Embassy REIT: The First Listed REIT of India

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This article has been written by Khubaib Abdullah for FinMedium Research Desk.

Good buildings come from good people, and all problems are solved by good design.

Stephen Gardiner

While this English politician would not have had the slightest clue, but what is captured in these words is the very essence of a successful REIT: good buildings and good management. Can Embassy Office Parks REIT continue to be the first choice of investors, read on to find out!

Introduction to REITs

A real estate investment trust (REIT, pronounced “reet”) is an entity that receives revenue through owning or financing an income-producing property.

Similar to other industries, REITs can be private organizations or they can be publicly traded on a stock exchange. To qualify as a REIT, a company must meet many specific criteria.

The most widely known provision is that a REIT must pay shareholders a dividend equal to at least 90 percent of its otherwise taxable income.

There are several types and categories in which REITs can be classified, based on their kind of activity, and the kind of properties they specialise in.

Embassy REITs is an equity-based REIT focussing mostly on office and luxury hotels assets focussing on tier 1 cities pan India. There are 3 major routes that REITs take to expand their business viz Development, Acquisitions and Financing.

Embassy REIT focuses on acquiring the land and then developing the property on it.

There are a few factors that make the REITs different from the other companies and thus offer unseen before opportunities:

  1. First and foremost, they remove the biggest pain real estate brings with itself: buying and selling. Real estate properties are notoriously hard to buy or sell, taking months, even years. On the contrary shares of the REIT can be sold and bought on an exchange in an instant, let alone the hassle of owning and managing the property yourself.
  2. The second major benefit is that REITs act as the junction of a lagging (real estate prices) and leading indicator (stock prices) of the economy.
  3. Because real estate has its own unique drivers and cycles that are separate from that of other equities and bonds, real estate investments promote portfolio diversification.
  4. REITs can hike up their rent demands to keep up with rising prices due to inflation (this is called mark to market) and thus they provide a strong hedge against inflation, albeit with a minor delay.
  5. REITs are compelled to pay out at least 90 per cent of their otherwise taxable income, and many payout 100 per cent or more. REITs pay their dividends in cash and, therefore, operate with limited retained earnings. As a result, they generally issue new public equity every other year in order to finance growth, thus being exposed to another level of scrutiny from the Banks helping them issue their stock. This ensures greater transparency. It is very important that the management is answerable and shareholder-friendly if one is to make any significant gains on his investment and not blow it all.
  6. Most REITs pay their dividends with religious regularity and thus seem almost like a bond that generates interest payments, but whose price has an infinite potential to grow., essentially combining the best of stocks and bonds. ( A REIT may suspend dividends during times of severe economic distress )
  7. The dividends to the shareholders of the REIT are virtually guaranteed of their dividends even if the tenant goes bankrupt as the bankruptcy court places rent payment as an operating expense, making it senior to the debt payment, interest payment or dividends payment. Thus the REIT continues to benefit even as the tenant goes bankrupt.
  8. To qualify each year as a REIT, REITs must pay their common and preferred shareholders dividends that equal at least 90 percent of what would otherwise be taxable income. If a REIT pays out only 90 percent of its taxable income, it will owe corporate taxes on the 10 percent it retains. By distributing 100 percent of taxable income (including capital gains) and satisfying other REIT requirements, REITs can avoid paying corporate income taxes. The REIT shareholders then pay their appropriate taxes on the dividend income received. 
  9. This translates to extraordinary dividend yields offered by REITs and the constant pressure on the management to keep up with the dividends yields otherwise their stock price gets punished.
  10. REIT dividend consists of:
    1. Ordinary dividends (income tax rates apply)
    2. Capital gains (generally 15% at December 31, 2015), and
    3. Returns of capital (nontaxable)
  11. Thus a certain portion of the dividends announced may be capital gains (made from the sale of some asset) and is thus taxed even lower to the REIT shareholders.

For more information on the kind of REITs, leases, and analysis of REITs head on here.

Asset Portfolio of Embassy REIT

Asset base of Embassy REIT

Embassy REIT owns and manages three major kinds of properties:

  1. Office spaces and business parks.
  2. Luxury Hotels
  3. 100 MW of solar park that serves its needs in the most important location of theirs, Bangalore. This allows for some amount of backward integration benefits playing in.

Their mode of expansion is two-fold: development and acquisitions. Embassy REIT owns a large land pool and develops properties and buildings on it.

It is also involved in buying already made buildings for its expansion, the most recent being Embassy TechVillage in Bangalore.

