Pain continues for the commercial real estate sector as the pandemic extends into FY2022: ICRA

While lease terminations remained in line with past trends, refilling of vacant spaces is taking more time in the post-Covid environment, it said.

Collections from the occupied portfolio, however, remained robust at 97-100%, it said.

Notwithstanding the moderation in incremental demand, the supply pipeline for the near term remains largely intact, especially from the large organized developers or companies backed by institutional investors, it said.

Area under construction of around 130 msf represents around 7x of absorption in CY2020 and 4x of the average absorption over the past 5 years; sharp recovery would be required in leasing demand to rebalance the demand-supply gap, it said.

It noted that continued supply- demand mismatch would put pressure on rental rates for new leasing as  well as contractual escalations.

Leasing in FY2021 was led by IT-BPM sector, followed by engineering and manufacturing and BFSI; While flexi-work contributed to 6% in the past year, the proportion may rise in the current year, given the increasing corporate preference for flexible spaces, the report said.

Most large leasing transactions were for built-to-suit offices in the under-construction stage; activity did not adequately offset the reduction in occupancies in the existing asset portfolio, it said.

Recently completed/under-construction assets expected to get completed with lower levels of pre-leasing, resulting in exposure o risks of timely refinancing of the construction finance(CF)loans, it said.

FY2021 was characterized by differing levels of cash flow impact on the segments, with office segment showing high resilience and retail segment depicting high volatility, including a sharp bounce-back in latter half of the year.

With the second wave peaking in Q1 of FY2022, the sector is expected to confront similar challenges as in FY2021. While the retail leasing segment prospects are intricately linked to the recovery in retail sales and discretionary consumption spending by the urban population, demand recovery in office leasing segment is influenced by multiple factors as corporate occupiers evaluate the challenges and opportunities created by the pandemic on their real estate resource planning.

“Though cash flows remained materially unimpacted in FY2021, we are seeing increasing vacancy levels in the rated portfolio as the pandemic has resulted in deferment of new leasing transactions by tenants while the available inventory builds up in line with scheduled completions,” said Shubham Jain, Group Head & Senior Vice President, Corporate Ratings, ICRA.

While the factors that have supported the high level of absorption of office space in the country in the past – viz, abundant and cost competitive talent pool – remain intact, the evolving work practices in response to the pandemic may create, at best, a temporary deferment of leasing decisions or, in the worst case, a permanent reduction in the demand for real estate space, he said.

Until the implications of the pandemic on the demand trends become clear over the medium term, portfolios with moderate leverage and low share of under-construction assets will be better placed to weather the short-term challenges such as drop in occupancy or lower than anticipated growth in rent rates.

ICRA’s rated portfolio has DSCR metrics that provide adequate buffer to absorb the current level of decline in occupancies witnessed. Nonetheless, a sustained gap in the demand-supply position which can spill over into reduction of rent rates and/or occupancies in the broader market will be a key monitorable. In ICRA’s rated portfolio the share of construction finance debt outstanding as percentage of total debt was less than 10% for A category and above whereas it was around 18% for BBB rated entities.

Cash flow pressures on retail leasing

The cash flow pressures on the retail leasing segment are more evident in the near term as state level lockdowns and restrictions on mall operations impact the tenants’ revenues and will translate into rent concessions being granted by mall operators.

As retail operations eventually recover from the impact of the pandemic, the rental collections are also expected to revert to the earlier levels. Nonetheless, the timelines for such recovery will depend on the pace of vaccinations in the target consumer segment for retail malls, as well as the revival in consumer sentiments following the adverse impact that the second wave had on disposable incomes.

The rising share of retail sales cornered by e-commerce marketplaces will also have an impact on the trading values of traditional retailers in malls, thus impacting the business profile of the mall operators as well, the report said.

“The first wave had resulted in reduction in net operating income of retail malls by up to 50% in FY2021. However, the recovery in operating metrics witnessed in the second half of last fiscal would have been heartening for the industry. The prospects for such a steep recovery in FY2022 could be dampened by the income shock created by the second wave due to the associated healthcare costs that many families incurred.

In addition, the possibility of subsequent waves will weigh on the decision-making by authorities regarding relaxation of restrictions as well as the propensity for visitors to return for non-essential shopping and leisure. Over the medium term, the industry is likely to see a shift towards more experience based outlets rather than pure retail stores as malls combat the rising share of e-commerce in overall retail,” Jain said.

The credit outlook for the retail leasing segment remains negative due to the high level of cash flow disruption in Q1 and the rest of the year, particularly in the absence of regulatory measures such as moratorium on debt servicing, which had supported liquidity in FY2021.