Embassy Office Parks REIT (EMBASSY) Earnings Call Transcript

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

Thank you. Welcome to the Q2 FY 2024 earnings call for Embassy REIT. Embassy REIT released its financial results for the quarter and half year ended September 30, 2023, a short while back. As is our standard practice, we have placed the financial statements, earnings presentation discussing our performance and the 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 provide on this call are management estimates based on certain assumptions and have not been subjected to an audit review or examination procedures. You're 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. Over to you, Aravind.

Thank you, Sakshi. Good evening, and thank you all for joining us today to discuss our Q2 results. To start with the key highlights for the quarter, we achieved our highest ever quarterly leasing of 2 million square feet, delivered a new office tower of 1 million square feet in Bangalore and announced distributions of INR 5.53 per unit. Although our portfolio occupancy saw a temporary dip due to an anticipated large IT services exit, we have a strong pipeline to backfill the space. We remain on track with our FY '24 financial guidance and taking into account a large early renewal of space at our Embassy GolfLinks park, we are raising our leasing guidance from 6 million square feet to 6.5 million square feet for the full year. To start on the macro front, global companies continue to flock to India on the back of our skilled Indian talent available at scale. In the first half of calendar year '23, 41 new global captive centers were set up in India, including 18 new entrants. Considering this buoyancy in demand for premium Indian office spaces, independent property consultants have raised their current year forecast for India office absorption. We're also seeing an increase in the active request for proposals in the market which have gone up from 8 million square feet as of July 23 to 20 million square feet today. Notably, around 60% of these open space requirements are for Bangalore, our core market. Additionally, the return to office continues to pick up pace in India with multiple large employers mandating employees to work out of offices. With this backdrop, let me now update you on our Q2 leasing performance. We leased a record 2 million square feet across 25 deals and expanded our occupier base to 240. This included 1.2 million square feet of new leases and 0.7 million square feet of renewals at 56% rent reversions. The renewals included a 0.6 million square feet of lease expiry due in FY '25 for which renewal terms were agreed with IBM over a year in advance. Further, for our existing tenant, ANZ, exercised a hard option for an additional 133,000 square feet in the underdevelopment M3 Block B in Bangalore. And with this, the building is now fully preleased. Continuing the trend from the last quarters, the leasing demand was primarily driven by global captives, contributing to over 70% of our leasing. In terms of sector, technology, BFSI and health care firms led the demand. Interestingly, 7 deals over 100,000 square feet, including 1 deal over 500,000 square feet were signed by us this quarter. This clearly indicates that global corporates are getting increasingly confident on the business and headcount growth in India, and hence, accelerating their medium-term real estate planning. We noted leasing traction across our assets and signed deals for 9-odd of our properties. With this, 50% of our properties are now back to 90-percent plus occupancy level, and our Embassy 247 park in Mumbai is 100% occupied. In terms of markets, Bangalore and Mumbai led the demand and contributed over 90% of the total leasing this quarter. These 2 cities, which represent our largest market and over 85% of our portfolio value are near or above 90% occupancy levels now. Overall, our office portfolio is at 83% occupancy by area and 86% by value. On a same-store basis, the occupancy stood at 87%, which excludes the recently delivered M3 Block A, Hudson and Ganges Block in Pune and the recently vacated F2 building in Embassy Manyata, which is currently under refurbishment. In terms of exits, I want to highlight that of the total 2.3 million square feet that exists in the last 6 months, we have already backfilled 1 million square feet of space at market rents. The balance, 1.3 million square feet, was primarily exited by 2 large Indian IT services players at our Embassy Manyata and Galaxy business parks. We have a strong pipeline for both these spaces and are confident of backfilling at least 50% of the space by the end of the financial year and realizing over 50% mark-to-market on the same. Of the 6.2 million square feet current vacancy, around 60% is concentrated in Pune and Noida, both of which are significantly lower rental market for us. The vacancies in these 2 cities will take some time to fill, but it is important to highlight that even post-full stabilization, it will translate to only approximately 5% of our current NOI. So the halfway mark for this year, we've already leased 3.1 million square feet and have a record leasing pipeline of 2.5 million square feet, which includes 1.3 million square feet against existing space and 1.2 million square feet of precommitments in our development portfolio. Considering the 0.6 million square feet of early renewals signed this quarter, we are raising our FY '24 leasing guidance from 6 million square feet to 6.5 million square feet. This comprises 4 million square feet of new leasing, including the new building deliveries planned this year, 1.3 million square feet of precommitments and the revised 1.2 million square feet of renewals. Overall, we expect that by the end of the financial year, our full portfolio occupancy will end at around 85%. This will include the impact of 2.1 million square feet of buildings being delivered this year, including the 0.7 million square feet tower in Noida, where the leasing demand is muted. On a same-store basis, we expect occupancy to end at around 88% levels by March '24. On the SEZ front, we have successfully de-notified the 0.4 million square feet D3 building in Embassy Manyata. We've also applied for de-notification from the recently vacated 0.8 million square feet F2 building in the same park, which is also under refurbishment. We already have a healthy non-SEZ leading pipeline for this block. For a partially vacant SEZ building with around 3.5 million square feet of vacancy, we understand that a likely amendment to the SEZ Act is in advanced discussions at the relevant ministry level, and we continue to be hopeful for a quick resolution on this matter. Moving to our development portfolio. During the quarter, we received occupancy certificate for the 1 million square feet M3 Block A in Embassy Manyata. In the coming months, we expect to deliver another 1.1 million square feet across 2 blocks in Embassy Business Hub and Embassy Oxygen at Bangalore and Noida, respectively. Our current development pipeline now totals 7.1 million square feet. Of this, around 90% is in Bangalore, the city, which continues to lead India's office absorption on the back of sustained interest from global capitals. Notably, around 25% of our Bangalore development pipeline is already pre-leased, and there is a 1.2 million square feet advanced pipeline for the remainder. Lastly, on our hotels. Our Q2 hotel occupancy stood at 52% and ADRs at over INR 10,000 per room night, resulting in a quarterly EBITDA of INR 37 crores. Overall, our hotels delivered a 24% year-over-year ADR growth stronger than the market. Particularly, the 3 Hilton hotels continued to grow strongly and deliver NOI margins close to 50%. Finally, we are delighted to launch the Indian REITs Association last month as a founding member. The association has already started work on key agenda items, such as educating investors, improving liquidity and collaborating with regulators on enhancing the REIT governance and investor protection norms. We are confident that together with IRA, we will continue to build understanding and awareness of the REIT product in India and further expand our unitholder register, which has already touched 89,000 this month. Let me now hand over to Abhishek for our financial update.

