Embassy Office Parks REIT (EMBASSY) Earnings Call Transcript

Good evening, everyone. A very warm welcome to the Embassy REIT's First Quarter FY 2024 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would like to introduce your host for today's call, Ms. Sakshi Garg, Investor Relations Manager of Embassy REIT. Ma'am, you may now begin. Thank you.

Thank you. Welcome to the First Quarter FY 2024 Earnings Call for Embassy REIT. Embassy REIT released its financial results for the quarter ended June 30, 2023, a short while back. As is our standard practice, we have placed our financial statements, earnings presentation discussing our performance and a supplemental financial and operating data book in the Investors section of our website at www.embassyofficeparks.com. As always, we would like to inform you that management may make certain comments on this call that one could deem forward-looking statements. Please be advised that the REIT's actual results may differ from these statements. Embassy REIT does not guarantee these statements or results and is not obliged to update them at any time. Specifically, any financial guidance and pro forma information that we will provide on this call are management estimates based on certain assumptions and have not been subjected to any audit review or examination procedures. You are cautioned not to place undue reliance on such information and there can be no assurance that we will be able to achieve the same. Joining me today are Aravind Maiya, our CEO; Abhishek Agrawal, our CFO; and Ritwik Bhattacharjee, our CIO. We'll start off with brief remarks on our business and financial performance, and then open the floor to questions.

