embassy office parks reit buyvid.investmentguruindia.com/report/2020/april/embassy_reit_updt_… ·...

Please refer to important disclosures at the end of this report

Market Cap Rs273bn/US$3.6bn Year to Mar FY19 FY20E FY21E FY22E

Reuters/Bloomberg EMBASSY IN Revenue (Rs bn) 18.8 22.7 23.5 27.2

Shares Outstanding (mn) 771.7 Adjusted PAT (Rs bn) 3.7 8.7 9.5 10.3

52-week Range (Rs) 480/313 EPU (Rs) 4.7 11.3 12.3 13.4

Free Float (%) NA % Chg YoY NM 137.7 9.6 8.6

FII (%) NA P/E (x) NM 31.2 28.5 26.2

Daily Volume (US$'000) 2,472 P/B (x) NM 1.2 1.3 1.4

Absolute Return 3m (%) (16.0) Net D/E (x) 0.1 0.2 0.3 0.4

Absolute Return 12m (%) 21.9 Distribution yield (%) NM 7.0 7.2 7.7

Sensex Return 3m (%) (28.3) RoCE (%) NM 3.9 4.5 5.5

Sensex Return 12m (%) (22.9) RoE (%) NM 3.9 4.5 5.1

Equity Research March 31, 2020

BSE Sensex: 29468

ICICI Securities Limited is the author and distributor of this report

Company update and reco change

Real Estate

Target price Rs423 Target price revision Rs423 from Rs433

Price chart

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Embassy Office Parks REIT BUY Upgrade from HOLD

Resilient in tough times Rs351

Research Analyst:

Adhidev Chattopadhyay [email protected]

+91 22 6637 7451

We are upgrading our Rating on the Embassy Office Parks REIT to BUY from

HOLD post the 23% COVID-19 induced correction in unit price over the last one

month. We have cut our FY21-22E revenue/NOI estimates by 3-4% factoring in

lower occupancies in the two operational hotels (less than 5% of portfolio revenue)

and leasing delays and arrive at a revised March 2020 DCF based target price of

Rs423/unit (earlier Rs433/unit). While concerns over the medium-term demand

outlook for offices in India remains a key risk, the recent rollback in the Dividend

Distribution Tax for investors, FY22E distribution yield of 7.7% and high-quality

tenant mix in the REIT’s portfolio makes risk-reward favourable in our view.

DDT rollback a key positive: In February 2020, the Government of India’s (GoI)

2020 Union Budget had proposed to impose a Dividend Distribution tax (DDT) on

REIT investors which had dampened sentiment for REIT investors. Although the

proposed DDT had negligible near-term impact as the Embassy REIT has been

paying out distributions mostly in the form of interest and capital return, numerous

representations by industry stakeholders has prompted the GoI to rollback the

proposed DDT on REITs in March 2020. However, this waiver is on the condition that

REIT SPVs will not move to the new tax regime (of lower tax rate).

Embassy REIT portfolio cushions the COVID-19 blow: While we acknowledge the

risk to medium-term demand for office spaces in India, we believe that the office

portfolio of the Embassy REIT is relatively resilient in these tough times. The REIT’s

current tenant portfolio has over 50% of tenants in the technology domain with even

smaller verticals such as financial services and research/consulting consisting of

Global in-house captives. Currently, the REIT’s top ten occupiers contribute ~43% of

the gross overall rental income as of December 2019. Globally MNC occupiers

typically enter into long-term tenancy contracts with office developers for 8-10-year

periods with a contracted rental escalation of 15% every 36 months. They also invest

at least Rs3,000-4,000/psf for fit-outs for their offices in addition to the contracted

rentals keeping in mind the longer tenure of their leases.

