mn sft respectively in 2020. However, the supply in the sector is likely to keep pace with demand in the majority of the markets except Hyderabad as developers and the tenants are focusing on cost reductions on the operating costs and overall profit and loss of the organisation. The lower vacancy level of 8-10% across top commercial markets in the country is also expected to work in favour of the office segment in the country. 

The office space has also seen some cases where tenants are giving up the space or reducing real estate to cut down on real estate costs. Most of these exits are predominantly in Grade B assets classes where the tenants are worried if the ecosystem of the asset as a whole will be future proof i.e. ability to manage safety at work, provide comfort to occupants, manage indoor air quality and sanitation requirements arising out of CoVID.

Increased office space consolidation and optimisation strategies of corporate occupiers resulted in subdued net absorption levels, which could not keep pace with new completions. This resulted in overall vacancy increasing from 13.1% in Q2 2020 to 13.5% in Q3 2020. Despite the rise in vacancy levels in southern markets, Bengaluru, Chennai and Pune continued to hover in single digits. This augurs well for a strong rebound in these markets when economic and business conditions improve in the coming quarters.

Is having a large portfolio a concern?

The outbreak of COVID-19 has affected the real estate sector in the country in the doldrum and a huge liquidity squeeze on the builders. Some of the large commercial builders are now looking to raise capital through core asset sales as they look to reduce debt.  However, the stress of the pandemic on the developer varies upon the size of the portfolio and the type of tenants mix that the builders host.

There are short term liquidity concerns for players holding large commercial portfolios of assets but the developers having the right tenancy mix is expected to tide the current crisis better than the builders who were not focussed on liquidity. The funding requirement of the commercial developers can be met by the banks that are open towards reducing the interest level on the existing LRD and alternate areas such as platform level sales to institutional investors.  Additionally, delay of the new projects development will help the developers to manage cash flow better.

The impact of pandemic on the office builders having 30-40mn sq.ft.of  portfolio has been minimal. Some of the large builders having sufficient operating income on an ongoing basis and even during the pandemic have been able to collect 95% above rental income.

Deleveraging for Growth:

Builders have reiterated that cash is king even as financial institutions curb lending to the sector. Majority of the office builders are resetting their portfolio in terms of debt equity ratio even as uncertainties loom large in the sector. Any blips that may come in the NOI with regards to vacancy has a direct impact on developers servicing their loans. 

The large commercial developers are resetting to affordable and realistic debt levels in such a manner that there is no need to depend on the 5-10% vacancy.  While they are selling core assets due to the tough business environment, plans to grow once the debt is reset. 

The real estate sector has been highlighting severe liquidity crunch and its negative impact on the sector even before Covid-19 crisis. Builders believe that this is not the best time to raise debt from banks to buy land or greenfield projects as demand remains are a concern in the short term. 

Many companies have availed moratorium to bring down debt repayments, which has provided some support in terms of debt coverage levels. However, moratorium alone is not a key factor for long-term business. The expected judgment of the supreme court on moratorium will have varied impacts on the developers as there was no reason for the large institutional players to seek moratorium and hence they would be indifferent. However, for the smaller players it could probably provide a boost to remain solvent.
 
The moratorium on loan repayments provided by banks at the behest of the Reserve Bank of India (RBI) has provided much-needed liquidity support to mid-sized sub-investment grade companies. It has also prevented a sharp weakening of their credit profiles. While the moratorium ended in August 2020, debt restructuring announced by the RBI recently can play a crucial role in supporting the credit profiles of mid-sized companies.  

Opportunity for large global investors

There is a huge capital dislocation in the market dividing it into haves and haves not. Opportunity exists for players with deep balance sheets to come and acquire assets that are likely to wither the short-term problems and give good returns in the long term.

For developers not able to get enough funding or are unable to service their existing funding the only source for liquidating the assets is to crack good deals with the institutional investors.
There will be opportunities of strata sales for the developers and opportunities for the institutional buyers looking at investing in the country’s core assets.

Covid-19 has bought some of the office marque portfolio in the market that was earlier not on the market but is now on the market for the global investors to grab. Developers with such portfolios are the ‘winning sellers’ and the institutional investors with deep balance sheets are the ‘winning buyers’. This sets parity in terms of price and valuation perspectives as well.

Some of the large office portfolio transactions occurring in the market for debt reduction provides a vote of confidence in the market for the long term outlook of the commercial markets in India. These transactions will also pump in liquidity in the office market which has always been an issue in India for the Grade A assets. 

