This is a guest post by Ruchik Chauhan. He is an analyst and a content specialist on topics like investing, ESG, equity research, and finance. He holds a B.S. from Purdue University and an M.B.A from Babson College. You can connect with him on LinkedIn.
Gold and real estate have traditionally been the two most popular asset classes for Indian investors. The real estate sector has received plenty of bad press lately as it goes through a major downturn. Some commentators suggest that right now is possibly the best time to invest in real estate. Others point to all the risks and negatives of investing in real estate. Amidst these debates, something significant happened in April 2019. India’s first REIT listed on the stock exchanges. What kind of an asset class is an REIT? Who should invest in it? How to evaluate an REIT? And most importantly, should you invest in REITs?
What are REITs?
Real Estate Investment Trusts (REITs) are investment vehicles with a similar structure to mutual funds. They own a portfolio of income-generating properties like commercial buildings and office parks. The sponsor or the investor of the REIT initially creates the trust and transfers ownership of the properties to the REIT in exchange for units.
The sponsor holds a certain minimum percentage of the total units while the rest are traded on the stock exchange. Investors like you and I can hold the REIT units just like we can hold mutual fund units. REITs are managed by a fund manager, who makes investment decisions, and a trustee who acts on behalf of the unit holders.
REITs can generate income for investors in three ways:
First, it is required to distribute at least 90% of its net operating income (rents minus the expenses to manage the properties) as dividends. The rental income that REITs generate depends on the occupancy levels, the location of the properties, the quality of construction, and the efficiency with which those properties are managed. The dividend payouts can rise if rental rates rise or if the REIT builds additional properties and leases them out. More rent equals more dividends.
Second, an REIT can distribute interest income that it earns on loans given out to its subsidiaries. Most REITs do not own properties directly. Instead, they hold stakes in special purpose vehicles which, in turn, directly hold the properties. REITs can lend money to these SPVs for constructing or managing a building and the SPVs then repay those loans back with interest to the REIT over time.
Third, the price of an REIT’s units can rise (like stock prices) and result in capital gains for the investor. The capital values of properties that an REIT controls can rise over time. Higher rental incomes due to escalation clauses or the on-boarding of new properties can also lead to a re-rating of an REIT unit’s price. Interest rates also play a part as falling interest rates can push down the yields through price appreciation (similar to bond prices).
Who should invest in REITs?
REITs can be considered a hybrid investment class. They have the characteristics of both equity and debt. Since it is mandatory for REITs to distribute 90% of its net distributable income, they provide a steady stream of regular assured income. Income investors are a good fit for REITs.
Investors who want portfolio diversification are also good candidates for REITs. Historically, in the US market, the REIT-stock correlation has varied between 0.2 and 0.8. So, REITs do not move as closely with equity as other investment options like ETFs and mutual funds. With long-term leases and rent escalation clauses, the income from REITs is less volatile than that of many popular asset classes. A certain percentage of the debt portfolio can certainly be made up of REIT holdings.
REITs also make sense for those investors who wish to participate in the real estate sector without having massive budgets or having to deal with some of the major risks that Indian real estate comes with. Firstly, REITs allow individual investors a chance to earn rental income from Grade A properties (worth crores) with a budget of only a few thousand or a few lakh rupees. Secondly, REIT units are a lot more liquid than physical property. You can sell a part of your REIT holding or all of it with just a few clicks. There is no need to hire a broker and negotiate for months. Buying and selling is quite straightforward.
How to select the best REIT?
Currently, there is only one REIT listed in India. It is called Embassy Office Parks. Therefore, there isn’t much selecting to do. However, in the future, there may be more REITs coming up. If you were to evaluate a REIT, you need to analyze a few things.
Firstly, you want to know who the sponsor of the REIT is. The quality of the developer is perhaps the most important factor in any Indian real estate decision. A blue-chip or brand name developer is more likely to complete construction on time and deliver buildings with a high quality of construction. Timely completion of construction increases rental income while delays impact earnings.
Secondly, you want the properties to be leased by high-quality tenants. Blue-chip and MNC tenants reduce the credit risk or the risk of rent default. They are also more likely to fulfill long-term leases. A longer tenure lease adds greater rent visibility into the future.