High quality talent pool and affordable rentals in India: India leads in STEM

(Science, Technology, Engineering, Mathematics) talent for technology assignments

with over 2 million students graduating each year. Further, employees’ costs in India

would not be more than 20-25% of comparable cost for employees in the occupier’s

country of origin. India remains one of the more affordable office markets in the world,

with average rentals for Grade A office markets in peripheral/suburban micro-markets

hovering around 1 USD/psf/month or Rs70-75/psf/month. Further, with rental costs for

MNC occupiers being just 2-3% of their revenues, we do not anticipate any major

payment issues for the Embassy REIT.

INDIA

Embassy Office Parks REIT, March 31, 2020 ICICI Securities

2

Embassy REIT: Resilient in tough times

Question mark on medium-term office demand

The Indian Commercial Real Estate (CRE) office market saw record leasing in CY19

with 42msf of annual net absorption. The office market has been in a upcycle over

CY14-19 with rising rentals, falling vacancies, consolidation among developers and

emergence of REITs. At the beginning of CY20 (January 2020), the outlook was bright

with healthy pre-leasing for upcoming supply. However, the evolving global situation

owing to the Coronavirus (COVID-19) threatens to spoil the party. While we do not see

material risk to existing leases, incremental leasing decisions may get deferred by a

couple of quarters till Q4CY20. In our view, the bigger risk is economic slowdown in

USA and Europe (two-thirds of Indian office demand is from MNCs) impacting medium

term demand for offices in India.

Embassy REIT portfolio cushions the blow

While we acknowledge the risk to medium-term demand for office spaces in India, we

believe that the office portfolio of the Embassy REIT is relatively resilient in these

tough times for the following reasons:

Tenant mix of global IT MNCs and Global In-House Captives: Embassy REIT’s

current tenant portfolio has over 50% of tenants in the technology domain with

even smaller verticals such as financial services and research/consulting

consisting of Global in-house captives. Currently, the REIT’s top ten occupiers

contribute ~43% of the gross overall rental income as of December 2019.

Chart 1: Embassy REIT Sectoral and Tenant Wise Breakup

Technology

52%

Financial

Services

12%

Research,

Consulting &

Analytics8%

Retail

8%

Healthcare

6%

Telecom

5%

J.P. Morgan

salesforce

Others

9%

DHL

Industry Diversification(1)

43% of Gross Rentals Originate From Top 10 Occupiers

Top 10

OccupiersSector

% of

Rentals

IBM Technology 12%

Cognizant Technology 10%

NTT Data Technology 5%

Cerner Healthcare 3%

PwC Research & Analytics 3%

Google Technology 3%

NOKIA Telecom 2%

JP Morgan Financial Services 2%

Lowe's Retail 2%

L&T Infotech Technology 1%

Total 43%

Source: Company, I-Sec research


3

Sticky nature of global MNC companies: Globally MNC occupiers typically enter

into long-term tenancy contracts with office developers for 8-10-year periods with a

contracted rental escalation of 15% every 36 months. They also invest at least

Rs3,000-4,000/psf for fit-outs for their offices in addition to the contracted rentals

keeping in mind the longer tenure of their leases.

High quality talent pool in India: India leads in STEM (Science, Technology,

Engineering, Mathematics) talent for technology assignments with over 2 million

students graduating each year. Over the last decade, the emergence of GICs

(Global In-House Captives) has led to more high-end development work being

done in India. Further, employees’ costs in India would not be more than 20-25%

of comparable cost for employees in the occupier’s country of origin.

Affordable rentals: India remains one of the more affordable office markets in the

world, with average rentals for Grade A office markets in peripheral/suburban

micro-markets hovering around 1 USD/psf/month or Rs70-75/psf/month. Further,

with rental costs for MNC occupiers being just 2-3% of their revenues, we do not

anticipate any major payment issues for the Embassy REIT.

Mark-to-market opportunity is back-ended: While the mark-to-market

opportunity for higher rentals in the REIT portfolio are now at risk, with just 3% of

overall portfolio expiring in FY21E and 5% in FY22E, we do not see any risk to our

assumptions of a 5% CAGR growth in rentals across the portfolio with FY23E

having ~10% of portfolio expiry when the demand situation may normalise.

