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Equity Research INDIA March 5, 2019 BSE Sensex: 36443 Real Estate ICICI Securities Limited is the author and distributor of this report CRE: #10yearchallenge – Faster, higher, stronger While India’s Residential Real Estate (RRE) market has seen a slowdown over Sector update CY14-18 compared to a stellar run over CY09-13, the Commercial Real Estate (CRE) office market has seen contrasting fortunes with a painful CY09-13 period being Real Estate followed by a strong recovery and consolidation over CY14-18. The CY14-18 period has seen falling vacancy levels, rental appreciation and consolidation within the space with just a handful of 8-10 large pan-India office developers dominating the DLF market. At the same time, the office space has seen healthy inflow of institutional (BUY, TP Rs280) money from foreign investors (private market deals) to these developers’ portfolios Oberoi Realty to add incremental space. As we head into CY19, we continue to retain our bullish (BUY, TP Rs564) stance on office asset developers and reiterate our BUY ratings on DLF, Oberoi Realty, Prestige Estates and Brigade Enterprises. A possible listing of India’s first Prestige Estates Real Estate Investment Trust (REIT) by Embassy Office Parks in H1CY19 may (BUY, TP Rs301) provide clarity on the cumulative yields that Indian REITs may offer as a mix of The Phoenix Mills existing rental income and capital appreciation. (BUY, TP Rs772) Cycle remains favourable for office sector: The India office market continues to see Brigade Enterprises low vacancy levels and limited supply in the preferred micro-markets across India’s tier (BUY, TP Rs304) I cities. After a muted CY17 where net absorption fell to 24msf owing to low supply Godrej Properties addition vs. levels of over 30msf seen in CY14-16, CY18 has seen a bounce back with (HOLD, TP Rs744) net absorption of 27msf. Among cities, the Bengaluru and Hyderabad markets continue to see the strongest demand among occupiers while select micro-markets in Sunteck Realty other cities such as Central Business District (CBD) areas of Gurugram in NCR (BUY, TP Rs513) continue to see strong occupier interest. While the rise in Indian G-sec yields to close Sobha Ltd to 7.5% make an argument for a possible expansion in cap rates for annuity assets (ADD, TP Rs524) (we assume 9% cap rate across companies), we are of the view that these Grade A assets command a scarcity premium and that cap rates for high quality assets should continue to see valuation multiples sustain. Prefer players with strong annuity asset portfolio: The volatile nature of the stock performance of listed real estate players means that investors need to seek the right entry point to make outsized returns. We argue that companies that already have an operational portfolio of annuity assets and are significantly investing in capex to add more such assets will have a sizeable recurring revenue stream in another 2-3 years which will account for 60-70% their EV. Further, all the large annuity players in India have access to a pool of global capital to fund their growth rather than taking on more leverage on their own balance sheets. In our view, these annuity assets would act as a cushion for valuations in all these companies through cycles. Rental portfolio of annuity players to see robust growth: DLF’s rental arm DCCDL which will have an exit rental EBITDA of Rs30bn by FY19E will continue to see at least 10% rental income growth over the next 4-5 years driven by another 4msf of assets becoming operational along with ~24msf of balance land bank in that entity. Prestige Estates should reach an exit rental EBITDA of over Rs11bn by FY21E from Rs7.3bn as of FY18 while Brigade Enterprises should see its rental EBITDA rising to Rs5.3bn by FY22E from Rs2.4bn as of FY18. The Phoenix Mills should see its existing malls Research Analyst: cross Rs11bn of rental EBITDA by FY21E from Rs8.7bn in FY18 and is also expected Adhidev Chattopadhyay to add over Rs5bn of rental EBITDA from fresh capex across malls by FY23E. Oberoi [email protected] +91 22 6637 7451 Realty has also changed its upcoming project mix to include 50% of annuity/hotel assets vs. a 24% share in its ongoing projects. Please refer to important disclosures at the end of this report Real Estate sector, March 5, 2019 ICICI Securities Indian office market We remain bullish on the prospects of India’s office market over CY19-20E. There are multiple factors driving office demand in India and our bullishness is predicated on the following thesis: Pre-leasing momentum continues to sustain: The Indian office market has clocked net absorption of over 30msf over CY14-16 and while CY17 was a relatively subdued