Industry Growth and Opportunity for Embassy REIT

Industry Overview of Embassy REIT

With the ongoing COVID pandemic, the future of office spaces may seem a little bleak, the foundations of the Indian office spaces continue to be strong as:

  • India is a young country with a graduate population that represents a world-class workforce. Global corporations hire talent in India for these skill sets. Every aspect of the global technology landscape has a foothold in this country because of the ability of the Indian technology professional to deliver quality. As technology becomes more sophisticated, the demand for Indian talent by global corporates will only grow.
  • Second, Indian real estate offers significant cost arbitrage without compromising quality. Rents that multinationals pay in India are a fraction of the global rents they pay overseas, but the quality is completely matchable.
  • The only sector that benefited from the pandemic seems to be the technology sector. Looking at the customer base of Embassy REIT, they seem to be well suited to bent from this technology companies’ windfall. 42% of the gross revenues come from top 10 occupiers.
Customer Base of Embassy REIT

Embassy REIT seems to be well-positioned in terms of its own operations:

  • Diversified & high credit quality occupier base with 50% technology & 48% Fortune 500 companies.
  • Stable cash flows expected due to long-term lease structure and contracted rental increases, with only 6.6% of rents due for expiry in the remainder of FY2021. This implies not just chances of renewal, but also income via renewals.
  • Embassy REIT has a difficult to replicate portfolio with important pieces of real estate in key cities across India.
  • Another unique trend in the industry is de-densification which was started at the economic boom of the 1980s seems to be reversing as social distancing is now mandatory at the office spaces. With close to 6% of the portfolio eligible for renewals, Embassy REIT expects to increase their lease area, directly translating to higher rents.
  • There is an increase in the company’s focus on their employee well being, safety, health and wellness. With other office parks failing due to lower or no rents, Embassy REIT expects to witness a flight to quality and with several msf (million square foot) area under development, seems to be very well suited for such companies.
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Risks and Emerging Trends for Embassy REIT

The risks, as well as the emerging trends in the industry, are essentially the same and very obvious, the global pandemic COVID 19.

Due to the scare, if the pandemic takes its toll, a lot of the companies have opted to keep their employees out of focus and shift to work from home model.

This has especially been the case with technology companies such as Infosys has announced permanent work from home for 33% to 55% of its employees. TCS too has proclaimed that by 2025, only 25% of its workforce will need to come to its offices. 

Embassy REIT faces a bigger problem in this regard as it happens to have almost its whole client base of technology firms, which although Embassy REIT touts as its strength, may as well turn out to be a curse as more and more technology companies announce work from home measures.

While the occupancy levels continue to stay high 92% – 95%, there is no guarantee of what the future holds.

Another phenomenon that has taken shape is that of Co-Working Spaces.

A lot of startups and even large MNCs have caught on to the idea of these unique office spaces wherein instead of entire floors being leased out, mere desks are leased out for very flexible lease structures.

Unlike a traditional office set up, in a co-working space, you get to interact with people from similar and different businesses. It’s like an informal collaboration because you can exchange new ideas, perspectives and contacts.

Several smaller REITS and co-working spaces have copied the hospitality industry model and converted their co-working spaces on an ad-hoc basis like hotels, where one can book a room for two or three days. This implies a shift from a rental model to more hospitality setup.

Lastly, barring large MNC tenants, there is a shift from triple net leases (lease agreements where the tenant pays for the insurance, taxes and maintenance of the building, in want of the greater flexibility this offers) to full-service leases (where the landlord pays not just the mentioned costs, but also provides other services such as food courts) with lower CAM costs (Common Area Maintenance).

Embassy REIT Structure

Embassy REIT has a partial UPREIT structure. In a UPREIT structure the REIT does not own most of the properties itself, rather is in an operating partnership with some other company called the Operating Partnership (OP).

As we can see below in the chart, the UPREIT is the sole partner of the OP. The OP is responsible for managing the properties, collecting rents, operating them if need be and then passing on the profits in the form of dividends to the UPREIT (Embassy REIT in this case), which then passes on the dividends to unitholders like us.

The benefit of the OP is twofold, one, it allows to jump through legal hoops and second, it creates a new form of currency for the UPREIT which already is stripped of cash: the OP shares.

These OP shares can also be used to acquire properties without getting into risky financing. 

This REIT structure is a more modern approach that was the sole reason behind the REIT boom in the west.

Adoption of such a model by the Embassy REIT further strengthens its position as the largest REIT in Asia.

Furthermore, this brazen acceptance of the modern structure has led to Embassy REIT getting incorporated in global indices such as the S&P Global Property Index and S&P Global REIT Index.

Structure of Embassy REIT

Financial Performance of Embassy REIT

Key Factors driving financial performance:

Commercial Real Estate Market

The demand-supply of commercial real estate and the ability of the market to absorb more supply especially in Noida, Bengaluru, Mumbai and Pune, the key market for Embassy REIT.

