Reits for Real Estate, Ready or Not?

Buying real estate is not new to well-heeled investors.

But if you are not so rich and still want to invest in property without the cumbersome formalities there is an easy solution.

All the headaches of going through the legal process of checking that the title of the property is of clear ownership, regulatory hurdles, managing the documentation, maintenance, repairs, etc. can be avoided.

You get the benefit of investing in real estate without having to buy physical property is investing in Real Estate Investment Trusts or REITs.

In mature markets like the US, Singapore, and Japan, REITs have been a popular product for many decades. In India, on the other hand, the adoption of REIT has been slow so far.

What is a REIT?

Real Estate Investment Trust (REIT) is a tax-efficient vehicle that owns a portfolio of income-generating real estate assets. A REIT is created by a sponsor, who transfers ownership of the assets to the trust in exchange for its units.

It is like a mutual fund, where money is pooled from investors. In return, they are offered mutual fund units. Instead of shares of companies as in the case of Mutual Funds, REIT units represent ownership of real estate assets. Profits for the REIT are generated in the form of dividends & capital appreciation of the real estate assets.

While REITs can invest in all kinds of income-generating real estate assets, including residences, offices, hotels, malls, and warehouses, REITs in India are primarily focused on commercial real estate.

India saw its first REIT (Real Estate Investment Trust) in 2019. Four years later there are now three – Mindspace REIT, Brookfield REIT, and Embassy REIT. REITs as an investment option have been gaining significant popularity among institutions & retail investors. One can buy units of REITs just like shares through regular trading accounts on BSE and NSE, the major exchanges. Hence ease of buying/selling and liquidity concerns are taken care of.

Structure of a REIT

REITs have a similar structure to that of mutual funds with a sponsor, a fund management company, and a trustee.

• The sponsor who is usually a Real Estate company promotes the REIT with its funds
• The fund management company selects and buys properties for the portfolio.
• The appointed trustee ensures that the funds collected are utilized and managed, keeping the investor’s interest in mind and the Sponsor cannot directly control them.

A REIT may control its Real Estate Holdings either directly or through the formation of a Special Purpose Vehicle (SPV). The SPV is a company that holds the Real Estate Assets on behalf of the REIT, and as per regulations, the Trust holds a 50% or higher stake in the SPV. A REIT can raise money through the sale of units either publicly on stock markets or through private investors.

The Regulatory Angle

The market regulator, SEBI, formalised the REIT guidelines only in October 2013, after over a decade of preparations, and has since effectuated several changes in the regulation of REITs, to increase their popularity.

To improve liquidity in REITs and bring in more listings, the SEBI, in 2021 lowered the minimum investment amount in a REIT, from Rs 50,000 earlier to Rs 10,000-15,000 now and also revised the trading lot cap of 200 units to just 1 unit.

The other requirements are:

• SEBI regulations require REITs to payout 90% of distributable cash flows to unit-holders.
• REITs must have at least 80% of their assets to be completed & income-generating. This decreases the execution risk.
• The sponsor is obligated to hold certain units of the REIT & remaining are issued to investors in the form of an IPO.
• Once listed, they serve as a permanent vehicle to raise debt and equity in the capital markets to acquire new assets & grow.

What to look for in a REIT?

• Distribution Yield

By law, REITs have to pay at least 90% of distributable cash flows to the investors. Higher the better.

• High occupancy

The occupancy rate is the percentage of the square foot available in the portfolio of REIT. This is an important indicator of its performance. This ensures consistency in payouts, increasing rental & dividend income. The higher the occupancy, the more stable the cash flows.

• Portfolio

It is essential to look at the portfolio holding of the REIT i.e the Companies who have leased the office space. Non-payment or irregular rent payments can have an impact on the REIT.

• Diversified portfolio

A well-managed property in a prime location will have the highest occupancy rate. On the other side, an oversupply of properties can reduce occupancy rates & rental income. REITs having diversified portfolios across geographies & tenants are less prone to oversupply & concentration risk.

• Sector Diversification

Historically seen, the IT sector has been the prime occupier of premium and high-quality office spaces, and over-dependence on one sector can be risky. As seen recently, working from home trend could continue in many cases. Vacant spaces or non-payments will affect the REIT’s performance. Therefore, while choosing a REIT, ensure that the asset portfolio is well-diversified across different sectors such as Banking, FMCG, Healthcare, Pharma, etc.

• Rolling renewals and Re-leasing spread:

Usually, the leasing commitment period is around five years. The rolling renewals indicate the number of tenants who are exercising their renewal options at the end of the lease period. A good number of rolling renewals will indicate stable returns. Re-leasing spread is the change in the per square feet (PSF) rate between the new and expiring leases expressed as a percentage that signifies the REITs ability to execute the new leases at the increased prices for the same property.