Thank you, Sakshi. Good evening, and thank you all for joining us to discuss our Q1 results. To start with key highlights for the quarter, we leased a total of 1.1 million square feet, delivered a NOI growth of 9% year-over-year, and announced distributions of INR 5.38 per unit. In addition, based on our Q1 performance, our existing healthy pipeline and considering a clearer interest rate outlook, we have provided guidance for the full-year FY '24, which Abhishek will take you through shortly. On the macro front, India has emerged as the fastest growing large economy in the world and its stature continues to grow as a real alternative to China. Along with this, moderating inflation levels and a pause in policy rate hikes has improved the general business and market sentiments, as well as reinforced the growth stance of the government. The same positivity is also reflected in the Indian commercial real estate market. The demand remained strong from premium office spaces. This is in stark contrast to many developed office markets and is largely supported by 2 factors. First, the growth of global captive centers, or GCCs in India is currently driving the new demand. By leveraging the Indian skilled talent and the associated cost arbitrage, these global companies continue to set up and expand their offshoring centers in India. As per recent industry reports, 115 sub-centers are expected to be set up every year in this decade, employing 2.6 million additional head count. This will be a key driver for the new office space requirement of over 450 million square feet expected over the next 10 years. Also, moving up the value chain, these GCCs are emerging as centers of excellence and innovation and are driving product development in multiple areas such as AI, cloud, engineering and data analytics. Second, the physical office attendance continues to improve in Indian office market as compared to the west, where remote working is still quite prevalent. Even in our properties, back-to-office numbers are rising steadily. It is also encouraging to see the recent commentary from multiple industry leaders regarding their updated back-to-office strategy and their continued focus on getting their employees back to the offices. With this backdrop, let me move to our portfolio and start with the leasing performance for Q1. We leased 1.1 million square feet across 22 deals, including 407,000 square feet of new leases at 68% re-leasing spreads. We also pre-committed 448,000 square feet in our under-development projects at a premium to market rents and renewed 209,000 square feet leases at 15% renewal spreads. The leasing demand was primarily driven by GCCs contributing to over 71% of our total leasing. In terms of sectors, besides technology occupiers, BFSI, consulting, engineering and manufacturing firms led the demand. We also noted a strong trend of expansionary demand with over 80% of the new or pre-leasing by our existing occupiers. Also, deviating a bit from the last quarter trend, couple of large sized deals got signed in Q1. Embassy Manyata contributed 61% of the total leasing this quarter and its occupancy touched 91%. This asset has been going through a positive churn in terms of occupier mix and we've been able to increase its in-place rentals by around 20% in the last 18 months. So, now, our 2 largest markets, Bangalore and Mumbai, are at greater than 90% occupancy levels. Factoring the 702,000 square feet of exits during the quarter, primarily from IT services occupiers, our Q1 occupancy stood at 85% for the overall portfolio and 87% on a same-store basis. Of the 5.1 million square feet current vacancies, around 67% is concentrated in Pune and Noida, significantly smaller markets for us. Hence, on a value basis, this Pune and Noida vacancy translates to only 5% of our portfolio value. Looking forward, we have a promising leasing pipeline of 2 million square feet for our operational portfolio as well as our under-development projects. On the SEZ front, we are still awaiting regulatory clarity on the SEZ bill amendment, and we continue to be hopeful for a resolution soon. In the meantime, we continue to work on what is under our control. We leased 0.5 million square feet of SEZ space this quarter to existing SEZ occupiers looking to expand. We are in the final stages of de-notifying our existing 0.4 million square feet D3 building in Embassy Manyata. We have already leased 41% of this building at 210% re-leasing spreads. With a pipeline of another 225,000 square feet, we are hopeful to fully lease this building by end of the year. This is a perfect example of the strategy that we continue to follow to de-notify and completely vacant -- denotify any completely vacant SEZ building where leases get expired or where we are able to relocate existing occupiers. We have identified another such building in Manyata, totaling 0.8 million square feet, which we will look to de-notify within this financial year. With this, our current SEZ vacancies stood at 15% or 3 million square feet, seeing an improvement from the last quarter. Also, the non-SEZ vacancy for our portfolio is 10%, excluding the new buildings in Pune delivered last year. This non-SEZ space has good traction and we are confident to lease up the same. Moving to our development portfolio. Our development pipeline totaling 7.9 million square feet is a key organic growth lever for us over the next 3 years to 4 years. With the total committed CapEx of INR 4,000 crores, these projects are expected to add approximately INR 900 crores annual NOI upon stabilization, resulting in a very attractive yield. 3 projects totaling 2.1 million square feet are due for delivery this year across Bangalore and Noida. Of this, the 1 million square feet M3 Block A in Embassy Manyata is awaiting occupancy certificate, which is expected by next month. This block is already 45% pre-committed with a healthy pipeline for the balance. In addition, 0.4 million square feet of Embassy Business Hub is on track for delivery next quarter and is almost fully pre-leased. Overall, over 90% of our total development projects are in Bangalore, which continues to lead India's office absorption. Around 1/4 of the total developments are already pre-committed to leading global companies and we are building a strong pipeline for the remainder. In terms of key upgrades, we have completed the refurbishment of 0.2 million square feet Block K at Embassy Manyata. Around 72% of this block has already been leased at 215% re-leasing spreads. For the remainder, we have a healthy pipeline of over 100,000 square feet and we expect to fully lease this building by the end of this year. Lastly, on our hotels, the strong rebound in our hospitality business continued with a 53% occupancy, or 30% year-over-year ADR growth and an EBITDA of INR 40 crores in Q1. We are extremely proud to see our unitholder register crossing 85,000 as compared to 4,000 at the time of our listing and around 47,000 at the same time last year. We particularly welcome the expansion of domestic institutional and retail investors in our book. Also, to build the understanding and awareness of the REIT product, we've undertaken multiple educational initiatives for retail investors across India and we are happy to see increasing recognition of the long-term potential of the product. Finally, I'm pleased to announce the elevation of Abhishek Agrawal as the CFO of Embassy REIT. Abhishek was designated as the Interim CFO of REIT in May 2022 and is known to all of you. I wish him great success in his elevated role. And with that, over to Abhishek for our financial update.

