How work from home policy will hit REITs

The price of India’s first real estate investment trust (REIT), Embassy Office Parks, has corrected around 30%, as on 14 July, since its peak in March despite the fact that the overall markets have seen a sharp recovery from March lows. The correction has wiped out most of its gains of the investors since its listing in April 2019. Currently, it is trading 12% above its issue price.

Apart from the lockdown-related market correction, the fall in the value of REITs can be attributed to concerns over the demand for office space as some companies, especially in the IT sector, are planning to continue with the work from home (WFH) model adopted to battle the covid-19 infection. IT companies are among major clients of REITs. According to media reports, they have approached the IT ministry to allow WFH on a permanent basis. This will reduce the demand for office space, hitting REITs’ revenues.

Also, the change in the income tax law, making dividend income taxable in the hands of some investors, will make REITs less attractive. Rental income from REITs is distributed as dividends.

So does it still make sense to invest in these trusts?

What are REITS?

REITs are products like mutual funds through which investors can own income-generating properties such as commercial buildings and office spaces which they otherwise can’t afford to invest in.

According to the Securities and Exchange Board of India’s (Sebi) regulations, REITs are supposed to invest 80% of their assets in developed and income-generating assets, including commercial real estate and office spaces. They need to distribute 90% of the rental income as dividends, according to Sebi rules.

REITs also receive interest income from special purpose vehicles (SPVs) through which they hold properties. They lend money to SPVs and distribute the interest income among unitholders. Investors also gain from the appreciation in the price of listed units.

The pandemic impact

New leasing in office space is expected to go down to less than half in 2020. “Calendar year 2019 (CY19) saw new leasing of 45 million sq.ft, which is expected to go down to 20-25 million sq.ft,” said Parikshit Kandpal, institutional research analyst, HDFC Securities.

For a REIT, rental income can be 6-8% of the annual investment initially and can go up as occupancy and rents increase. Drop in leasing activity can impact the growth in rentals. “Generally, commercial leases are six-to-nine-year-long with rent escalation clause of 15% every three years. Renewals can result in one-time rental increase of 15-30% depending on the property and market rate, but poor demand can reduce the owner’s power to increase rent for new lease agreements and those up for renewal,” said Kandpal.

Also, it is feared that vacancy levels may go up. “REITs face a vacancy risk when the occupier decides to move out of the buildings. So, in the risk-return scenario, generally 10% vacancy risk is considered,” said Sunil Rohokale, managing director and CEO, ASK Group, a financial services firm.

But the pandemic may also come to the aid of the office space sector in other ways. “The de-densification of office space to maintain social distancing and expected increase in outsourcing business would largely compensate for any fall in demand due to the adoption of WFH policy by corporates,” said Tushar Mittal, founder, Workplace Trends India, a global forum to connect industry professionals.

Also, the pandemic hit the supply of Grade A offices which can benefit existing REITs owing them. “Grade A office supply had started to trail off with a 30-40% decline in the first quarter of this CY. That decline is expected to continue in the next few quarters. That puts landlords like us in a relatively strong position and that’s one of the reasons why we are able to maintain an occupancy of 93% across our portfolio,” said Mike Holland, CEO of Embassy Office Parks.

the tax impact

The dividend received was earlier tax-free in the hands of investors, but Budget 2020 made it taxable at slab rates. The government later amended the announcement, but with a caveat. Now, if a REIT opts for lower corporate tax rate of 22% instead of 30%, the dividend will be taxable in the hands of investors. This may impact the returns of some of the investors. “REITs are like debt products, where any taxation incidence could change the attractiveness of the investment,” said Piyush Gupta, managing director, Capital Market at Colliers International India, a property consultants.

“The returns would now be lower for investors in the higher tax brackets. The new tax changes are a dampener for investors, and are not in line with global best practices," said Shishir Baijal, chairman and MD, Knight Frank India, a property consultant firm.

What you should do

The short-term outlook for REITs is not positive but experts don’t write them off in the long term. “REITs should be part of the asset allocation strategy along with gold, debt and equity,” said Sameer Kaul, MD and CEO, TrustPlutus Wealth Managers (India). Rohokale said within the fixed income category, REITs may give “fixed-income-plus” returns in the long term. However, in the near term, the value of listed units of REITs and rental income may see some downward pressure. “Investors who can understand how REITs work and have the ability to evaluate the sustainability of rental income should invest in REITs,” said Shyam Sekhar, chief ideator and founder, iThought, a Sebi-registered investment advisory firm.

Investors considering REITs for diversification should evaluate factors such as the quality of the underlying assets, type of tenants (it is advisable to go for MNC tenants) and the track record of asset managers, among other factors.