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Industry sector of occupiers

Most of the portfolio consists of large technology companies which seem to have fared really well during the pandemic. About 78% of them are large MNCs, which rules out the case of bankruptcy en masse.

Occupancy rates

Prudent management is always able to manage its properties such that the occupancy levels remain high.

This translates to not just higher rents, but also significantly increases other income avenues such as CAM (Common Area Maintenance) fees. Embassy REIT has managed to keep its occupancy rate very high ranging from 87% – 95% overall. 

There is one property that deserves mentioning: Embassy One that has an occupancy of less than 5%.

This is not a disputed piece of real estate. Embassy REIT points the reason towards the new Four Seasons Hotel that is on the premises and was opened in February of this year, right before the pandemic hit.

Naturally, the hotel has been struggling since its inception.

Lease Expiries

Embassy REIT typically enters into long-term leases, which provides a steady source of rental income. REITs that have lengthy average lease terms tend to be very stable and not very volatile.

The tenure of leases for the office parks is typically 9-15 years (assuming successive renewals at our occupiers’ option), with a three to five-year initial commitment period, and contractual escalations of 10%-15% every three years.

For the city-centre office buildings, the lease tenure is typically five to nine years with a three to five-year initial commitment period and contractual escalations of 15% every three years.

Embassy REIT has also forayed into the riskier business of hotel management.

Hotels are much riskier as the lease is not consistent for each unit (key as it called), but can be hiked or downplayed as per the demand. The one hotel that Embassy REIT has actively ran into bad luck with the COVID pandemic.

There are two more hotels that are in the acquisition process.

Escalations

After each renewal, the tenant has to pay some predetermined improved rent that is higher than the previous term’s. This is called escalation and is put in place by the landlord so that the rent keeps up with the inflation. 

Embassy REIT leases typically have contractual escalations in the range of 10% to 15% every three to five years, which is around 3% every year, noticeably lower than the annual inflation rate.

Further, due to the tenure of existing leases and growth in the market rents of our Portfolio, the average in-place rents are significantly below current market rents. This points to a significant growth opportunity once the leases are renewed.

Development timeline and costs

As of March 31, 2020, Embassy REIT had 2.6 msf of Under Construction Area and 4.5 msf of Proposed Development Area. This shall prove to be useful as the flight to quality phenomenon kicks in.

Operating and maintenance expenses

Embassy REIT’s operating and maintenance expenses primarily consist of repair and maintenance (of buildings, common areas, machinery, and others), power

and fuel expenses, property management fees and expenses related to  housekeeping and security services.  

There are a few hitches that one faces when analysing SPV such as Embassy REIT. One of them is that there is no standardised reporting when it comes to reporting their financials. 

Why can they not use the same IND AS guidelines as used by other companies?

The reason lies in the very structure of REITs. Most of the value of a REIT arises from the properties that it holds.

While standard accounting calls for a gross book value of that property, depreciated by the chosen method over its useful life to arrive at its Net Book Value, this can’t be used for REITs such as Embassy REIT.

This is because these properties act more like investments that can appreciate in value rather than always depreciate no matter what, the way standard accounting calls for. 

You may arrive at some Net Book Value of the REIT using the standard way. But the number you arrive at will be far off from the actual market value of the assets. You may end up undervaluing a REIT that may actually be healthy!

Another important distinction is regarding earnings. What we call earnings for other companies, does not really make a lot of sense for the REITs, such as Embassy REIT.

What replaces earnings here is FFO or Funds From Operations. This the cash that the REIT generates from the existing asset base, less the effects of financing, acquisitions, or other such overheads and non-business operations.

Operating Metrics

NOI – Net Operating Income

Net operating income, or NOI, is similar to an operating company’s gross profit margin.

NOI equals the sum of rental revenues from properties plus any tenant reimbursement revenue, less all property operating expenses, including fees paid to any third-party property managers, taxes, and insurance.

NOI measures the property-level profit on a stand-alone basis, excluding the REIT’s corporate overhead or the effects of financing. 

As can be seen, Embassy REIT has very high NOI levels in all except the Hospitality business which is clearly lagging.

Apart from the COVID 19 effect, the hotel business, in general, is risky and susceptible to wild swings. The hospitality business deserves to be kept an eye on.

Same-Store Earnings

Growth in a REIT’s same-store NOI measures a REIT management team’s ability to grow earnings internally, or “organically”— without buying or building new assets.

Embassy REIT’s same-store earning stands at 94% indicating robust ability to generate business organically, without acquiring/building new properties.

However, it must be noted that Embassy REIT has 2.6 msf of the area under construction and 4.6 msf of the area proposed under construction.

Thus Embassy REIT has not just strong internal growth, but also a potential for robust external growth as well.