year owing to delayed completions, CY18 saw a bounce back with ~27msf of net absorption on the back of higher pre-committed supply becoming operational. Preferred micro-markets have low vacancy levels: The preferred locations for offices in cities such as Bengaluru and Hyderabad have Grade A vacancies of just 5-6% and corporate occupiers are now looking at pre-booking space in preferred locations given unavailability of large spaces. Global in-house captives (GICs) to drive IT/ITes hiring and office leasing: While news flow has suggested slowdown in hiring by domestic IT/ITeS companies which in turn will lead to sluggish leasing demand, we choose to highlight that majority of incremental hiring in the sector would be driven by Global In-House Captives (GICs) for higher-end jobs. Co-working spaces have emerged as an additional driver: According to a report by Colliers India, India has more than 160 co-working space operators running over 350 centres in India. Of this, majority of the centres are based in Bengaluru, Mumbai and NCR having occupancies of 60-80%. As per industry estimates, co-working spaces accounted for absorption of 3-4msf each in CY17-18 with another 9-10msf of space expected to be absorbed over CY19-20E. Limited number of developers capable of building quality rental assets: Unlike the residential market which has relatively lower entry barriers in India, the Indian office and mall market is a capital-intensive business requiring developers to have adequate balance sheet strength. Further, the trend has now shifted to office campuses with larger plot layouts which require adequate planning. The few notable names are DLF, Prestige Estates, K Raheja Corp, Embassy Office Parks, Brigade Enterprises, RMZ Corp and The Phoenix Mills. Institutional money flowing into Indian rental assets and emergence of REITs: Many large transactions which have taken place over CY14-16 in the Indian office/mall space such as Brookfield buyout of Hiranandani office assets in Mumbai, Blackstone JV with Embassy/Panchshil, RMZ tie up with Qatar Investment Authority, imminent deal between GIC Singapore and DLF for the latter’s rental portfolio point to the resilience of the Indian office market. In the mall space, consolidation has taken place with many underperforming malls shutting down, helping players like Phoenix Mills to strengthen their position along with GIC Singapore’s buyout of stakes across the remaining quality malls in India. While Real Estate Investment Trusts (REITs) in India are clearly a possibility over the next 3-6 months, the market is awaiting clarity on the cumulative yields that Indian REITs may offer as a mix of existing rental income and capital appreciation. 2 Real Estate sector, March 5, 2019 ICICI Securities CY14-16 saw strong absorption of office space India’s office market was a laggard over CY08-13 wherein lease rentals had corrected by 40-50% from CY08 peaks and continued to stagnate owing to supply outpacing demand. At the same time, the Indian residential market saw a strong recovery with prices doubling across cities from CY09 levels and remaining sticky. From CY14, net absorption of office space witnessed strong recovery for the first time with 39% YoY growth to 30msf. CY15 saw net absorption of 32.6msf and CY16 net absorption of 32.9msf (marginally up from CY15 levels), primarily owing to strong leasing in Bengaluru of over 12mn sq ft due to completion of pre- committed supply in Q4CY16 of over 6msf. Hyderabad market also clocked a record year for office absorption in CY16 with net absorption of over 6mn sq ft. The 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 CY16. In CY16, share of leasing by US-based firms jumped up to 42% from 32% in CY15 led by expansion of many companies such as Amazon, Microsoft, Google. Domestic firms continue to account for a third of demand. Chart 1: India office quarterly supply and absorption trends Supply Absorption Vacancy (RHS) 16 20 14 18 16 12 14 10 12 (%) (msf) 8 10 6 8 6 4 4 2 2 0 0 Q4CY09 Q2CY10 Q4CY10 Q2CY11 Q4CY11 Q2CY12 Q4CY12 Q2CY13 Q4CY13 Q2CY14 Q4CY14 Q2CY15 Q4CY15 Q2CY16 Q4CY16 Q2CY17 Q4CY17 Q2CY18 Q4CY18 Source: Cushman & Wakefield, I-Sec Research Table 1: India office absorption over CY12-CY18 City CY12 CY13 CY14 CY15 CY16 CY17 CY18 MMR 6.0 4.6 3.9 2.9 3.0 2.4 2.9 NCR 4.8 3.6 6.2 3.8 4.3 3.7 4.8 Bengaluru 7.3 4.6 8.9 10.3 12.3 8.0 7.9 Chennai 2.7 2.4 2.6 2.8 2.9 2.2 1.7 Hyderabad 2.8 2.4 4.4 5.5 6.3 4.9 6.0 Pune 3.0 3.5 3.6 6.2 3.3 2.0 3.4 Kolkata 1.3 0.9 0.8 1.1 0.8 0.8 0.4 Overall 27.8 21.8 30.3 32.6 32.9 24.1 27.1 Source: Cushman & Wakefield, I-Sec Research 3 Real Estate sector, March 5, 2019 ICICI Securities CY18 net absorption 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.