Covid-19 second wave may dash expectations of office leasing sharp recovery in 2021

The rising Covid-19 second wave across India that has left the metro cities especially vulnerable, may delay the recovery in new office space leasing activity, thereby putting pressure on operating metrics for the industry on an aggregate, said ratings agency ICRA.
The office leasing segment of the commercial real estate sector had maintained stable credit metrics over financial year 2020-21 on the back of healthy collections, low-to-moderate impact on occupancies and expectations that had built-up in the latter half of the year of a bounce-back in new leasing activity.

The share of employees continuing to work-from-home may remain elevated in the near term, owing to the health risks. Without immediate visibility on the larger number of employees returning to offices, potential leasing transactions may get further deferred, ICRA said.

“In assets which are already operational, the quantum of lease terminations has broadly been in line with past trends, indicating that such terminations were not entirely on account of Covid-19 pandemic, barring some corporate office occupiers rationalising their space requirements,” said Mathew K Eranat, Co-Group Head & Vice President at ICRA.

However, refilling such vacant spaces, according to him, is taking longer time in the post-Covid environment, leading to higher vacancies in operational assets. On the other hand, with a steady pipeline of assets becoming operational in the near term, the demand supply gap could temporarily widen further.

While certain large sized leasing transactions have been announced even during the financial year 2020-21, the volumes may not adequately cover the increase in completed stock from the larger organised developers.

Nonetheless, long-term demand prospects appear favourable for the sector considering that the broad occupier base in such assets has not witnessed any material business impact due to Covid19. Recovery to earlier levels of demand can rebalance the current demand-supply mismatch over the medium to long term, he added.

ICRA notes that in comparison to other segments within the real estate sector, the office leasing segment witnessed the least impact on operational cash flows during 2020-21. Collections from existing leases remained largely intact with no major challenges observed in realisation of the rents billed. This was despite a very low proportion of employees returning to the workspaces, with reported employee-occupancy levels between 10-20% at most of the IT and business parks.

The adoption of work-from-home and travel restrictions, however, resulted in delays in signing of new leasing transactions, which has resulted in occupancies declining in operational assets, albeit in a gradual manner.

Prior to the second wave, it was expected that the share of employees in workspaces will gradually improve to the earlier levels, supported by expectations of widespread vaccine coverage. Such a pickup in employee strength at the offices would have been a precursor to recovery in fresh leasing transactions which are driven largely by the expansion requirements of corporate.

According to the ratings agency, without immediate visibility on a larger number of employees returning to offices, potential leasing activity by the corporates will be further pushed back. Moreover, international travel restrictions and potential lockdowns may inhibit travel from the head offices of the tenants who will finally approve decisions pertaining to real estate planning.

The year 2020 already witnessed a significant gap between the incremental supply and absorption, resulting in increase in vacancies across all markets, largely impacting the recently completed properties.

Net absorption during the year across the top six office leasing markets was under 20 million sq ft, falling short of the supply for the year of over 35 million sq ft and the five-year average net absorption of around 30 million sq ft.

A large share of the absorption during the year would have been on account of pre-leasing tie-ups before the outbreak of Covid-19 pandemic. Close to 130 million sq ft of the projects are under various stages of development across these markets currently. Even assuming that 20% of such projects may see delays or deferment, the supply pipeline in the next three years would remain stable.

In this context, credit metrics for developers with relatively large portfolios of assets which have been recently completed or are about to be completed will be under pressure. Barring a sharp rebound in new leasing demand, occupancies in newly completed assets will remain under pressure. Buffers in the form of extended debt maturities or financial flexibility through assets with low leverage will be key supports to protect the credit profile, ICRA said.