Will return to office give a new lease of life to Reits?

There has been a resurgence in demand for office space leasing this year as more firms summoned employees back to offices and this marks a positive turn for Reits, which were facing difficult times since the pandemic began and people opted to work from home amid lockdowns.

A Reit is a trust that owns a pool of income-generating real estate assets held as special purpose vehicles (SPVs). To be sure, at least 80% of these assets must be completed and income-producing. Reits, which are mandated by market regulator Sebi to distribute at least 90% of their cash flow to unitholders, have a unique structure that allows investors to participate in the income generated by commercial real estate assets.

India has three listed office Reits—Brookfield India Real Estate Trust (Brookfield Reit), Embassy Office Parks REIT (Embassy Reit), and Mindspace Business Parks REIT (Mindspace Reit) and one listed retail REIT—Nexus Select.

Retail Reits focus on properties such as shopping centres and malls that generate income from leasing space to retailers, including restaurants.

What investors get

As unitholders, investors receive a portion of the net distributable cash flow (NDCF) of a Reit, periodically. A Reit generates income in the form of interest and principal repayments on loans extended by it to the project SPVs and dividends in return for its equity stakes in these projects. All expenses at the Reit level are deducted from the total income to arrive at the NDCF.

Apart from this regular income, Reit units trade on the exchanges like shares and offer unitholders the possibility of capital gain or loss. REITs are, thus, a hybrid product that can offer high-risk investors attractive yields.

Investors in listed Indian Reits receive varying distributions of income. For instance, Embassy REIT provides 27.2% in dividends, 26.3% in interest, and 46.5% in capital repayment. Mindspace REIT offers 91.9% in dividends (tax free) and a substantial 8.1% in interest.

 Brookfield REIT divides its income, with 3% in dividends, 58% in interest, and 39% in capital repayment. Specific distribution details for Nexus Trust were not available. These distributions highlight the income composition and strategies of each Reit, assisting investors in assessing their income potential and risk profiles.

Reits and net asset value (NAV)

Reits currently exhibit notable market price to NAV discounts, emphasizing the divergence between their stock market prices and the estimated value of their underlying real estate assets. Embassy REIT is trading at a substantial 24% discount, while Mindspace Business Parks REIT shows a 10% discount, and Brookfield India Real Estate Trust stands at an even larger 27.50% discount.

The significant discounts at which these Reits are trading can be attributed to several factors. First, changes in interest rates can have a profound impact on investor sentiment regarding the future earnings of the Reits. When interest rates are expected to rise, investors may anticipate a decrease in the Reits’ future earnings, leading to a decline in their market prices.

Another key factor contributing to these discounts is the relatively slow and infrequent changes in private market prices and NAVs. Property appraisals in the private market do not occur as frequently as stock market price movements. Consequently, public market prices of Reits can deviate from their NAVs, leading to discounts.

Yields, price correction

During the period from February to 29 September, these Reits experienced varying degrees of drawdown in their market prices, reflecting fluctuations in market sentiment. The drawdown is calculated as the decline from the highest peak to the trough during this period. Embassy REIT had a maximum drawdown of -13.20% and a current drawdown of -9.60%, Mindspace Business Parks REIT had a maximum drawdown of -12.60% and a current drawdown of -6%, while Brookfield India Real Estate Trust saw a maximum drawdown of -17.97%.

In contrast, Nexus Trust, which listed in May, did not experience any drawdown during this period, with its market price up by 21%.

Despite these drawdowns, the yields from these Reits are still attractive, as of September. In February, Embassy REIT had a yield of 6.80%, which increased to 7.23% in September. Mindspace Business Parks REIT’s yield went from 5.70% in February to 7.12% in September, while Brookfield India Real Estate Trust’s yield increased from 6.10% to 7.90% during the same period. Newly listed Nexus Trust did not have yield data in February but it was 6.44% in September.

These yield figures provide insight into the income potential that Reits offer to investors, taking into account their distribution per unit (DPU) divided by the current market price.

Comparing the performance of Nifty Reitss & InvITs Total Returns Index with Nifty Realty Index during the same period, the former had a price return of -12.34%, while Nifty Realty Index showed a significant price return of 35.77%. However, when considering yield, Nifty REITs & InvITs Total Returns Index had a yield of 6.81%, much higher than the 0.35% yield of Nifty Realty Index. This would suggest that the recent declining trend for office Reits is not related to market volatility, but is rather the result of weak fundamentals.

InvIT is short for Infrastructure Investment Trust.

Why Reit prices are down

Rising interest rates have cast a shadow over the real estate investment landscape, impacting both commercial and residential markets. The Federal Reserve’s swift monetary tightening cycle has made real estate owners grapple with challenges in obtaining financing or refinancing, primarily due to the increased cost of debt, lower property valuations, and more conservative loan-to-value requirements. Lenders, wary of the office sector, now demand a larger safety margin.

However, financially robust Reits with capable management teams can navigate these challenges by implementing rental rate increases and other measures.

When asked about the reasons behind the fall in Reit prices, Prateek Pant, chief business officer, White Oak, said “Reits and interest rates have a negative correlation. When rates rise, their market prices tend to fall and vice-versa. While Fed’s hawkish and higher for longer stance is creating pressure on Reits globally as interest rates still stay high, Indian Reits are a phenomenal buying opportunity right now. Some of the best quality assets are available at very attractive prices. The other overhang is office occupancy levels and lease renewal rental growth. Lastly, the Indian market still lacks a clear understanding of the product and investor awareness around Reits could create potential inflows and lead to portfolio diversification."

Investors are increasingly sceptical about the long-term demand for office spaces as hybrid work arrangements gain acceptance among employees and employers. Actual office traffic remains at approximately half of pre-pandemic levels, and layoffs in certain sectors, coupled with cost-cutting efforts by companies, are contributing to this uncertainty.

Furthermore, the rise in interest rates has presented investors with alternative fixed income options like FDs, Gsecs or AAA-rated corporate bonds. As a result, Reits have seen some price drops, which, to some extent, have increased dividend yields to enhance their competitiveness in the income-focused investment landscape.

Market experts have a word of caution. Even if buying more Reit units isn’t right for you just now, don’t rush to sell the units that you have. There are unique situations in the broad sector, like offices, that have notable problems. But overall, Reits are not in a bad place. It is really just investor sentiment that has changed. And since markets are notoriously volatile, it is probably better to view the drop as an opportunity.