• Taxation

The cash distributed to the unit holders is a combination of three parameters – Interest income, Dividend income & Repayment of debt. Taxation works the same for all REITs except for dividend income. It depends on the tax regime the Trust had opted for.

Latest Change in Taxation in Budget 2023

The recent taxation changes made by the government have led to a substantial increase in taxation for investors on the gains from REITs. It proposes to tax a part of distributions that are classified as ‘repayment of loans’ (or return of capital) in the hands of unitholders, which will be taxed as ‘other income’.

As per the current system undertaken by the three existing REITs, the new taxation changes would levy up to 1.5% on investors which is likely to discourage investor enthusiasm in the sector.

In short – An Investor will pay tax on the following types of income distributed by the REIT.

1. Interest income received – as Regular Income.
2. Rental income from assets received by the REIT – as Regular Income.
3. Dividends received by Investors from shares held in SPVs – will be taxed as Regular Income only if SPV has opted for a concessional tax regime. In such a case, the REIT is required to deduct taxes at the rate of 10% from the dividend. Or

– Will not be taxed for the Investor if the SPV has not adopted for the concessional tax regime. Also, no taxes will be deducted at the source by the REIT.

4. Repayment of loans/capital to Investors – as Other Income

In addition, if the investor chooses to sell any part of his investment, it will be subject to Capital Gains tax as per the prevalent rules.

 Brief background of each of the REITs in India (data as of Q3 2022)

Embassy REIT

Sponsored by Embassy & Blackstone, Embassy REIT is the first listed REIT in India & the largest in Asia (by area). The company owns & operates 43.2 MSF (million square feet). It has a portfolio of twelve office parks, six hotels & a 100 MW solar power plant. It comprises 33.4 MSF completed operating areas with an occupancy of 87% as of October 2022.

Bangalore is their biggest market with 74% of the asset value, followed by Mumbai (10%) & Pune (9%). Top 10 tenants contribute 37.4% of rentals, as compared to 42% in 2019. The company has an Average Lease expiry period of 7 years (the higher the better). Embassy is the only listed REIT that has exposure to hotels (6% of their Gross Asset Value).

Mindspace REIT

Mindspace REIT is sponsored by K Raheja Corp Group. It has a strong portfolio of office spaces across Mumbai, Pune, Hyderabad & Chennai with a total leasable area of 31.9 MSF.

Top 10 tenants contribute 36.4% of rentals. They are at 86.9% occupancy. Average Lease expiry period stands at 6.8 years.

Brookfield India REIT

Brookfield India REIT is the new kid on the block. It is sponsored by Brookfield AMC & is India’s only institutionally managed commercial real estate vehicle. They have commercial properties in Mumbai, Gurugram, Noida & Kolkata. Their total portfolio comprises 18.7 Million SqFt, out of which 4.4 Million SqFt will be developed in the future.

NCR region contributes 67% of the total asset value. The company has an occupancy of 89% & Average Lease expiry period of 6.9 years. The company is heavily dependent on few clients. Accenture, TCS & Cognizant contributes 41% of the leased area.

Brookfield & Embassy are more focused on NCR (67% of Gross Asset Value) & Bangalore respectively (74% of Gross Asset Value), while Mindspace is more diversified across 4 major cities.

Net Net…

REITs provide retail investors with an opportunity to diversify their portfolio but their limitations make experts advise caution to those who intend to invest.

REITs are interest rate sensitive. When interest rates are on an upward rate cycle, their cost of borrowing increases as they have to raise debt at a higher rate which will impact their profits.

In 2022, RBI gradually increased the Interest rate from 4% in early 2022 to current levels of 6.5%. The yields that REITs were offering (6-7%), were not attractive for the investors as the banks were offering above 7%. Hence investors shied away from REITs which trigged a 15-20% stock price fall across all three listed players last year. However, this may change as the interest rate starts to go down, and there could be a bump-up in REITs.

On a positive note, a new REIT fund sponsored by Blackstone – Nexus Select Trust is planning to enter the retail property space later this year which could add some zing to the whole industry.

In the future, because of limited stable fixed return options available to investors, REITs may become a meaningful component of an individual’s portfolio. NSE has announced the first-ever Reit + Invit (infrastructure investment trust) Index in India.

REITs are an exciting way to invest in real estate to participate in the opportunity of capital appreciation along with some regular income.REITS addresses the biggest challenge of a large surplus needed for investing in real estate and the illiquidity problem. Another advantage of REITS   is the non-correlation with other asset classes.

If one has a long-term horizon and is looking to build a REIT basket, it can be a good opportunity to accumulate slowly. However as discussed earlier, the latest changes in taxation where ‘repayment of loans’ (or return of capital) to the investor, will be taxed as ‘other income’ will make REIT less attractive to an investor.

It is an evolving investment option and going forward, one hopes that positive regulatory changes will help spur further growth in this sector.