Office space leasing revival is subject to conditions

Last week, the government proposed amendments to rules under the Special Economic Zones Act, 2005, permitting SEZs to lease space partially or floor-wise. This would help boost occupancy of office space in IT/ITES SEZ parks and reduce the high vacancies seen since the pandemic.

Demand for office spaces slumped when the pandemic hit, with most companies adopting the work-from-home model. A lack of clarity on SEZ leasing was seen as regulatory overhang and hurt the outlook for rentals. 

While the latest development is a step in the right direction, the benefits are unlikely to accrue immediately. Analysts note that denotifying certain identified SEZ areas as non-SEZs and leasing them could take six to eight months.

Permission for denotification is also subject to certain terms and conditions. For instance, the landlord or developer needs to repay the tax benefits (without interest) related to non-SEZ areas (calculated in proportion to the built-up area). 

Also, any tax benefits availed to develope infrastructure in and around this space must be surrendered. Going by the estimate of JM Financial Institutional Securities, office landlords and developers will have to surrender nearly ₹300-500 per square feet in tax benefits availed the SEZ Act.

Expectations are that the repaid tax benefits will be offset by improving rental income going forward, but here’s a catch. “The SEZ notification is unlikely to create substantial new demand; and while certain portfolio rents could benefit (for instance, DLF Cybercity SEZ rentals are 30% below non-SEZ rentals in the vicinity), overall market rental uptick is likely only as supply cools off," Jefferies India wrote in a report dated 10 December.

In addition, denotification will not be permitted if it reduces the SEZ area to less than half of the total built-up area. But given the high vacancy levels, this condition is not seen as a challenge right now. In fact, data compiled by property consultant Colliers India shows that since 2020, vacancies across SEZs (Grade A office stock) have been on the rise and currently stand at about 20% across the top six cities.

“Ever since direct tax benefits were taken away for new units in SEZs from March 2020, SEZs lost their appeal as there were no major benefits for the occupiers. They also had to be complaint with SEZ requirements. This led to exits and relocations to non-SEZ office spaces,“ Piyush Gupta, managing director, Capital Markets & Investment Services, Colliers India wrote in a note. Owing to this, the share of leasing for SEZ spaces in overall office leasing dropped from 22% in 2019 to 14% in 2022 and 7% during January-September 2023, he added.

Overall, these amendments are expected to help Grade-A office operators improve occupancy. In the listed space, all three office real estate investment trusts and DLF Ltd are seen as key potential beneficiaries, given the high vacancy share of SEZs in their office assets portfolio.

Stocks of listed REITs have lagged this year, fetching negative returns as leasing trends in SEZs have been muted even as non-SEZs have done relatively better. In comparison, stocks of listed residential real estate companies have delivered impressive returns as demand for residential properties displayed showed despite expensive home loan rates.

The return to office and new SEZ rules are positive developments, but amid a global slowdown, the pace at which leasing demand and rentals recover remains to be seen.