Will REITs strike the right chords this year?
Expanding sectors, improvement in macro-economic factors and tighter regulations make commercial real estate an attractive investment option
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Year 2016 was not a great year for the real estate sector in India. Despite the huge demand for housing in the nation, transaction volumes remained low in the residential real estate space.
Several policy reforms in the past year were introduced with the right intent to bring about more transparency in the way the realty sector functioned and to empower the potential homebuyer.
Significant among these were Real Estate (Regulation and Development) Act, 2016 (RERA), Benami Transactions (Prohibition) Act of 2016 and amendments to the Real Estate Investment Trust (Reit) regulations, which will now allow all kinds of investors to make investments in the realty sector on a secure platform.
While the residential sector remained subdued due to the above-mentioned policy reforms and the impact of demonetization, the commercial real estate sector witnessed growth in 2016.
After witnessing a lull for three consecutive years (2012–14), where the net absorption remained below 30 million square feet, the commercial real estate sector witnessed winds of change from 2015 onwards, with a gradual improvement in the macro-economic outlook.
With a host of companies in technology, healthcare and e-commerce expanding, the year 2015 witnessed a significant rise in absorption of office space, which rose significantly and reached about 38 million square feet.
The trend continued in 2016, as the commercial real estate sector put up a noteworthy performance with the overall absorption of prime office space across the seven leading cities of India reaching approximately 40 million square feet for the year.
Office supply addition rose by 29% on a year-on-year basis, with the cities of Mumbai and Chennai accounting for a bulk of the new supply, followed by Kolkata.
In 2017, there is significant optimism as office space demand has risen from sectors such as logistics, manufacturing and consumer goods, apart from information technology and information technology enabled services (IT and ITeS) and the banking and financial services sectors, which traditionally drive office space demand.
Another interesting trend in India’s commercial realty is the rise of small and medium office spaces, not just in the metropolitan (and tier 1) cities but also in the smaller cities across many areas, because of the massive increase in the number of start-up companies, which in turn are witnessing growing interest from domestic as well as global businesses.
The Reit opportunity
In the current year, excitement is palpable in the commercial estate space due to the big opportunity that Reits will bring in and the better alignment of developers due to compliance with RERA.
Commercial real estate that has been an integral part of the investment portfolio of large investors. It is now witnessing fresh investments as the yields on the commercial side are much higher—at 8-10% as against 2% in residential real estate.
The formation of Reits will further expand the universe of quality real estate, and give developers an opportunity to exit projects.
Commercial real estate properties, such as shopping malls and office buildings, are considered Reit complaint. This is because they already have tenants and their income stream is relatively easier to gauge.
As the value of these projects increases with the improving economic outlook and rising demand, Reits are expected to hold on to their assets for the long term. Investors will benefit from dividends that Indian Reits (in accordance with global norms) will be required to pay out—with 90% of their income generated from their stable assets—at least twice a year.
In the past year’s Union Budget, government had removed the dividend distribution tax (DDT) on special purpose vehicles (SPVs).
Further, the investment cap in under-construction projects was raised from 10% to 20%. These new rules will enable the successful listing of Reits, as the opportunities for them are growing with an increase in grade A commercial assets.
As per estimates of some real estate consultants, as much as 229 million square feet of office space is Reit complaint. Even if half of this were to list in the few years ahead, the total Reit listing in the next 5 years could be worth Rs1.25 trillion.
Given the big opportunity present and the good portfolio of superior office space in leading cities, there is significant interest from global private equity firms and the first listing may be as early as June 2017.
Reits debuted in the US in the 1960s. They have significantly benefitted investors across the globe, especially in countries such as the US, Japan, Australia, and Singapore. Riding on the successes, Reits have gone on to create a successful market for themselves.
The introduction of Reits in India will add more credibility to the Indian real estate market and boost the commercial realty segment in particular.
Despite the threats that Indian information technology firms are currently facing, India continues to remain a popular outsourcing location for many of the noted global companies.
This explains the rising demand for office spaces, which is now expanding to tier 2 cities as well. This, along with the excitement surrounding the debut of Reits in India, is expected to make commercial real estate an exciting opportunity to watch out for in 2017.
Sharad Mittal is director and head, Motilal Oswal Real Estate Investment.