The listing of India’s first Real Estate Investment Trust (REIT) by Blackstone-backed Embassy Group may now be a reality and it is good news for the real estate sector that has been experiencing severe liquidity crunch.
In a few days, any investor who has a ‘small appetite’ perhaps as small as Rs 2 lakh, can now think of investing in Grade A commercial real estate. What this means is that you can now consider adding real estate to your portfolio with a much lower amount.
REITs are investment vehicles that own, operate and manage a portfolio of income-generating properties for regular returns. REITable properties in our country will include commercial assets – primarily office spaces – that can generate steady rental income. They will operate like mutual funds or shares. REITs will have to be mandatorily listed on exchanges and traded like securities. Small investors can buy units of REITs from both primary and secondary markets just as they buy shares or mutual funds.
As per REITs guidelines, 80 percent of the company’s assets must be invested in completed projects, and only 20 percent will be in under-construction projects, equity shares, money market instruments, cash equivalents, and real estate activities. To ensure regular income to investors, it has been mandated to distribute at least 90 percent of the net distributable cash flows to the investors at least twice a year.
What are REITs?
A REIT is an investment vehicle that owns and operates real estate-related assets and allows individual investors to earn income produced through ownership of commercial real estate without actually having to buy any assets. It may later even include hotels, hospitals and convention centres and even common infrastructure for composite real estate projects such as industrial parks and special economic zones (SEZs)
Why was the need felt to launch REITs?
According to a report titled REIT-able Space in India A Closer Reality by Knight Frank and KPMG, the government’s demonetisation decision accentuated the case for REIT. From the REIT perspective, the decline in government bond yields and the overall interest rate regime has increased the spread with prime office properties. This has led to the compression of capitalisation rate for prime office assets that are perfect candidates for REITs.
When were they notified?
Although the regulations were notified in 2014, developers shied away from listing REITs due to tax and regulatory issues. However, a majority of these issues have been addressed through tax and regulatory changes.
How will REITs help the real estate sector?
Currently, developers incur huge capital expenditure especially in Commercial Real Estate (CRE) on land, construction, interior fit-outs, etc. which remain locked, even after the asset is complete until it generates returns to break-even. Through REIT, the developers and private equity funds can exit from the completed asset, and focus on development activity, which has a different risk-return profile. This is possible as REITs improve liquidity in the sector and help attract investment from local and global investors, who prefer a recurring, safe and moderate yield income.
REITs also allow developers to exit partially from the asset while the units listed on the exchange will keep them abreast with the underlying asset value, and help in raising finance at a better valuation.
Who can invest?
The entry point for an investor is as low as Rs 2 lakh.
The projected return on investment is anywhere between 8-14 percent in the short to medium term (post adjustment of the fund management fee), with minimum risks. REITs are far less volatile than the stock market, FDs, mutual funds and gold because as per regulations 80 percent of the REITs must be of rent-generating assets, said Shobhit Agarwal, MD & CEO – ANAROCK Capital
A lot of institutional capital is chasing the limited supply of investible Grade A office stock across top property markets. Therefore, the rents for these listed properties are very likely to rise steadily, and the contractual terms will be far more structured and transparent.
What asset classes can be included?
Grade A commercial real estate. Many commercial leased assets across cities such as Bengaluru, Mumbai, Pune and NCR have steadily mounting interest from occupiers and investors and vacancy levels have been declining in prime locales.
ANAROCK data indicates while commercial real estate supply across the top seven cities declined 24 percent in 2017 (after demonetisation, RERA and GST) over the preceding year, 2018 saw a 21 percent on-year jump in new commercial supply. Office space absorption remained steady with an increase of 5 percent year-on-year (YoY) in 2017, and 19 percent YoY in 2018 in the top seven cities.
Data suggests nearly 50 percent of total office stock in India can qualify for REITs from 30 percent two years ago.
What has been excluded?
Residential real estate is not included under REITs as is the case in developed global markets.
Experts say the lack of a sound and inclusive rental policy in India proves to be a major hurdle for REITs in the residential segment unlike countries such as Singapore and the US that have a defined rental policy.
Also, the yield on residential projects in India is nowhere near those of developed countries and hovers between 2-3 percent even in prime locales. Low returns and overall negative hype in recent years have led India’s residential sector to lose its candidature for REITs at least in the foreseeable future, explained Agarwal.
The proposed taxation structure is also an area of concern. As in the more developed countries with successful REIT platforms, India too must offer a logical tax regime with a single point of taxation to rise to globally comparable stature.
A realistic return on investment (RoI) expectation would be in the range of 7-8 percent annually, after adjusting the fund management fee. Investors can earn two types of income from REITs; through capital gains on the sale of REIT units and a dividend income.
Will investors stop putting in money in conventional commercial real estate?
Small investors, who found the prohibitive high barrier to investing in real estate to be a deterrent, will now be encouraged to invest small amounts in REITs.
Small investors who had started looking at affordable housing as an investment option, may also look at REITs.
But the segment that invests crores in conventional commercial real estate, especially the HNIs, may not immediately stop putting money in commercial real estate. Corporate and institutional investors could also include REITs in their portfolio mix.
However, it is still early days for the Indian REIT market and it will take time for them to displace direct investment into commercial real estate, explains Anckur Srivasttava, Chairman, GenReal Property Advisers (P) Ltd.
“Just as investors never stopped including shares as part of their portfolio when mutual funds were launched, similarly investors will continue to invest in REITs as well as conventional commercial real estate. REITs will complement their direct investments in commercial real estate,” he adds.
Therefore, a very large pool of investors will, for the first time, will now have access to a professionally managed portfolio of Grade-A properties leased to top-notch tenants in prime locations. This is a quantum leap in the evolution of Indian commercial real estate markets and the Indian REIT market is expected to grow very rapidly, he says.
Impact on co-working spaces
The trend of co-working or flexible working spaces will complement and act as a catalyst to the growth of institutional capital in commercial real estate. It is a given that wherever commercial office spaces receive institutional capital, they should also be in a position to cater to the needs of small Grade A occupiers. “Grade A commercial buildings require flexible spaces to complete and complement their offerings. What this means is that they would have to necessarily provide for the flexible space option,” he said.
On the flipside
The success of REITs in India will depend on benefits to investors. Currently, a plethora of taxes may make REITs unattractive. For instance, when a REIT sells shares of assets, the capital gains are taxable. In contrast, in the UK where REITs have been operating for over a decade, there is no taxation on income and gains from their property rental business. Instead, shareholders are taxed on REIT-related property income when it is distributed, and some investors may even be exempt from tax altogether.