How Revised SEZ Rules Will Benefit Listed REITs

Allowing conversion of SEZ space for non-SEZ use will likely help reduce office vacancies and improve rental yields, say experts.

<div class="paragraphs"><p>Embassy Quadron in Pune. (Source: Company website)</p></div>
Embassy Quadron in Pune. (Source: Company website)

India's commercial real estate got a regulatory boost after the government announced the new special economic zone rules.

It has allowed floor-wise conversion of space at special economic zones for information technology and IT-enabled services for non-SEZ use.

That will give the office space segment a push and the potential to improve the overall occupancies and rental yield in the coming quarters, according to experts. The amendment enhances flexibility in marketing vacant office spaces to large office owners, they said.

The government order states that only up to 50% of the SEZ space should still remain an SEZ. As a result, the developer will forfeit the tax benefit enjoyed for the area converted to the non-SEZ space.

The Benefit

This revision in SEZ rules will infuse new office supply, which in many cases is in sought-after markets, helping boost office demand.

“This amendment permits partial and floorwise denotification, thus introducing fresh possibilities for utilisation within SEZs, especially benefiting the IT and ITES companies as they currently dominate the SEZ landscape," said Vivek Rathi, national director-research at Knight Frank India.

Following the removal of direct tax benefit for new units in SEZs from March 2020, they lost appeal, leading to the exit and relocation of occupiers to non-SEZ office spaces.

The share of leasing for SEZ spaces in the overall office leasing dropped from 22% in 2019 to 14% in 2022, and to 7% in January-September 2023, according to Colliers data.

Since 2020, vacancies across SEZs have been on the rise, and currently stand at about 20% across the top six cities.

"Partial de-notification is likely to result in freeing up significant space and increase attractiveness for diverse occupiers," said Piyush Gupta, managing director of Capital Markets and Investment Services at Colliers India.

While residential property prices have risen significantly across cities, office rentals are largely flat. "The SEZ notification is unlikely to create substantial new demand; and while certain portfolio rents could benefit; overall market rental uptick is likely only as supply cools off," said Jefferies in a note.

Positive Development

Analysts consider this as a positive development for India’s commercial real estate sector, where the average vacancy as of October was about 17%, according to Ambit's estimates.

Among listed REITs, Embassy Office Parks REIT Ltd. and Brookfield India Real Estate Trust Ltd. have a higher share of SEZ (and corresponding vacancies) in their portfolios.

While the new move turns the overall sentiment positive, vacant area lease-ups in the SEZ portfolio will likely take another 12-18 months, said Karan Khanna, research analyst at Ambit. The brokerage remains "constructive" on REITs and with clarity emerging, and sees discounts to NAVs narrowing, with Mindspace Business Parks REIT Ltd. being its preferred pick.

Despite a short-term spike on REITs, after the SEZ rule change, valuations are still below average, according to Jefferies.

The research firm expects vacancy levels to now decline for Embassy, Mindspace and DLF Ltd. as they offer their well-located office properties to wider set of tenants, it said. Embassy is Jefferies' preferred pick.