- Wealth PMS
K Raheja Corp, a developer of residential and commercial complexes has come out with an Initial Public Offering for its REIT (Real Estate Investment Trust) called the Mindspace Business Parks REIT. This is only the second REIT to be listed in India, the first, by the Bengaluru-based Embassy Group, came out over two years ago. Embassy REIT- Worth it?
Short Answer: Mindspace Business Parks REIT has a strong portfolio of office spaces with marquee clients. However, at the offer price and recent performance, investors have to rely on future rental income growth to get favourable yield. We’d pass on this one for now.
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, if it directly owns properties: 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).
Read the rest of our primer on REITs
This chart helps explains the REIT structure
The REIT, through ownership of a bunch of Asset SPVs (Special Purpose Vehicles), owns office real estate in four cities in India. Wait, Asset SPVs?
Think of an entire office complex owned by a company. The developer creates the company and registers the ownership of the property in the name of that company. Now that company will collect rent, spend money on fixtures and maintenance, manage contracts and so on. When an REIT is formed, the shares of that company are then transferred to the REIT by the developer. (The developer in return gets units of the REIT as compensation)
Each SPV roughly corresponds to a project that was incorporated as an independent company at the time of launch. This is the similar to how the Embassy REIT is organised. The chart shows the REIT will own 100% of five Asset SPVs and 89% each of the other three.
The REIT will be managed by K Raheja Corp Investment Managers LLP. They are in effect fund managers responsible for monetising the office space owned by the REIT. All the SPVs are Raheja owned companies, one per project.
Where will the money go?
Of the ₹ 4,500 Cr being raised, Strategic Investors will put in ₹ 1,125 Cr. These are a combination of mostly US Funds (like Capital Income Builder) investing in real estate assets for fixed income, and sovereign funds (Singapore’s GIC Ltd)
Of the remaining, not less than 25% is for retail investors, and not more than 75% is for institutional investors.
The Mindspace Portfolio looks sound. Its sponsor is a pedigreed real estate developer. It has Grade A office spaces in four key office markets (Mumbai, Hyderabad, Pune, Chennai). It has largely MNC clients occupying its spaces, but are not dependent on any one or two clients. Their largest client, Accenture, contributes to 7.7% of gross rentals. They are at 92% occupancy, and they expect to collect almost all their rent for the quarters spent in lockdown. Their WALE (Weighted Average Lease Expiry) is 5.8 years which is how long their tenants are locked in for. Add to that most office leases in India are “warm shell”, meaning the tenant incurs most of the capex of fitting out the premises as per their specifications. This makes it less likely for tenants to up and leave.
It checks the qualitative boxes under “How to select a good REIT” in our primer.
But does that make it a good investment?
Here’s the cash flow projection statement:
Roughly ₹ 1,200 cr. is distributable in FY22, and for the first half of FY21, around ₹ 574 cr. is distributable. This is a projection we have to currently take at face value, assuming changed interest costs etc.
Post listing, 16.4 Cr outstanding shares will represent 25% ownership for the public. i.e. Assuming 65.6 Cr shares with claim on the distributable cashflow, this translates to:
There is a component of assumption here that rents escalate and they don’t see occupancy drop. The nature of the real estate yield means it increases every year going forward. However, we don’t know how much of this is taxable.
As an aside, given this is real estate, you could theoretically just apply the stated market value of ₹ 23,675 Cr to arrive at ₹ 360 market value / share. But if Mindspace needs to sell its properties in a liquidation, it is safe to assume it will receive far less. So that’s not a useful lens for an investor buying for the cash flows.
A part of the cash flows you will receive are tax free for you, but the rest is taxable:
Embassy REIT, the other competing REIT in the market, has a very different structure – most of its distribution is from loan repayment (about 60%), around 39% is interest, and only 1% of the distributed cash flow is dividend.
Given that dividend is taxed efficiently, this structure might end up becoming a very decent 7% post-tax return in two years, but that will change dramatically if they decide to take up the new tax structure (at which point dividends get taxed in your hands as income). This uncertainty and the lack of clarity on the elements of cash flow makes this more difficult to unravel.
Given current yield is not particularly exciting, there needs to be scope for improvement over the medium term for this REIT to look attractive.
For that Mindspace needs to earn more rental income.
Growth can come in two ways:
They have 92% committed occupancy and a WALE (Weighted Average Lease Expiry) of 5.8 years.
The Offer Document draws a confident picture showing 59% absolute increase in operating income at the end of three years.
Of the four levers for increasing income:
If these growth projections pan out, then the yield per share goes up to 7% and beyond. Add any share price appreciation and it starts to look really good. But…
There’s a good chance you’re reading this while you WFH (work-from-home). For some this will be more than just temporary.
Of course, it’d be naive to imagine companies are just going to empty out their offices permanently. Most homes, especially in our metros just don’t have the space to allow effective work from home. But until a tried-and-tested vaccine is available at scale, it’s hard to imagine companies committing to signing new leases in a hurry.
Also, with so much competing commercial space available, and around 20% of their leases ending in the next two years, they might see customers move to a lower cost competing office space, not only because of the Covid work-from-home, but also because rents may become much more attractive. There is some uncertainty now about how this pans out.
There’s additional uncertainty in the taxation of the elements of cash flow, which means we don’t know if 7% is pre-tax or post-tax. The yield would be attractive if post-tax, given the low levels of interest rates today.
At the offer price, we would give the Mindspace Business Parks REIT a miss for now. Going by the price fluctuation in the Embassy REIT, this one should give an opportunity to buy it a more attractive price at some point over the next few months.
Note: This market does tend to provide major opportunities on listing. If you’re a person looking to buy and flip on listing, then the fundamentals of the offer don’t matter. In that case, you should check for a lot of oversubscription and apply for exactly one lot (200 shares).
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