Chart 2: Mark-to-Market opportunity for REIT portfolio is back-ended

0.5 0.6

1.3

3.2

0.7

0.9

FY2021 FY2022 FY2023

Area Expiring (msf)

25

36% 15% 66% 45%Mark-to-market

opportunity

Rents Expiring 5.3% 2.8% 4.9% 9.5%

FY2019 FY2020 (2)



4

Limited completions in FY21-22E: As of December 2019, the Embassy REIT

had delivered 2 offices space of 1.4msf (0.8msf in Manyata, Bengaluru and 0.6msf

in Oxygen, Noida) around 2-3 quarters ahead of schedule of which ~44% area

was pre-committed with rentals expected to kick in from Q2FY21. These fit-

outs/pre-leases may get deferred by another 2-3 quarters on account of COVID-10

impact. However, with the next set of completions of 0.9msf being in Techzone,

Pune only in FY22E with the rest of the completions of 6.2msf scheduled post

FY22E, the REIT has enough leeway to control supply depending on the market

dynamics over the medium-term.

Chart 3: Near-term risk to incremental leasing is limited for the REIT portfolio

0.8

1.61.5

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0.9

2.4

FY 2019 FY 2020 FY 2022

Embassy Manyata Embassy Oxygen

Notes:

(1) Excludes 619 hotel keys across Hilton & Hilton Garden Inn at Embassy Manyata due for delivery in 3Q FY2022

(2) Occupancy certificate received post quarter ended Dec’19

(3) Excludes 138k sf growth options. Factoring the growth options, area pre-committed would be 64%. These options are exercisable till Jun’20

(4) Excludes 45k sf growth options. Factoring the growth options, area pre-committed would be 50%. These options are exercisable till Mar’21

(5) Includes acquisition of 0.6 msf M3 Block B located within overall Embassy Manyata upon building completion

Delivered

2-3 quarters

ahead of

schedule(2), 44%

pre-committed

FY 2023(5) Post FY 2023

Embassy Techzone

Delivered c.1.4 msf of office space ahead of targeted delivery with 44% pre-committed. Launched next

phase of growth with additional c.2.6 msf on-campus projects

Development Pipeline(1) (msf) Development Status as of February 14, 2020

Embassy Manyata

(NXT, 0.8 msf )

Delivered three quarters ahead of

schedule(2)

46% or c.359k sfpre-committed(3)

Embassy Oxygen

(Tower 2, 0.6 msf )

Delivered two quarters ahead of

schedule(2)

42% or c.246k sfpre-committed(4)

Embassy Techzone

(Hudson, 0.5 msf)

(Ganges, 0.4msf)

Hudson Block – Design and excavation

completed for revised area of 0.5 msf

(from earlier 0.3 msf); sub- structure

work underway

Ganges Block – Design completed;

excavation and sub-structure work

underway

Targeting Dec’21completion

Embassy Manyata

M3 Parcel

(Block A – 1.0 msf)

(Block B – 0.6 msf)

M3 Block A – Design and piling works

completed; excavation and sub-

structure works underway. Targeting

Jun’22 completion

M3 Block B – Pre-construction works

initiated. Targeting Mar’23 completion

Embassy Oxygen

(Tower 1, 0.7 msf)

Design completed, excavation and

pre-construction works initiated

Targeting Dec’22completion



5

Valuation:

The Embassy REIT unit price has corrected by 23% in the last one month owing to

COVID-19 related market correction and concerns on medium-term office demand.

Further, in February 2020, the Government of India’s (GoI) 2020 Union Budget had

proposed to impose a Dividend Distribution tax (DDT) on REIT investors which further

dampened sentiment. Although the proposed DDT had negligible near-term impact as

the Embassy REIT has been paying out distributions mostly in the form of interest and

capital return, numerous representations by industry stakeholders has prompted the

GoI to rollback the proposed DDT on REITs in March 2020. However, this waiver is on

the condition that REIT SPVs will not move to the new tax regime (of lower tax rate).