Thank you, Aravind, and good evening, everyone. Let me take you through the financial update for the quarter. Revenue from operations grew by 10% year-on-year to INR 914 crores. This was mainly driven by new lease-up at attractive re-leasing spreads, contracted rent escalations and a ramp-up in our hotel business. This was partially offset by the impact of exits in our office portfolio. Net operating income grew by 9% year-on-year to INR 738 crores, in line with the increase in our revenue from operations. Our office NOI margins stood at 85%, demonstrating our scale and efficiency. Net distributable cash flows grew by 1% year-on-year to INR 510 crores. The year-on-year increase in our NOI contributed positively to our distributions, which was primarily offset by an increase in interest costs as well as other working capital changes. Further, we have declared Q1 distribution of INR 510 crores or INR 5.38 per unit, making this our 17th quarter of 100% distribution payout. Moving to our balance sheet update. Our balance sheet remains best-in-class with a 7.3% in-place debt cost and dual AAA Stable credit ratings. We remain focused on active capital management and interest cost optimizations. In the last 2 months, we have successfully raised 2 NCDs, totaling INR 2,075 crores at an average rate of 7.8% to refinance bank loans, which were due for repricing. In this refinancing, we achieved a 120 basis points spread over G-Sec, our lowest ever. We also secured 146 basis points pro forma savings as compared to the expected rate on repricing of these loans. Of our debt book totaling INR 15,350 crores, INR 4,100 crores of NCDs are due for refinancing in the latter half of this financial year. Considering the continued pause in interest rate hikes by RBI as well as the rate achieved on our recent debt raise, we are confident of refinancing this at industry-leading rates. We will also look to raise debt across different tenures to continue staggering our debt maturities. Lastly, I will update on the outlook for the remainder of FY '24. Given that more clarity has emerged on our leasing pipeline as well as on the trajectory of market interest rate, we are providing guidance for the full-year FY '24. We expect our NOI to be in the range of INR 2,924 crores to INR 3,136 crores, and our distributions to be in the range of INR 20.5 to INR 22 per unit. Our outlook is based on the following key assumptions for the full year. Considering the market outlook and our pipeline, we have assumed a total lease-up of 6 million square feet. This comprises of 4 million square feet of new leases, including new building deliveries planned in FY '24, 0.7 million square feet of renewals and 1.3 million square feet of pre-commitments. With this, we expect our same-store occupancy to end up marginally higher year-on-year. We expect to achieve contracted rent escalations of 14% on 6.7 million square feet leases during the year. We expect continued improvement in our hotel business, both in terms of occupancy and ADR and have factored in a 60% year-on-year increase in our hotel EBITDA. Finally, we have assumed our overall interest cost for the year to increase by 15% to 18% year-on-year. 2/3 of this increase is expected to be due to overall increase in rate and the remaining 1/3 due to the additional interest costs related to our new deliveries. Also, while we do not want to give any specifics beyond FY '24, we believe that this year will likely represent the bottom of what has been an eventful first 5-year cycle for Embassy REIT. The key drivers for this will be; first, we expect leasing demand to pick up given how optimally positioned India is, both from talent availability and cost arbitrage purposes. Traditionally, the new supplies that we are developing in Bangalore will provide further impetus to our leasing, particularly from GCC. Lastly, we also expect the rate cycle to moderate and have a positive impact on our cost of funding. All of these factors should contribute to the start of a period of secular growth for Embassy REIT. With this, let's now move to question-and-answer period.

[Operator Instructions] The first question is from the line of Kunal Tayal from Bank of America.

Great. I have 2, 3 questions, if I could ask them in one go. The first one was around the swell your pipeline. I'm assuming that a lot of this comes from GCC, given the comments you just had. So bundling it, even for the pipeline, the observation is similar that bulk of it is coming from existing companies that already have GCC operations and they are planning to expand. Or do you think this is coming from new companies wanting to set up shop in India? That's the first question. My second one was, any additional color on whether IT services contribution is bottoming out for the business? I think last quarter you mentioned that it down to about 15% of the portfolio? And then the last one is on the delta between NOI growth and distribution. So, I do get it that interest expense is one component of it, but there ought to be some other factors as well. Wondering if it is working capital and what exactly is contributing to this increase in working capital versus earlier.

Thank you, Kunal. So let me take the first one, then hand it over to Abhishek in relation to the NOI to NDCF walk. So, firstly, in relation to pipeline, I would say it's a combination of couple of things. One, as we've mentioned, the pipeline is significantly coming from GCCs. And I would say it's a combination of existing GCCs who are looking to expand. Some of them expanding quite significantly and some of them marginal, as well as a few new guys who've entered into India. So, it's a combination of both, which is there in the 2 million square feet of pipeline. Secondly, in relation to IT services, the numbers, first of all, is largely similar. 15% is now down to 14%, because we did have one big exit. But I think in terms of overall, the way we are seeing going forward, probably it might be a good statement to make, probably that it's bottoming out for the simple reason that while overall business is down, if you look at it from a real estate point of view, the message which is coming from almost all leaders is very clear that they want people back in office. That's number one. Number 2, we were picking up data point from a recent research report, which said that the last 3 years hiring, only 27% of that has got converted to lease space, which basically means as people come back, they will definitely need more space. But having said that, probably the expansion of space might take a little bit more time for the business to stabilize. But in terms of downside, it might be a good statement to make that it is bottoming out. So these are the 2 quick responses to the first 2 questions. With that, why don't I hand it over to Abhishek for the third one.

