REITs may work in the long term but evaluate the risks4 min read . Updated: 04 Feb 2020, 09:30 PM IST
- Property vacancy is one of the biggest risks that real estate investment trusts face
- REITs allow investors to take exposure to high-quality rent yielding properties, which may be otherwise unaffordable
After the success of Embassy Office Parks, India’s first real estate investment trust (REIT) that listed on the stock exchange last year, more developers are planning to join in. Recently, Mindspace Business Parks REIT has sought the Securities and Exchange Board of India’s (Sebi) permission to launch an initial public offer (IPO). Mindspace REIT is backed by developer K. Raheja Corp. and private equity investor Blackstone.
According to ANAROCK Capital, over 150 million sq.ft of rent-yielding office properties could get listed in the top seven cities in three years, which is 25-30% of the total Grade A office space in the country. “At least four more developers are planning to go for a listing of their REITs. These include Bengaluru-based Prestige Group and RMZ Corp. Then there are Mumbai-based Godrej Properties and Pune-based Panchshil Realty," said Shobhit Agarwal, managing director and CEO, ANAROCK Capital.
REITs are similar to mutual funds—the money is pooled and invested in assets. While mutual funds invest in stocks, bonds or gold, the underlying asset in REITs is physical real estate.
What works for REITs
REITs allow investors to take exposure to high-quality rent yielding properties, which may be otherwise unaffordable. Once listed, the units of REITs can be traded on the exchanges, which helps you avoid the liquidity issue that real estate investments typically face. This also means that you can choose to bear only a fraction of the overall cost by buying just a few units.
Moreover, the entry cost is low compared to buying a property. When Embassy Office Parks raised money in March 2019, the minimum investment in the IPO was ₹2 lakh. Later, Sebi lowered it to ₹50,000. “Since only one REIT is listed at present, the lot size is decided by the exchanges. This could be brought in line with Sebi’s REIT public issue requirement of a minimum lot value of ₹50,000 or a lot size of 100 units, whichever is of higher value," said Venu Madhav, chief operating officer, Zerodha, an online broking platform. The minimum lot size for the Embassy Office Parks REIT is 200 units.
Another aspect that works in favour of REITs is safety. According to Sebi regulations, 80% of the real estate portfolio held by a REIT must consist of developed and income-generating properties. Up to 20% of the value of assets can be invested in under-construction properties, completed but not rent-generating properties, or listed or unlisted debt of real estate firms.
Income from REITs
REITs can generate income under two heads. First, rental income, which is distributed as dividends. It can be about 6-8% of the annual investment initially and increase later as occupancy and rents increase. Sebi regulations stipulate that 90% of the rental income will have to be paid out as dividends.
Second, income from interest earned. In a REIT, the properties are not directly held by the trust but through a special purpose vehicle (SPV) in which the trust holds a stake. The trust can also lend to the SPV. The money that the SPV repays is distributed as interest income to the unitholders.
The returns can increase with any rise in rents, leasing of vacant space, addition of new properties in the REIT’s portfolio through new development, leasing of under-construction projects and so on. “Any value-added service can aid in better rent realization. So does reduction in interest rates in the economy and increase in the capital value of the underlying assets. Once all this starts playing out, an investor can expect up to 11-14% returns over three-five years," said Nishant Agarwal, managing partner and head, family office, ASK Wealth Advisors.
You could also gain when you sell units. Embassy Office Parks REIT closed at ₹402.23 on 3 February, almost 34% above the issue price in over 10 months. The REIT’s issue price was ₹300.
“Typically, commercial leases are six to nine years long or more, with a rent escalation clause. This makes REITs less volatile than other investment avenues," said Samantak Das, chief economist and head of research, JLL India, a real estate consultancy firm.
Before investing, evaluate the REIT based on the track record of the sponsor and the brand. Assessing the quality of construction could be difficult for retail investors. “They should, therefore, look at the location of the different properties, the rental yield on each and the tenants. All these are available in the offer document," said Das.
One of the biggest risks that REITs face is vacancy. An investor should, therefore, look at the occupancy of the properties with a REIT and the average tenure of the lease. Property occupants should mostly be bluechip companies and multinational corporations.
If you are investing in the IPO, look at institutional investors as well. As there is only one listed REIT, avoid investing too much just because the returns are better than what fixed-income instruments give. As a category, REITs sit somewhere between debt and equities. “Allocation to REIT can be 15-25% of the debt portfolio. But it should be diversified between three-four issues," said Agarwal.
Then there are other risks such as an economic downturn, which can affect the demand for commercial real estate. Oversupply of commercial space in a location can affect the rate at which the rent rises. Delay in completion of under-construction properties will also impact earnings.
Investors, therefore, need to treat REITs as income-generating assets, which can deliver slightly higher returns than fixed deposits over the long term.