Thank you, Aravind, and good evening, everyone. Let me take you through the financial updates for the quarter. Revenue from operations grew by 4% year-on-year to INR 889 crores. This was mainly driven by our new lease-up at high re-leasing spreads, contracted rent escalations and a ramp-up in our hotel business, which was partially offset by the impact of exits in our office portfolio. Net operating income grew by 2% year-on-year to INR 719 crores, in line with the increase in our revenue. Net distributable cash flows grew by 1% year-on-year to INR 524 crores. The year-on-year increase in our NOI contributed positively to our distributions, which was primarily offset by an increase in the interest costs. Further, we have declared Q2 distribution of INR 524 crores or INR 5.53 per unit making this our 18th quarter of 100% distribution payout. Moving to updates on our balance sheet. During Q2, we successfully raised nonconvertible debentures and bank loans totaling INR 1,500 crores at an average rate of 8.1% to refinance our maturing debt. For the new NCD raised, we achieved a competitive 121 basis point spread over G-Sec and secured first time participation from pension funds, further diversifying our debt investor base. We had INR 2,600 crores of upcoming debt maturity in Q4 of this financial year. We already have significant interest from multiple banks to refinance the entire upcoming maturity. We will also evaluate the debt capital market at the appropriate time during the next few months. Considering our diverse debt capital market pool and credit lines available from banks and NBFCs, we are confident of refinancing this debt at industry-leading rates. From next year onwards, our bond maturities are much more evenly spread out. Overall, our balance sheet remains strong with dual AAA/Stable credit ratings and increased average debt cost of 7.4%, one of the lowest in the industry. Next, on our independent valuation. As of September '23, our gross asset value increased by 2% year-on-year to INR 52,651 crores and our net asset value by 1% to INR 398.86 per unit. This change was mainly driven by an increase in our hotel ADR, partially offset by a change in the leasing assumptions for our Pune and Noida assets. Lastly, an update on our FY '24 guidance. Based on our YTD performance, I am pleased to reconfirm the financial guidance provided last quarter. We continue to 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. This guidance is based on certain key assumptions, which includes a revised 6.5 million square feet total lease up, around 88% same-store occupancy by the year-end, a 60% year-on-year increase in the hotel EBITDA and a 15% to 18% year-on-year increase in the total interest expense for the year. Looking beyond FY '24, I would like to reiterate the key growth levers of our business. First, we expect our occupancy to stabilize at pre-COVID levels of mid-90s in the next few years. Second, we will continue to lock in the contracted rent escalations of around 15% every 3 years. Next, we expect to realize the current MTM potential of 12% over our remaining WALE of 6.9 years. We have consistently achieved these spreads in the past, around 20% on 2 million square feet area renewed or re-leased per year on an average since our listing. On the back of our portfolios premium positioning, our transacted rents have been typically higher than the market rents. Additionally, the 7.1 million square foot of new supply that we are developing primarily in Bangalore offers over 20% NOI yield. Compared to the current marginal borrowing costs ranging from 8% to 8.5%, this organic growth is expected to be highly accretive. Lastly, once the financing markets are conducive, any inorganic growth through accretive acquisitions will provide a further impetus to our distributions. These embedded growth levers sets us well to deliver consistent DPU growth to our unitholders from the next year onwards. With this, let's move to Q&A, please.