Thirdly, you want to see high occupancy rates across the properties being managed by the REIT. This will happen if the property is well-located and well-managed. High occupancy rates lead to more rental income and more dividends. Locations with an oversupply (or future oversupply) of commercial properties or properties which are not professionally managed can reduce the rental growth rates and occupancy rates.
Fourth, low-to-moderate concentration risk is preferable. Concentration can either be a geographical concentration of properties or tenant concentration. You ideally want to see a portfolio of properties across multiple cities rather than a property in one micro-market making up a majority of the REIT assets. You also do not want a single tenant making up a vast chunk of the total rental income.
Why is there only one REIT in India?
REITs were, in fact, introduced in India in 2014. However, it took 5 long years for the first REIT to list on the stock exchange. The lack of investor familiarity with such an investment vehicle and the lack of a responsive regulatory framework may have been a couple of reasons for this delay. SEBI’s original REIT regulations have gone through 5 different rounds of amendments since 2014. The latest version of regulations has ultimately paved the way for multiple REITs to come in. Some of the key amendments made in regulations were:
– Allowing REITs to issue debt securities
– Dropping the minimum revenue threshold for rent from 75% to 51%
– Minimum sponsor holding post-issue dropped from 25% to 15%
– Maximum proportion of the total investment for under-construction properties increased from 10% to 20%
– The biggest amendment perhaps was the removal of DDT for SPVs. The previous tax regime levied a corporate tax and DDT whenever the SPV distributed income to the REIT
What is the future of REITs in India?
Besides Embassy Office Parks, there are many other REITs expected to list on the market in the near future. One can expect the larger players to list their properties as REITs. Some potential candidates include Prestige Estates, RMZ Corp, K Raheja-Blackstone, Panchshil Realty, and Godrej Properties. In fact, K Raheja-Blackstone has already filed documents for an IPO planned this year. So, you should see India’s second REIT come out in the near future.
Smaller developers may find the regulatory and compliance requirements to be very high and may not list REITs anytime soon. The purpose of listing an REIT, from a developer’s perspective, is to monetize the income-generating commercial real estate. Smaller developers can monetize their assets by opting for loans via rent-discounting instead of going for an REIT.
In developed markets around the world, REITs make up a significant portion of the total real estate market capitalization. For example, in the US, REITs make up 96% of the total real estate industry’s capitalization. In Singapore and Japan, that number is around 50%. Therefore, there is no reason why REITs cannot become a significant investment class for investors in India. Anarock Capital estimates that 150 million sq ft of grade A commercial space can potentially get listed as REITs within the next three years.
So what can investors do?
REITs are definitely a great stabilizing asset class to be in. They provide regular income and an easy way to make a play in the booming commercial real estate market of India. When compared to purchasing direct real estate, there are plenty of benefits for participating in REITs like asset diversification, low construction risk, higher liquidity, high-quality tenancies, long leases, professionally managed properties, and so on.
The Embassy REIT has outperformed the Nifty50 over the last 10-11 months. The REIT has also outperformed comparable real estate stocks with the exception of Prestige Estates. The chart above does not take dividends or interest income into account. If we add those distributions made to unitholders over the last 2 quarters, then the returns would be higher.
However, the taxation angle should also be studied before making any investment. This is especially true after the recent changes in the 2020-21 budget regarding dividend distribution tax. Until now, DDT was not levied on the SPV, the REIT, or the unitholder. Now, the unitholder will be subject to DDT. The amount of tax will depend on your tax slab. So, investors with incomes below certain thresholds could still benefit.
I believe investors can wait for the K Raheja-Blackstone Mindspace REIT to list before making any REIT investments. Having two options to study and compare can help you make a better investment decision.
Holding multiple REITs is also a good idea as it can diversify the risk. It will be interesting to see what kind of yield the Mindspace REIT offers, especially after the changes in the current budget. Dividend payouts would be expected to go up, but given the fact that Embassy’s REIT is currently trading at sub-5% yields, the Mindspace REIT may be priced more aggressively by K Raheja and Blackstone. Let’s wait and see.