We have cut our FY21-22E revenue/NOI estimates by 3-4% factoring in lower

occupancies in the two operational hotels (less than 5% of portfolio revenue) and

arrive at a revised March 2020 DCF based target price of Rs423/unit (earlier

Rs433/unit). Accordingly, we upgrade our Rating on the Embassy REIT to BUY

from HOLD post the 23% correction in unit price over the last one month. The

recent rollback in the Dividend Distribution Tax for investors, FY22E distribution

yield of 7.7% and high-quality tenant mix in the REIT’s portfolio makes risk-

reward favourable in our view.

Table 1: Return profile of Embassy REIT

Embassy REIT Cash Flows FY20E FY21E FY22E

Revenue from Operations 22,655 23,494 27,175 Net Operating Income (NOI) 20,273 21,319 25,271 EBITDA 17,811 18,733 22,333 NDCF at SPV level 19,166 19,636 21,214 NDCF at REIT level 18,911 19,578 20,929 NDCF Distribution Payout (%) 100% 100% 100% NDCF Distribution by REIT 18,911 19,578 20,929 Distribution per Unit 24.5 25.4 27.1 Distribution Yield (%) 7.0 7.2 7.7

Source: I-Sec research estimates

Table 2: Table: Valuation of Embassy REIT

Enterprise Value 375,419 Less: REIT level debt 48,709 Equity Value 326,710 Equity Value per Unit 423


Table 3: Sensitivity of Target Price to Cap Rate and Cost of Equity

Cost of Equity (%)

Target Price 10% 11% 12% 13% 14% 15%

Cap Rate (%)

6% 543 512 485 463 444 427 7% 508 479 454 434 416 401 8% 476 448 423 407 390 376 9% 446 420 399 381 366 353

10% 418 394 375 358 344 331 11% 392 370 352 336 323 312



6

Indian Office Market: Key Trends

Chart 4: India office quarterly supply and absorption trends

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Q2C

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Y19

(%)

(msf)

Supply Absorption Vacancy (RHS)

Source: Cushman & Wakefield, I-Sec Research

Table 4: India office absorption over CY12-CY19

City CY12 CY13 CY14 CY15 CY16 CY17 CY18 CY19

MMR 6.0 4.6 3.9 2.9 3.0 2.4 2.9 5.2 NCR 4.8 3.6 6.2 3.8 4.3 3.7 4.8 10.0 Bengaluru 7.3 4.6 8.9 10.3 12.3 8.0 7.9 9.3 Chennai 2.7 2.4 2.6 2.8 2.9 2.2 1.7 1.8 Hyderabad 2.8 2.4 4.4 5.5 6.3 4.9 6.0 9.3 Pune 3.0 3.5 3.6 6.2 3.3 2.0 3.4 5.1 Kolkata 1.3 0.9 0.8 1.1 0.8 0.8 0.4 1.4 Overall 27.8 21.8 30.3 32.6 32.9 24.1 27.1 42.0


Bengaluru and Hyderabad remain strongest markets

Bengaluru continues to see low Grade A vacancy at 5 and accounted for ~22% of

net absorption of office space in CY19. We expect Bengaluru market to retain

more than 25% of net absorption over CY20-21E.

Hyderabad market clocked record annual absorption of 4.9msf in CY17 and

6.0msf in CY18. Vacancy levels for Hyderabad also fell to 7% in CY18 from 18%

in CY14. In CY19, Hyderabad has seen record net absorption of 9.3msf and is

now on par with leasing levels seen in Bengaluru. With the city continuing to offer

affordable rentals, occupiers continue to flock to Hyderabad for expansion

purposes.

Kolkata and non-CBD regions of Gurugram continue to suffer from supply glut

where current vacant office space is expected to take at least 24-36 months to be

absorbed.