Yes. So, Kunal, you rightly picked up that the delta -- actually, there are 2 major components. One is the interest as we said. The second one is the non-cash NOI. Why this will come is because the 6 million square foot leases that we will do, on that there will be a gap between the LCDs and the RCDs because of which there will be non-cash revenue which will come during the current year. And there will be slight portion of this working capital, which is normal in the business who have standing gap in collection and [Technical Difficulty].

The next question is from the line of Puneet from HSBC.

Yes. My first question is just on your [ NTU ]. It seems IBM -- the share of space from IBM has gone up again. Can you talk a bit more about what kind of space are they taking [Technical Difficulty] cost conscious customers earlier?

I think, Puneet, in terms of new take ups, let's say, in the quarter, there are none. The percentage change will just be a change in composition of the other tenants.

Yes. Okay. Because their own share has gone up from 6.5 to 6.7. That's the reason.

Yes. So it's because of change in composition of the top tenants. But just from a little bit of way ahead, if I can give some perspective, I think from a return to office point of view, based on discussions, they have been pretty clear while they had encouraged complete work from home, they have changed it. There is significant return back-to-office. So overall, from a business, while we are seeing some offshoots, I would say it's still early.

Okay. Second on your leasing. While Manyata seems to be improving a bit, there hasn't been any material improvement in leasing for Quadron, which I thought is non-SEZ and should lease out well. And similarly, if you can comment a bit more on what's happening on Galaxy and Oxygen as well?

Sure. In terms of Quadron, it's a SEZ space, Puneet.

So my bad then.

That's one factual change. And just from a legal point of view, considering all the infrastructure which is happening in and around that space, largely the metro, there is a bit of situation in terms of traffic, et cetera. So from a medium to long-term perspective, we are pretty confident of that park. We've already done the necessary upgrades. So that's on Quadron. In terms of Galaxy, we did have one large IT services tenant exiting this quarter. That's the reason why you see occupancy dipping. But this is a non-SEZ space and there is good amount of traction on this asset and a large part of the pipeline, which is there is also coming from this asset. So, we're pretty confident of leasing up this space.

In Oxygen?

In Galaxy.

The Oxygen?

It's a SEZ space. So, Oxygen, I would say, from an overall demand perspective is still sluggish. This, I would say, is an asset which we categorize similar to Quadron, where we'll have to wait for some overall infrastructure upgrades to be done, including the new airport. But just to give you a different perspective, if I were to take both Pune and Noida assets together and take the vacant space of these 2 assets, put together they are only 5% of the overall value. But yes, just to sum it up, these 2 assets will take some time for the lease-up to improve.

Understood. That's helpful. My last one is on the refurbishment costs. So, there seems to be a lot of refurbishments that you're doing. How would those refurbishment costs be treated from distribution perspective and also from P&L perspective?

Yes. So the refurbishments are largely funded by debt, which has typically been our strategy around all CapEx. And these refurbishments, at least in the case of Manyata, which we've done have provided us significant returns because you would have seen that both B and K Block, we have been able to get re-leasing spreads in excess of 200%.

Right. And what kind of refurbishment expense should one run with for next few quarters?

So the way to look at it is, based on historical evidence, these refurbishments can range from INR 1,000 to INR 1,500 depending on the age of the asset and what are the upgrades which are required. So one, other than the 2 which we have already disclosed, I did mention in my remarks that we have another building. So, we do have another IT services tenant, which is expected to vacate later in the year, which is part of our expiries. So that's one full block in Manyata and we would be taking up refurbishing that building similar to D and K. And we expect similar results in terms of the re-leasing spreads on that building.

The next question is from the line of Murtuza Arsiwalla from Kotak Investments.

