Home >Mint-lounge >Indulge >REITs: Financially engineering bricks and mortar

Surge in property shares," screamed one headline as Real Estate Investment Trust (REIT) rules were announced in the Union budget for fiscal 2014-15 earlier this month. The fickle market didn’t think it was a game changer, reversing most of the 10th July gains in realty stocks on subsequent days. However, the budget does mark a watershed in the development of the real estate market in India. This is not because of the tax breaks that have been the subject of focus in the press but the fact that REITs seem to be on the verge of achieving reality. This is a welcome development after years of debate (not helped by Securities and Exchange Board of India’s unfortunate timing of the release of the first draft REIT regulations in December 2007 when global markets were well on their way towards the Lehman moment).

For the uninitiated, REITs are a way to enable retail investors to buy a share in a property portfolio. They may be considered as a mutual fund for the property market. However, unlike a mutual fund, they have some peculiar characteristics. REITs are intended for the purposes of income generation rather than capital appreciation. They are usually (and this is the case in India as per Sebi’s draft regulations) supposed to invest in properties that generate rental income. This income is then passed on to the REIT investor. Hence usually (again the case in India) there is a restriction on the proportion of the portfolio that can be invested in land and properties under construction. Also, commercial real estate is favoured given the higher rental yields.

So why is introduction of REITs in India such a big deal? The first obvious advantage is easier access to another asset class for the investor. This is great not only because real estate is a highly prized asset class especially in India but also because of the diversification benefit. Instead of shelling out a crore or more at the minimum to invest in real estate, REITs allow you to tailor your exposure by buying as many REIT shares as you deem fit (Sebi’s draft guidelines suggest a minimum trading lot size of 2 lakh). Moreover, commercial real estate REITs diversify the portfolio by providing exposure to an asset class that is typically the preserve of institutions and HNWIs (as they are the ones who can afford to buy entire office buildings).

The second advantage is liquidity and reduced transaction costs of owning real estate. Buying and selling can be done instantly on the stock exchange compared with the long-drawn purchase/sale process of a building. Moreover, by buying and selling REIT units on the stock exchange, you avoid financing your friendly neighbourhood property broker’s third BMW. Economies of scale in outsourcing tenant servicing and maintenance to the REIT manager leads to lower running costs per rupee invested. Another big upside is the fact that there is no stamp duty incurred on buying REIT units.

The third advantage is increased transparency in the real estate market. Sebi draft regulations require public disclosure of asset valuations that need to be conducted at least once a year or once every six months in case of changes in the REIT property portfolio. In a market where price data is almost impossible to come by, this will be a revolution. It will help in making more informed investment decisions as returns can actually be analysed rather than be based upon anecdotes. You can finally look at hard data to see whether the risk-reward in Indian real estate measures up to the hype. For the more public-minded among you, transparency around valuations may also reduce the incidence of black money in real estate. While it will not solve the problem of black money, it might make it more difficult to transact at prices that are clearly below market. Hopefully in time, it may help develop a more mature and liquid market with broad participation from investors.

These are all well and good, but what are the immediate implications, I hear you ask. These are to do with the fact that the budget has made it easier for foreign direct investment (FDI) in commercial real estate and foreign and NRI investment in REITs. By opening the sluice gates to capital inflows, finance minister Arun Jaitley has ensured that this is the area where fortunes will be made (and lost). With the hunt for yield on in earnest in global markets, it is a matter of time before liquidity starts flowing into the Indian real estate market. Indeed Blackstone, the global private equity firm, is already gearing up to cash in on its Indian commercial property holdings.

The influx of money has two immediate investment implications. First, commercial real estate seems to offer the prospect of decent long-term returns for those who believe in the Indian growth story. Even if hot money flows fail to materialize in the short term (either due to pessimism on India or broader global market jitters), Indian commercial real estate presents a large opportunity to foreign pools of capital over the longer term. Given the cyclical nature of the asset class, economic growth will increase demand for commercial space and rental yields will rise. In addition, the recent economic slump has left prices at inexpensive levels, providing a favourable risk-reward ratio.

The other investment thesis is buying equity or debt of property development companies such as DLF. These companies can offload their property portfolio at a profit to a REIT and also reduce their working capital requirement in the process. Investor demand for REITs also increases the likelihood of being able to sell projects quickly after completion. The ability to churn projects and a lower need for debt-funding a property portfolio makes investing in property developers attractive. However, company-specific factors will remain important. Still, an investor can seek to ride the upswing that will likely occur as REITs pick up steam.

In conclusion, as capital trickles and then floods into the Indian real estate market, investors should take advantage. To paraphrase Friedman, “asset inflation is always and everywhere a monetary phenomenon". And monetary conditions are as favourable as they can be with Indian inflation slowing and continuing global liquidity glut.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.

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