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

Good quarter on leasing. My first question is on the expiries. It seemed to have gone up for FY '24. I'm adjusting for the earlier renewal, which has happened. So I'm just curious as to which segment is this uptake in expiries coming from? And is it typical that if the demand or the leasing environment is improving that expiries should also be going up? That's my first question.

Sure. Kunal, you want to finish off your questions?

Yes. My other question is around the MTM potential, which you noted, has come down to 12% over the period of last few quarters. The question here is, is that because you've been very successful at renewing at market or market plus kind of rate? Is that the driver? Or is it also because of the fact that the market rate itself may no longer be going up at the pace that they were doing earlier?

Sure. Kunal, thanks for your questions. Just starting off with the expiries for FY '24. Largely, the increases are coming from IT service players, IT/ITES service players. The exits predominantly are from that sector. A combination of continued work from home as well as the profit pressure, which you are seeing in that segment. So that's the key reason for the increase in exits. From a leasing market perspective, Kunal, I think it's -- as we've said in our results as well as what I spoke a little earlier, overall, very positive, especially for the 2 key markets for us, Bangalore and Mumbai. Occupancy also has gone up, and then if you'll adjust it for the Cognizant space that's vacated in our Manyata Park in Q2, our occupancy has -- Bangalore as a whole is also about 90%. Mumbai is at 96%. Recall, 2 million square feet leased at quarter, 2.5 million square feet of pipeline as we speak. Overall, RFP is also in the market much higher. So leading market is much better. I think it's a transitory period for us where the occupancy is low, but we will see that going up, as we mentioned, even in our year-end guidance. So that's my view on the leasing market. And the last question, I think you kind of answered it yourself. It's largely because of both the reasons. One, our ability to do renewals, re-leasing at or above market rates, number one. Number two, other than probably Bangalore and now a little bit in Mumbai, the market rents have not necessarily gone up to the same extent the way it used to go pre-COVID. So a combination of both factors, you see the current MTM spread available at a much lower number than what it was before.

Understood. And just one quick follow-up. The pipeline value of 2.5 million, again, is quite strong. Would you still characterize it as mainly coming from GCCs? Or is the strength in that sense, spreading to other segments as well?

Honest answer is largely GCCs. And it's -- just to give a little bit more flavor, it's a combination of large RFPs, which has -- we've not seen in the past. Number two, it's also regular lease-ups for existing spaces. But I think one important number to highlight over here is almost 50% of those RFPs are new channels for us looking at growth, and additional 40% of these RFPs are existing tenants who are looking for more space. So when you look at it together, a large part of it is growth. So that's, I think, overall very positive.

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

Just wanted to check, while the leasing activity has been good, obviously, the exits have been bothersome. Even this quarter, you've had this [ 1.6 ], some of it was anticipated. Some may have come in as a surprise. Any sort of -- any trend that you can pick up in terms of the exit? Is it a particular client segment? Is it -- in terms of size, whether they're big tenants, small tenants? Or any visibility going forward from here, whether we're seeing the same end of these exits? Because we are able to lease up pretty well, but with the exits, you're not able to sort of capitalize on the end of new leasing that we are doing. So any color that you can give on how should we think of the exits from here on? Is there no predictability? Anything that you can give on these exits?

Sure, Murtuza. I think exits are bothersome to us also, even though we've been able to re-lease much faster. But having said that, I think a clear trend is what I mentioned, majority. A substantial majority of our exits are coming from the ITES sector. A combination of both reasons, profits or overall margins being down. Their business model more amenable to work from home. That's, I would say one sector which just stands out, which has added to the exits. So 2 things I would like to add on over here. Number one, IT/ITES services in our portfolio is now at 12%. This number was 25% at the time of IPO. So there's already a substantial reduction in this portfolio size. So that's probably one indicator for you as to what's the further downside in this market. It's not much. Second, overall when you look at it from an FY '25 point of view, I'll not want to go beyond '25, there's about 1.1 million square feet of expiries. While I wouldn't want to specifically give a guidance, but I would say, as we speak now, the trends are more positive.

Sure. And even in the '24 for the second half, you've got another 1 million square feet. Are you expecting to renew them? Would you be more confidently be able to renew them?