7

Table 5: India Grade A office stock vs. vacancy

City (Dec-19) Stock (msf) % share of stock

Vacancy (%) Occupied space (msf)

% share of occupied stock

MMR 92.4 17% 19% 75.0 16% NCR 112.9 21% 23% 86.6 19% Bengaluru 143.2 27% 5% 135.9 29% Chennai 50.2 9% 10% 45.3 10% Hyderabad 56.9 11% 6% 53.8 12% Pune 52.1 10% 4% 50.0 11% Kolkata 26.4 5% 36% 17.0 4% Overall 534.1 100% 13% 463.5 100%


Two-third of India office demand driven by MNCs

IT-ITES sector has remained top-most in terms of share of office occupancy across

major Indian cities. The sector maintains its lead with 35-40% share in office

occupancy. While there has been a noticeable slowdown in absorption by E-

Commerce companies, they only accounted for 3% of demand in CY17.

Chart 5: India office absorption by sector

0%

20%

40%

60%

80%

100%

CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16 CY17 CY18 CY19

IT & ITES Manufacturing / IndustrialBFSI Telecom, Pharma & RealtyConsultancy Business EcommerceProfessional Services/Coworking

Source: JLL India, I-Sec Research

In CY16, share of leasing by US-based firms jumped up to 42% from 32% in CY15 led

by expansion of companies such as Amazon, Microsoft, Google. Domestic firms

continue to account for a third of demand. Incrementally, we expect this trend to

continue as majority of office expansion, especially in the IT/ITeS segment, is being

driven by Global In-House Captives (GICs). Further, large domestic IT/ITeS

companies such as Infosys and Tata Consultancy Services (TCS) now prefer to lease

office space as per their requirement vs. the previous model of building large captive

campuses.


8

Chart 6: India office absorption by country of origin of the occupier

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16 CY17 CY18 CY19

USA India EU APAC Others

Source: JLL India, I-Sec Research


9

CY19 net absorption is higher on back of higher completions

CY14-16 has been a period of recovery for the Indian office market with falling

vacancies, quality locations seeing strong demand and rentals increasing by up to

50% in preferred micro-markets. While H1CY17 saw slower leasing activity owing to

global factors and corporates holding back decisions, H2CY17 saw a turnaround in

absorption levels and pre-commitments.

However, delayed supply in CY17 where incremental supply was just 23.5msf

compared to completions of over 30msf annually over CY14-16, led to CY17 net

absorption levels also seeing a decline to ~24msf. However, higher supply infusion of

~30msf in CY18 has helped CY18 net absorption to increase to ~27msf.

CY19 has seen record net absorption of 42msf vs. the previous high of 37msf seen in

CY08 and absorption levels of 25-27msf seen in CY17-18. This record absorption has

been driven by record completions of 44msf in CY19. This is largely owing to majority

of upcoming supply being already pre-committed.

With significant pre-committed supply across Bengaluru, Hyderabad and Pune

expected to be completed in CY20-21E, we expect pan-India net absorption levels to

trend in the 35-40msf level over the same period.

With a significant number of leases also up for renewal in CY20-21E, IT/ITeS office

occupiers in markets such having low office vacancies will either have to pre-commit

space in new buildings or look to pay higher rents in existing offices.

Chart 7: India annual absorption-supply of offices and forecast

0

5

10

15

20

25

0

20

40

60

CY

02

CY

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CY

20E

CY

21E

(%)

(msf)

Supply Absorption Vacancy (RHS)

Source: Cushman & Wakefield, JLL India, I-Sec Research


10

Financial summary (Consolidated)

Table 6: Profit and Loss statement

(Rs mn, year ending Mar 31)

FY19 FY20E FY21E FY22E

Revenue from operations 18,771 22,655 23,494 27,175 Operating Expenses 5,174 4,844 4,760 4,842 EBITDA 13,597 17,811 18,733 22,333 % margins 72.4% 78.6% 79.7% 82.2% Depreciation & Amortisation 3,563 5,080 5,089 5,303 Interest expenses 7,060 3,711 3,780 6,322 Other Income 1,539 277 293 308 Exceptional items - - - - PBT 4,514 9,298 10,157 11,015 Less: Taxes 2,012 1,395 1,523 1,652 PAT before Minority/Associate 2,502 7,903 8,633 9,363 Associates 1,152 781 887 972 Net Income (Adjusted) 3,653 8,684 9,520 10,335