Yes. Couple of questions. One is, typically, how much time is it taking for you to de-notify? You've had some sort of bidding wise de-notification. So how much time is the entire process taking? That's question number one. Question number 2 is on the hotels business. Generally, when we look at other hotel companies out there, they are showing pretty robust numbers in terms of occupancy. You room rates obviously have increased, but anything that's holding back on the occupancy? And the third is a more generic one. All the common area maintenance, the facilities management business, particularly what's the kind of margins that you're making?

Got it. Thank you, Murtuza. Time for de-notification, I think we've discussed this in the past. But let me take Bangalore as the right example, because this is where we will be undertaking more de-notifications in the time to come. What our experience in the recent building of D3, while it's, let's say, 2 weeks away, it's taken us about 5 months to de-notify that space end to end. There are a few, little bit of learnings which we have taken from this de-notification which should compress this time a bit. So overall, I would say, 4 months to 5 months is what we need to de-notify buildings in Bangalore. Pune, the Hudson & Ganges, which we did de-notify took much more time because the process was more difficult. If you were to replicate that in Pune, probably we could again learn from that experience and reduce the 12 months to -- it will be difficult for me to give an exact timeframe, but definitely we can look at some reduction even in Pune. Noida is one area, as we've mentioned, it's taken us a lot of time on the overall construction as well. We have gone a little slow considering the demand. So, we will undertake that de-notification as and when the building is coming up more close to completion. So, that's on the de-notifications. In terms of hotel, honestly, Murtuza, the 2 Hiltons, which is Embassy Golflinks and Manyata are doing phenomenally well. Golflinks is upwards of 60%, which is in, I would say, in similar range as compared to peer hotels, but the ADRs are much higher. Similarly, Embassy Manyata, it's much [Technical Difficulty] right, our most recent months [Technical Difficulty] as well. So, that also [Technical Difficulty] perspective, the occupancy is still not significantly up because of the IT services and SEZ. So, we believe that this will pick up significantly in the next few months. The only hotel which kind of brings the average down for us is 4 Seasons. That is one focus area for us as we look into the year ahead. We are working closely with our operator, which is 4 Seasons to look at more initiatives in relation to marketing as well as profiteer, but this is a space to watch out for -- specifically for us as management. Lastly, on CAM, Abhishek, do you want to take it?

What actually happened is we have 20% mark up to all the cost that we have spend on our campus. Does it answer your question?

Murtuza, are you there? Okay. Operator, I think we can move ahead.

Mr. Murtuza, you may please go ahead, sir, if you can hear us?

I can hear you, guys.

Okay. Sorry, we lost you. I didn't know whether you got answers.

No, I got my responses. I was just saying thank you. But I don't know why it wasn't audible.

Next question is from the line of Vishal Parekh from Kotak Investments.

Yes. So, on the refurbishment cost, I had one query. So the new block which you have put for refurbishment, approximately, I think INR 1,250 per square feet seems to be the cost which you have indicated in the CapEx schedule. So does that include de-notification cost as well? Because I think that particular building is SEZ and occupied by one client, which is expected to vacate.

No, Vishal. It doesn't include the de-notification cost because that's the number which could vary depending on how the assessment goes with the local state authorities. So, we have not factored that cost.

Understood. And on the statement of maintaining a similar occupancy going ahead, considering that, that particular tenant is moving out and you will have to de-notify that particular tower, would you still be able to maintain similar occupancy versus the pipeline which you have in Manyata?

So the way to look at it, Vishal, is this tenant is expected to exit in the next quarter. Of course, there would be some time gap by the time we fill up this space. So on a quarterly basis, you could see this number going down. But when we end the year, we are pretty confident that on an overall portfolio as well as Manyata, we will be marginally higher including same-store. We should be marginally higher than what we are as of June.

The next question is from the line of Pritesh Sheth from Motilal Oswal.

Yes. Sorry. Just one question to clarify. So out of the 1.3 million square feet that is expected to expire in Embassy Manyata this year, 0.8 million square feet is the refurbishment tower, is that correct? Any sort of negotiations that are happening for the rest of the 0.5 million square feet, if you can highlight that?

