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Conventional wisdom says that rate-sensitive sectors such as real estate suffer when interest rates are on the rise. Recently, the RBI raised the benchmark interest rate for a third straight meeting in a row. Add to it, high input costs are increasing cost for property developers. And while hiring expectations are upbeat, there are uncertainties on the return to office mode, raising concerns for office space rental demand. In this backdrop, is there merit in investing in any of the three listed Real Estate Investment Trusts (REITs) - Mindspace, Brookfield, and Embassy?
How it works?
Going by the basic principles of REITs, there may be reasons why investors can evaluate these players in the current environment. For one, it offers a tax-efficient way to own a portfolio of income-generating property assets, mainly office spaces. Returns come in two forms - dividends (90 percent of distributable cash flows must be paid out) and capital appreciation.
The three REITS have returned between 7-13 per cent from January-2022 by way of capital appreciation. Mindspace (since July 2020) and Brookfield (since February 2021) have returned 21 per cent and 30 per cent since their IPOs. Embassy REIT with a pre-Covid listing history, is down 20 per cent from its high touched in March 2020 just before Covid.
The other return parameter - distribution per unit, yields 5-6 per cent (dividend yield). At the lower end, Embassy returned 5.85 per cent (₹21.76 per share) in FY22 and average of 6.5 per cent in the last three years. The other two with shorter operating histories have returned 6.7-7.05 per cent in FY22.
If REITs have low debt or low cost of debt that is locked in at a rate that is lower than the rental yield, they would be able to provide stable or growing dividend. SEBI rules require that at .least 80 percent of the assets of REITs must be already completed and generating income. This limits the cost and execution risks for investors. Also, as a listed player, they can see lower cost of debt or be able to raise equity to grow by acquiring new assets.
Despite the back-to-office worries, data on office rental market appears bright. Many cities saw an increase in rental rates, as there was a gap in demand and supply of Grade A space. Data from property consultant Knight Frank India showed that office rental rates were up 13 and 8 per cent respectively in Bengaluru and Pune in the first half of 2022. Transactions across eight major cities jumped 107 per cent YoY in this period and Bengaluru recorded the highest prime office rental percentage growth (12.1 per cent YoY) in the entire Asia Pacific region in the June quarter.
So, REITs can be a good defensive asset class for investors who look for steady dividend in periods of volatility. While these will not deliver outsized returns, say from capital appreciation perspective, but the downside is also limited, providing portfolio diversification with risk reduction.
Q1 performance
Investors can take comfort in the fact that the three listed REITs have delivered on key metrics – occupancy, weighted average lease expiry (WALE) period, revenue and margin in the recent June quarter. Their average borrowing cost and loan to value also provide succour.
The earliest listed REIT, Embassy, has a portfolio mix of office parks (eight), hotels (four completed and two under-construction) and a solar power plant. Occupancy rate was steady at 87 per cent and cost of debt at 6.9 per cent (with 64 per cent of its borrowings locked in). Embassy raised rent by 15 per cent on average on its leases during Q1 of FY23. It expects 14 per cent rent escalations during the year, thanks to the current rent being 22 per cent lower than market rate. Embassy’s revenue grew 12 per cent QoQ to ₹829 crore. However, margin dipped and distribution cash flow fell 5 per cent due to operating cost of Hilton hotels and new developments. Its WALE is healthy at 6.9 years with just 4 per cent each of area coming up for renewal in FY23 and FY24. Diversification wise, Bangalore accounts for 74 per cent of its asset value and top 10 tenants contribute 39 per cent of rentals. It also has potential to add to its portfolio – through construction completion and rights to buy property assets. It has some leverage potential, with net debt at 27 per cent of capital.
Mindspace REIT had stable occupancy rate of about 82 per cent in June 2022. Revenue grew 4.5 per cent QoQ to ₹491 crore, but net operating income only rose 0.5 per cent due to higher costs. Its office space portfolio is across Mumbai, Pune, Hyderabad and Chennai with 36.3 per cent of rental income from its top-10 tenants. Only 4-5 per cent of its portfolio is coming up for expiry each year over the next 3 years and WALE stands at 6.9 years. Its cost of debt is 6.9 per cent as of June (up from 6.6 per cent in March) and only 41 per cent of its debt is fixed cost (includes the NCDs raised in June and July 2022). Its leverage is low, at 16.6 per cent.
The last one to be listed, Brookfield India REIT, saw an over nine per cent increase in operating lease revenue and a nearly flat net income. Average term on new leases increased from 8.4 years in March 2022 quarter to 11.3 years in June. About 31 per cent of rentals will be expiring in the next two years. Loan to value stands at 31 per cent, with headroom for borrowing. The cost of debt was 7.16 per cent. Occupancy was stable at 83 per cent in June 2022 and WALE at 7 years. It’s portfolio is spread across NCR (Gurugram and Nodia), Mumbai and Kolkata with NCR contributing 67 per cent of the total asset value. There is also a lot of revenue concentration – with top-5 clients accounting for 51 per cent of leased area. However, the company expects that with new assets in the pipeline, this will drop to 39 per cent. New asset purchase (over which it has rights) can also help increase operating income by 25 per cent over the next three years.
How investors can choose?
All the three players are somewhat comparable on many metrics. Those with a view on specific geographies – for example Bengaluru vs NCR – may select Embassy vs. Brookfield, based on the level of exposure to that region; Opt for Mindspace if you want regional diversification. Likewise, if you are averse to tenant concentration, go for Embassy or Mindspace, over Brookfield.
Investors who are conservative can consider Embassy or Mindspace as there is more stability in the outlook for leases. Mindspace’s balance sheet is strong, with potential to leverage. If you take a growth and capital appreciation view - like an equity investor - Brookfield possibly has the most potential, followed by Mindspace.
The writer is an independent consultant and doesn’t hold positions in these stocks
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