Profitability Metrics

Like C-corporations, REITs report net income and EPS calculated in accordance with INDAS. However, REITs must depreciate the cost of their properties (excluding the amount allocated to the cost of land) over the useful life of an asset.

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Yet well-located and -maintained buildings tend to appreciate in value over time.

To address the discrepancy between INDAS rules and current market values for real estate, the REIT community adopted FFO as a supplemental measure of earnings per share. FFO and two additional supplemental performance metrics—adjusted FFO (AFFO) and cash (or funds) available for distribution (CAD or FAD).

The calculations attached above show that Embassy REIT had cash for distribution of about Rs 21027 million and out of this amount, Embassy REIT chose to pay out around Rs 18,820 million in the year 2019-2020.

This amounted to a total of Rs 24.39 DPU compared to the possible DPU of Rs 27.25. This also shows that Embassy REIT has a comfortable dividend safety buffer.

Embassy REIT pays at least 90% of its cash as dividends each quarter.

Note: To know more about the terminology used, head here.

Balance Sheet Metrics and Analysis

Leverage results in impressive FFO per share growth; however, it also adds significant risk and, historically, when combined with an economic slowdown, has been the root cause of many private real estate company bankruptcies. Thus it is important that this metric is kept under control at Embassy REIT.

Debt-to–Total Market Capitalization Ratio

This is a measure of how much of the company is funded by debt and how much by equity. Embassy REIT claims to have a covenant of not funding any property by more than 49% by debt.

We can see this for the company as a whole.

It is easy for REITs to fund their growth using debt, but real estate cycles can be long and slow to show up.

What may seem like a great time to borrow may turn into hard times as the payment matures. This was seen typically in the 1980s in the US when REITs financed their properties by as much as 90% by debt.

Debt to Gross Book Value

This is a measure of how much of the debt taken by the company can be covered by the book value of assets.  This number must be as low as possible.

Debt to NOI

This is a measure of how much time it will take for the REIT to pay off its debt. For Embassy REIT, it will take around 3 years to pay off its debt if the current levels of NOI continue for the next 3 years and no more debt is taken.

For more of such valuation techniques head on here.

Valuation Metrics

Price to Earnings 

As was discussed at the beginning of this chapter, REITs trade-off expected FFO per share estimates rather than EPS.

Accordingly, REIT earnings multiples are expressed as FFO multiples, calculated simply as the current stock price divided by current FFO per share estimates.

A lower FFO multiple may indicate a REIT is trading at a bargain price.

Embassy REIT trades at a rather low Price to FFO of 9.75.

Dividend Yields

There are three General Rules about Dividend Safety

  • REITs that own property types with short-term lease revenues carry more risk of cutting their dividends than those with longer-term leases.
  • Dividends tend to be more at-risk in companies whose management teams incur too much leverage. A debt-to–gross asset value of 50 per cent generally should be the absolute maximum amount of leverage. 
  • REITs with dividend yields that materially exceed the industry’s average tend to be companies with significantly more corporate risk and less secure dividends. 

A lot of investors hold REITs for the security of the dividends they offer.

Embassy REIT offers a dividend yield of 7.14% which is much higher than a bank FD rate of around 4% and also higher than the coveted ITC stock’s dividend yield of 5%. 

Dividend Payout Ratio

FFO Payout Ratio indicates the relative safety of the dividend. If the number is below 100%, the dividends are relatively safe. FOr Embassy REIT it is close to 70%.

The dividends are secure too as the CAD of Embassy REIT is 27. Combined with the new foray into the Hospitality business, Embassy REIT also appears to have some promise of being a growth stock. 

Net Asset Market Value

Net asset Value is an important metric for Embassy REIT as most of its properties are located in fast growing, tier 1 cities of India.

Thus unlike the usual companies where land or real estate is more of an asset related to operational sied of the business, for a REIT, it is more on the investment side.

It is always better if the valeu of the property increases as time goes on. Thus looking at only the book value of the assets of Embassy REIT would be very partial.

As is evident from the above table, the NAV per unit of Embassy REIT is less than 374.64. This is even lower than its CMP at 341.8.

We have seen the business of Embassy REIT. The REIT is a new innovation in the Indian markets.

Such SPVs have already caught steam in US and European nations where they have already proven themselves as safe, dividend yielding stocks that offer all the benefits of owning real estate without the hassle that comes along with it. 

Other Important Data for Embassy REIT

Read more such research reports here.

This article has been written by Khubaib Abdullah for FinMedium Research Desk.

Cover Image: Economic Times

Sources: All data are taken from AR 2019-2020 and Investor Presentations

References:

Brainy Quote | The Hindu Newspaper | The Intelligent REIT Investor Book |

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