I think in terms of 0.8 million square feet, you're absolutely right. That's part of the 1.3 million square feet. The balance, without getting into specifics of Manyata specifically, I think we have indicated the overall renewal number for the full year. Of the balance expiries, we expect 0.5 million square feet to be renewed off the balance and logically, the balance should be more slightly exits.

Sure. And just in terms of refurbishment, I think you answered in a way in the previous question how much time it takes for you to refurbish the tower and then re-lease it based on your experience in D3?

So the D3 and K have taken similar time of around 9 months. If you look at it, K Block is 70% leased by the time the building was refurbished. D3 is around 40% plus re-leased with both these assets having significant pipeline, So, you could say another 3 months to 4 months or 6 months max for it to be back to fully leased.

Sure. And with this floor-by-floor de-notification, I mean, given where your portfolio stands, especially Embassy Manyata where you are looking to de-notify whole tower, will this floor-by-floor denotification help you in your other assets? I'm not sure if there is any scope for doing that in other assets. So if you can help, I guess.

There definitely is scope for doing floor-by-floor in other assets and Manyata. So, we will still be having vacancy across our parks, which is not necessarily full buildings and not necessarily we will be able to relocate some of the tenants to make it fully vacant. So 100%, the floor-by-floor de-notification is going to benefit us significantly across all our parks.

Sure. And if you just help me with your current SEZ vacant space. I'm not sure if I've missed that if you've mentioned earlier.

Yes. The current SEZ vacancy is around 14% for the entire portfolio.

The next question is from the line of Pradyumna Choudhary from JM Financial.

So the exits during the quarter at 0.7 million square feet seems to be quite high compared to the renewables of 0.2 million square feet. So what would explain this? Like, any -- you spoke about IT being weak during the quarter. But generally, why the renewables have been quite low? And are we seeing enough demand from other segments to make up for these exits because the occupancy seems to have slightly fallen in the quarter?

Sure. Of the 0.7 million square feet exits, we had a large occupier in excess of 0.5 million square feet, which exited in our Galaxy park in Noida for various reasons. As I mentioned, this is an asset which is in Sector 62 of Noida, where we are seeing significant amount of demand for this. So, we're pretty confident of leasing up this space. If you look at the balance expiry for the year, I did cover one large potential exit, which is coming up in Manyata. Again, a similar story, IT services. So, overall, this is the reason, Pradyumna, for the exists what you are seeing. But at the same time, if you see the new lease-up which is happening as well as the new lease-up which is projected and what you're seeing in the overall market, it's a significant shift what you're seeing from IT services to GCCs, right? From our portfolio point of view, 55% plus now is within GCC. The first quarter lease-up, 70% plus is GCCs and that's evident in all the research reports you're seeing in terms of how it is not just back-office work, which is coming to India but its value-added work. And as per the recent NASSCOM Report, GCCs are now becoming the transformation hubs for their home centers, whichever country they are in. So overall, it's a shift in the occupier base for the entire industry. Bangalore, of course, is benefiting the most from the GCC. 34% of the overall head count of GCC is located in Bangalore. 50% of the new GCCs set up last year were in Bangalore. So when you take all of this together, the shift is working out very well for us because, again, these guys are not very cost conscious. They don't mind paying the best rent for the best assets, which we own.

I understood. And so what would explain the fall in occupancy considering the demand still is quite strong for the grade A offices? So why has there been a fall in occupancy? And are we seeing any kinds of -- any kind of slowdown from any other segment apart from IT?

Yes. Pradyumna, what you'll continue to see for later part of this year is there will always be a gap, right, from our occupier leaving to a new tenant coming. So, that will always be there. Number one. Number 2 is, as we did mention in terms of GCC what's happening is, there is -- still last quarter, you would have seen that the general average lease-up would have been in the range of 50,000 to 100,000, but you have seen 2 large deals, which has happened this year. Having said that, any large deal, even from a GCC point of view, it does take a little bit more time for the sign-off to come from global offices, including their global CEOs, CFOs, whoever might have to approve. So the decision taking might end up being a bit slower than what we want, causing this temporary gap in our occupancy.

Understood. And any other segments, which are witnessing some sort of a slowdown apart from IT? Not necessarily, Pradyumna. Nothing to highlight.

The next question is from the line of Kunal Lakhan from CLSA.