Net leasing¹ of commercial office space² will reach 90-95% of the pre-pandemic level next fiscal, up from an estimated 70-75% in the current one, with return to office gathering steam and new hiring picking up strongly. This, along with steady rental collections, which had not fallen significantly, will ensure the credit profiles of commercial real estate owners remain ‘stable’, a Crisil Ratings estimate shows.

Net leasing had taken a massive hit during the last fiscal, almost halving to 20 million square feet (msf) as absorption of new spaces was tepid and some tenants even vacated office premises.

Leasing remained modest in the first half of this fiscal, too. With supply exceeding demand, market occupancy reduced to ~85% in September 2021, from the pre-pandemic mark of ~89% in March 2020. That said, leasing activity is expected to pick up from the fourth quarter of this fiscal and occupancy to improve to ~87% next fiscal, closing in on the pre-pandemic level.

Says Anand Kulkarni, Director, Crisil Ratings, “A gradual return to office and strong hiring in key sectors such as information technology (IT) and IT-enabled services (ITeS) will catalyse office demand. Based on an analysis of 10 large IT/ITES companies³, Crisil Ratings expects net employee addition to grow ~40% this fiscal compared with ~10% growth last fiscal. This will drive a reversal of the decline in office occupancy during the pandemic, even as most offices adopt a hybrid working model⁴.”

While the hybrid working model is here to stay, corporates are still evaluating logistical challenges and working on optimal solutions. Crisil Ratings estimates that a hybrid working model, with up to 25% of the workforce having flexibility to work from home, could reduce demand equivalent of 12-15 months. However, the entire loss may not be permanent and could be recouped in the next few years as people gain confidence in working from office.

The IT/ITeS sector, which accounts for ~45% of office stock, is the most amenable to work from home, followed by segments such as research, consulting and analytics (8-10% of stock) and financial services (15-17% of stock). That said, the loss in demand for office space will be lower due to de-densification, leading to an increase in area per employee, with no loss in common areas.

Occupancy will also be supported by factors such as substantial fit-out costs (equivalent to around two years of rentals) incurred by tenants, while only a third of the leases is expiring over the next three years.

While occupancies reduced during the pandemic, the credit profiles of office real estate players remained resilient, with less than 4% of entities seeing rating downgrades during the 18-month period ended September 2021, shows a Crisil Ratings analysis of 90 entities with around Rs 50,000 crore of debt and total leasable area of around 150 msf (~24% of operational stock in the top seven cities). This sample includes marquee names as well as assets under real estate investment trusts.

Says Kshitij Jain, Associate Director, Crisil Ratings, “Credit profile of the Crisil Ratings portfolio should remain stable considering the low leverage, strong counterparties and negligible impact on collections. We expect the average debt service coverage ratio to remain healthy at ~1.6 times in fiscal 2023, which will be a marginal improvement from ~1.5 times this fiscal, supported by the improving market scenario.”

While companies had maintained comfortable leverage in view of the uncertain business environment, their risk appetite may increase as business performance improves. Any significant increase in debt due to acquisitions, capital expenditure or dividend distribution will remain a monitorable. Furthermore, a moderate third wave could push recovery back by 1-2 quarters and will bear watching.

¹ Net leasing refers to absorption of new office space less space vacated by tenants
² Represents Grade-A office space across top seven cities: Bengaluru, Chennai, Hyderabad, Kolkata, MMR, NCR and Pune with an operational stock of around 625 msf as of March 2021.
³ Infosys, TCS, Wipro, Tech Mahindra, HCL, Coforge, L&T Infotech, Mindtree, Mphasis, L&T Tech
⁴ Hybrid working model refers to flexibility to work on-site for part of the week and remotely part of the week.