I think it's going to be a combination of both, Murtuza. I would say it will be a combination of exits and renewals, almost equal.

Yes. Because your full year guidance for renewals is about 1.2 million, you've been able to do about 0.9 million so far. Fair enough.

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

And sorry to dwell on the same point. If I see Slide 16, it talks about 4.2 million square feet of expiries. I think the same number was 2.8 million just a quarter back. What really added to substantially? Or am I not reading it correct?

Yes. So one is this big early renewal, Puneet, which is 0.6 million square feet of IBM at Embassy GolfLinks, that's reason number 1, which is a positive. Second is almost 800,000 to 900,000 of additional expiries, which have come in. And that, for the sake of repeating the answer, it's largely coming from the same IT/ITES sector.

And what kind of discussions drive these early renewals?

Early renewal?

Yes.

I think one of the key things is, considering this specific example, it's a large space. From their point of view, also, they need to be sure of where they will be, let's say, 12, 15 months down the line. So it makes sense for them also to secure themselves whether they want to continue in the same space or if they want to explore a new space. They might actually need more time, right, to move to a new space, set up new offers with fresh putout. So it's largely driven from the occupiers themselves because of the quantum of space, which they already hold.

And in your data book there is also a 0.9 million square feet of leasing, which happened in Manyata. I presume part of it would be the M3 block, which is re-leased. Can you give some color on what is the average rental there if we look at it right now?

Yes. Average rentals, I would say, ranges between [ INR 96, INR 97 ] to a little above [ INR 100 ] depending on age of the buildings as well.

Understood. And then also if you can give some color on what's the status of the M3 Block? How much is it leased totally? And how much more needs to go? And what does it finally cost, the REIT?

Sorry, can you repeat the last question again, Puneet? I didn't hear you.

And how much did it cost now entirely to build M3, cost to company? Yes.

Well, it's around 45% leased. On the cost, I'll just hand it over to Abhishek.

So Puneet, the total cost to company was INR 1,050 crores including the amount that we paid earlier and additional true-up consideration based on the agreement that we had.

Okay. And 45% leased and presumably sale value at INR 96 to INR 100.

Yes, the new blocks, I would say we've been able to exceed above INR 100, Puneet.

Okay. Okay. That's very good, sir. And lastly, if I can add one more. There is a positive working capital adjustment this quarter. How long can we see these kinds of adjustments? And what is driving this?

Puneet, again, I would say that looking at -- we don't look at working capital adjustment quarter-on-quarter. What we look at is for the year, because quarter-on-quarter comes out of other regular matters also. Like, for example, when you see current quarter versus previous quarter, the current quarter working capital is coming out of the fact that during Q1, we had paid corporate tax for half year. The impact of that is somewhere around INR 55 crores. So Out of the INR 62 crores, main INR 55 crores is coming out of this.

Okay. So that was not there at the time that -- but why shouldn't it capture in working capital? Should it not be somewhere else in the P&L?

So Puneet, what happens is if we pay this working cap of this property tax in advance, so it goes and sits in my advance payment. And during the next quarter, when I do a working capital movement of all the payables, receivables and advances, so it's just there, because it gets reduced there. So if you look at just from a cash perspective, last quarter, INR 56 crores cash out versus this quarter's INR 0 cash out.

Understood, understood. Got it. That's very helpful. And lastly, if you can comment on the distribution from the Embassy GolfLinks? That has also gone down a bit.

Yes. So Puneet, what happens is for Embassy GolfLinks, the distribution that they give to us is based -- purely based on the cash flow that they have. Last quarter, the distribution that we got into to all 3 components taken together was INR 80 crores compared to INR 68 crores, which we received this quarter. Also, what they do is some of this cash that they generate, they use it for refurbishments and other projects also and not necessarily funded through debt. So that's the reason, it is reduced a bit during this quarter.

If I could just add on to that, Puneet, I think from a GolfLinks point of view, both we and the joint venture partner look at the cash flows on a quarterly basis, look at what's required from a next quarter point of view. And there could be some movements on a quarter-on-quarter basis. It did not necessarily move [ linearly ].

Okay. So how can we think about the way -- I mean should we expect it to go up?

I believe you're breaking up. Sorry.

Sorry. I'm sorry. How should one think about this number from the next quarter or second half perspective? Should it go down? Or should it come back up to the previous levels?

So Puneet, what happens is that out of the 3 components, one is interest, which is based on the coupon rate. The other 2 components is based on the availability of cash. I would say that the way to look at it is, you can say whatever we received during the first quarter and second quarter -- whatever we received during the half year, you can say double of that we would receive in the full year. It's per quarter on an average run rate basis.