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REITs are a new avenue, but will have to struggle to deliver good enough returns
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After almost six years since the concept was introduced in India, it seems real estate investment trusts (REITs) will finally become an investment option for investors. On 10 August, the Securities and Exchange Board of India (Sebi) approved REITs to be set up here.
These will be closed-end schemes with a minimum subscription of 2 lakh, with each unit size being equal to 1 lakh. (Mutual fund units are usually priced at 10 a unit initially.)
REITs will be allowed to raise funds through an initial offering and will have to be listed on a stock exchange. REITs can further raise funds through follow-on offers, rights issues or qualified institutional placements.
These instruments will need to have assets worth at least 500 crore at the time of an initial offer and the minimum issue size has to be 250 crore.
REITs have been discussed since 2008, but it was only in October 2013 that Sebi issued draft guidelines. The market regulator’s board has retained most of the proposals put forth in the draft guidelines.
Prior to the budget announcement which gave REITs a pass-through status in taxation, the main bone of contention was the tax treatment. A pass-through status means that income will be taxed in the hands of the investor and not the fund. Earlier, it was feared that income of both may be taxed leading to double taxation, which was the single biggest hindrance in the path of REITs, according to all the experts Mint Money spoke to.
“This will be a game changer in a way. Implementation of REITs in India as an investment product will boost the liquidity situation of cash-starved developers, who are struggling to find funds for construction activities. Clearly, it would help in lifting the subdued investor sentiment in the country," said Devina Ghildial, deputy managing director-South Asia, Royal Institution of Chartered Surveyors.
How does it work?
Under a REIT, money is pooled from a set of investors and a manager invests, either directly or through a special purpose vehicle, in income-producing real estate assets. Whatever is the income, most of it is distributed among the investors; Sebi has set this limit as 90%. At present, only high net worth individuals and institutions will be allowed to invest in REITs, but eventually, retail investors will also be able to participate.
Globally, there are various structures and REITs generally fall into three categories—equity, mortgage and hybrid. In India, according to the guidelines, REITs will focus on revenue generating properties, which should form at least 80% of the portfolio. The remaining 20% can be put in specified products such as under-construction projects that are still to get occupancy certificates, equity shares of real estate companies having 75% income from realty activities, and so on.
Most of the listed realty stocks gained on Monday and the S&P BSE Realty index rose 0.96%.
But will India be able to build a REIT market? Let’s examine a few issues.
Investment options
A pure REIT by mandate is supposed to hold most assets in income-producing real estate assets. Something similar to REITs is a business trust, which can hold investments in, say, infrastructure projects, roads, hotels, hospitals, and so on. However, one of the largest challenges is lack of investment grade properties in the country. On top of that, 90% of investment grade properties are limited to the top 7 cities. With such little availability, the REITs market may lack depth. “If you look at the office market in tier I cities, there is a significant quantum of grade A space that is available for occupation. The challenge for realtors has been that absorption has been slow and in most key markets has been largely driven by consolidation and relocation needs than by growth," said Viswajit Srinivasan, director-business development and wholesale lending, Capri Global Capital Ltd, a non-banking finance company.
A REIT works on a lease model and a lot depends on the economy being able to generate lease rentals and robust market.
However, an estimate by Cushman and Wakefield, assets that may qualify to be included in REITs may reach $20 billion by 2020, and REITs may be able to raise $12 billion in the next three to five years.
The matter of returns
The guidelines released in October had indicated that both foreign and domestic individuals would be allowed to invest in REITs. However, after the approval, as of now only HNIs and institutions have been allowed to do so.
Diwakar Rana, director-capital markets, Cushman and Wakefield, said that though there will be domestic investors but one cannot grow a REIT by selling only to them.
Apart from a narrow investor base, there are issues in terms of returns. “Generally, REITs are supposed to be ultra-low risk. That’s because they hold income-producing assets giving regular income, and are backed by a tangible asset," said Gaurav Pandey, chief executive officer, Golden State Capital, a real estate private equity firm. However, he added that worldwide, REITs have been successful in places where comparable benchmark rates were low. “For instance, in Singapore, which has a big REIT market, government bond yields are 3-4% and fixed deposit rates are 1-2%, while REITs give around 6%," said Pandey. “India’s benchmark bond yield hovers just a notch lower than 9%. So, for India to have a robust REIT market, returns will need to have a reasonable spread for investors to overlook property, currency, sectoral and developer associated risks. Or, bond yields have to come down, which is a function of several factors," added Pandey.
REIT managers should not have biases, nor should a developer be a REIT manager as the position requires for the person to protect interest of investors; there shouldn’t be any conflict of interest either, said Pandey.
Of course, the first thing a REIT will have to do is generate sufficient returns compared with other products.
Can REITs give that much return? The rental yield from grade A properties has been 9-10%, and stable at that level for around 10 years. However, smaller projects, which do not attract high quality occupiers will give lower returns, thus limiting the market.
The one plus point in favour of REITs is the potential of capital appreciation of the underlying real estate asset. However, REIT traditionally is a long-term regular income generating investment and gains from capital appreciation should be looked at as an added bonus.
“If done properly, REITs will change the landscape as it happened in 2005, when foreign direct investment was allowed. Now, we are seeing sovereign funds coming in," said Rana.
According to Anshuman Magazine, chairman and managing director, CBRE South Asia Pvt. Ltd, a successful India REIT market will require strong support from existing landlords and investors, as well as favourable market conditions. The market’s growth will depend on implementation, the regulatory environment and the response from issuers as well as investors. REITs may, in fact, become an investment avenue for mutual funds and insurance companies as well.
Whether that happens or not, REITs are a welcome investment option, especially for those looking to diversify their portfolio.
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