Source: Company data, I-Sec research

Table 7: Balance sheet


As at March FY19 FY20E FY21E FY22E

Assets

Total Current Assets 68,849 19,328 21,074 20,701 of which cash & cash eqv. 51,069 4,781 6,368 5,296 Total Current Liabilities & Provisions 17,468 14,027 14,216 15,044 Net Current Assets 51,381 5,301 6,858 5,657 Goodwill 51,699 51,699 51,699 51,699 Investments 25,519 31,967 31,967 31,967 Net Fixed Assets 2,15,863 2,11,763 2,07,654 2,19,649 Capital WIP 5,018 9,671 16,086 6,183 Total Assets 3,49,480 3,10,401 3,14,265 3,15,155

Liabilities Borrowings 79,111 50,513 64,493 76,263

Net Worth 2,28,945 2,18,463 2,08,347 1,97,467 Minority Interest - - - - Deferred Taxes 41,424 41,424 41,424 41,424 Total Liabilities 3,49,480 3,10,401 3,14,265 3,15,156


Table 8: Cashflow statement


Year ending March FY19 FY20E FY21E FY22E

PBT 4,514 9,298 10,157 11,015 Interest income and fair value change in financial assets (1,293) (277) (293) (308) Finance costs 7,060 3,711 3,780 6,322 Depreciation and amortisation expense 3,563 5,080 5,089 5,303 Others 259 - - - Operating cash flows before working capital changes 14,102 17,811 18,733 22,333 Changes in Working Capital 155 (208) 29 129 Cash generated from operations 14,258 17,603 18,763 22,462 Income taxes paid, net (1,863) (1,395) (1,523) (1,652) Operating Cashflow 12,395 16,209 17,239 20,809 Capital Commitments (12,010) (5,633) (7,395) (7,395) Free Cashflow 385 10,576 9,844 13,414 Investments 11,470 (5,667) 887 972 Others 1,597 277 293 308 Cashflow from Investing Activities 1,056 (11,023) (6,215) (6,115) Issue of Share Capital/(Distribution) 47,500 (19,166) (19,636) (21,214) Inc (Dec) in Borrowings (5,599) (28,598) 13,980 11,770 Finance costs (7,177) (3,711) (3,780) (6,322) Others - - - - Cashflow from Financing activities 34,725 (51,474) (9,437) (15,767) Chg. in Cash & Bank balances 48,176 (46,288) 1,587 (1,072)



11

Table 9: Key ratios

(Year ending Mar 31)

FY19 FY20E FY21E FY22E

Per Share Data (Rs)

Earnings per Unit 4.7 11.3 12.3 13.4 Distribution per unit (DPU) NA 24.5 25.4 27.1 Book Value per Unit (BV) 296.7 283.1 270.0 255.9

Growth (%) Net Sales 16.5 20.7 3.7 15.7

EBITDA 12.8 31.0 5.2 19.2 PAT (3.0) 137.7 9.6 8.6

Valuation Ratios (x) P/E

31.2 28.5 26.2 P/BV

1.2 1.3 1.4

Distribution Yield

7.0 7.2 7.7

Operating Ratios Debt/EBITDA (x) 5.8 2.8 3.4 3.4

Net D/E 0.1 0.2 0.3 0.4

Profitability/Return Ratios (%) RoE

3.9 4.5 5.1 RoCE

3.9 4.5 5.5

EBITDA Margins 72.4 78.6 79.7 82.2 Net Income Margins 19.5 38.3 40.5 38.0



12

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New I-Sec investment ratings (all ratings based on absolute return; All ratings and target price refers to 12-month performance horizon, unless mentioned otherwise)

BUY: >15% return; ADD: 5% to 15% return; HOLD: Negative 5% to Positive 5% return; REDUCE: Negative 5% to Negative 15% return; SELL: < negative 15% return

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