Global funds are chasing yields to tide over their short-term uncertainty. The developers willing to sell part of their assets not only provide an opportunity for the funds and platforms but also a head start to the new funds who have been evaluating India from the sidelines but not finding the right opportunities. Additionally, partnership with global investors also provides a foresight over a much larger portfolio and brings in more experience. 

Cap rates- upward or downward?

With the interest rates falling down it is expected that the cap rates will follow that trajectory. The pandemic has opened up a great opportunity for new partnerships and relations with a great time to buy and sell.

In the current cycle, the interest rates are going down however the banks have not yet passed on the reduction in RBI repo rate in the market. As a result, there is some head room for interest rates to go down even further and will aid in solidifying the cap rate more. However, the institutional investors feel that the commercial assets cap rates depend a lot on the quality of assets in the portfolio and the type of tenancy.

The good assets under management will always demand a higher premium and players will be holding onto that stock irrespective of the choppy waters. The office developers are going to wait and watch rather than sell in a hurry. 

It is expected that the cap rate for such assets will hold good for some time and will not go up in the near to distant future.  Nevertheless, an 8-9% cap rate is considered to be8 a decent deal right now. The two large commercial transactions will give an indication of where the cap rates are settling as the market progresses through CoVID.

However, Institutional investors are expected to look at the inherent micro economic factors to purchase office assets apart from the macro economic factors. 

Consolidation in the space

There is no one size fits all approach in the current environment. It is more of a ‘one to one’ discussion depending on the appetite of the purchaser and level of impact of leverage on the balance sheet for the seller. Not all office developers have the wherewithal to stand the pandemic.
 
On an overall level there is likely to be consolidation with  the players that have an appetite and ability to write big cheques. If large funds  come out and acquire office asseta it will result in consolidation at the national level and large portfolios will exchange hands over the next year or so. 

By and large it will become a game of the few i.e. for players who understand the entire life cycles have the ability to readapt the physical asset. Post COVID the fundamentals of commercials will have to be looked at from how the assets deliver service to the occupants, handling of operations, redesigning of office both in terms of interiors and exteriors.  

The mid-size and small developers may not be able to stand by the wave leaving them with the option to join hands with bigger players or players that can bring in equity as well as the experience. The financial stress can lead to certain actions but the value creations will be the core fundamentals of real estate due to which long term players that always had the vision of creating an ecosystem beyond the asset will be more sustainable.

Renegotiation in leases

With less than 1% of the working staff turning up to work, the CxOs see the offices constantly empty which raises certain concerns. Further, large tenants have dictated to work from home upto December 2020. Some of the large clients are pushing on Consultants to go back for renewals at lesser rates and relook at rentals.

 This is however a short-term blip for The commercial real estate that is here to stay. Some of the large office occupiers mentioned the current pause in leasing is not indicative of the long-term strategy as rop management across companies realise The pros and cons of working from home. Some big companies have already asked employees to come back to work earlier. The tone of the conversation has shifted from the initial months on productivity to now talking about mental health and cultural aspects. 

Looking at markets such as China (95% occupancy) and Singapore – give us a strong indication on the prospects for India. While the time taken will be longer the trajectory will be similar.

Even in pandemics, the India market can achieve significant uptick in the rent. From a long-term valuation perspective there is no impact on the inability of the developer to mark-up the rentals. Developers can structure around this for one year in case of the stress on the tenants’ balance sheet. In these times there is a need to be creative in the way leases are structured.
           
Except for Bengaluru which witnessed a marginal increase in rents, office rents in Q3 2020 vs Q2 2020 remained stable across all markets under review. With stable rental values and low vacancy levels, the office market in India continues to be landlord favourable. On the office front,Southern cities of Bengaluru, Hyderabad and Chennai saw rental inching up by 0.5% to 4% in the Q3 2020. However rentals across bigger markets like Mumbai, NCR, Kolkata and Ahmedabad fell in the range of 1-6% during the third quarter, while Pune saw flat growth.

However, it is important to note that landlords across markets have become more flexible in providing increased rent free periods, reduced rental escalation and fully furnished deals to prominent occupiers which reduces their net outgo. 
 

Outlook for the sector going forward

Strength for the developers is in the agility to adapt to the trends which can be a combination of better designs and adapt to real estate as a service.  Lot of the value of the portfolio lies in the building and parks and not the supporting infrastructure. The ability to provide world-class infra is a key USP for developers in these times. Focus should be on building the network and build valuation in assets and enabling infrastructure around the asset. Developers will need to develop real estate as a service bringing in technology and solutions to make working from the office better from home.

However, with the unlocking in progress, going forward as India edges back economic recovery, the office market dynamics are also expected to improve. The recent success of REITs can be understood as an indicator of long – term confidence of investors for office space.