REITs DECODED: AN INVESTOR PERSPECTIVE
What are REITs?
Real Estate Investment Trusts (“REITs”) are companies that own, and often actively manage, income-producing commercial real estate like shopping malls, offices, hotels, and warehouses. Much like mutual funds, REITs give an investor the option of hassle-free, diversified investment without having to invest large amounts. In essence, a REIT pools in the resources of large number of investors and uses the lumpsum amount collected from the investors to buy real estate properties that would generate income. This income is then distributed among the investors or unitholders. REITs offer multiple avenues of income. Firstly, an investor gets dividend income from the rent received through their unit in the real estate. Secondly, there is scope for capital appreciation. When the market value of the property increases, it increases the value of the unit held by the investor. Lastly, REITs also provide for market arbitrage opportunities.
REITs could be of different types. Retail REITs own shopping malls and retail hubs. Residential REITs, on the other hand, own multi-family rental apartment buildings and manufactured housing. These REITs flourish in markets where home affordability is low; the high cost of single homes compels people to live in rental homes and increases the rent that a landlord can potentially charge. Similarly, there are Healthcare REITs and Office REITs that own or operate hospitals and office spaces respectively. Lastly, some REITs also invest in mortgages. Such mREITs buy loans where real estate has been given as security to earn interest. In order to determine which REIT an investor should entrust their money in, it is important to scrutinize the portfolios of the REITs to check what properties they hold, where the money would be invested, the extent to which those properties are occupied, which companies come within their clientele and the portfolio of investors.
REITs are regulated by the SEBI (Real Estate Investment Trusts) Regulations, 2014. According to the investment conditions and distribution policy laid down in the regulations, at least 80% of the value of the REIT assets should have been invested in completed and rent and / or income generating properties. This means that REITs do not make large investments in properties that are under construction or would potentially generate income in the future. Additionally, not less than 90% of net distributable cash flows of REITs are required to be distributed to unitholders. Since investments are directed at readymade, revenue-generating commercial properties and the benefit of the income has to be necessarily transferred to the unitholder, it significantly reduces the risks of an investor.
REITs as an Emerging Concept in India
REITs are a relatively new concept in India. Indian REITs perform a facilitative role in establishing a system involving the trust, its stakeholders, SEBI as well as the auditors and appraisers. The key stakeholders of a REIT are the sponsor, trustee, manager, unitholders and the independent valuer. The sponsors, typically a real estate developer owning commercial real estate, create a trust that usually owns a portfolio of properties meeting a minimum value threshold. The sponsor appoints a trustee who holds the assets on behalf of the unitholders. The trustee cannot themselves hold units in a REIT and are supposed to act in the interests of the unitholders. The trustee, in turn, appoints a manager who manages the REIT assets and is in charge of making investment decisions. They are responsible for the efficient and prudent management of the assets and operations. A REIT is independent of its sponsor and managers. The unitholders or investors are the ultimate beneficiaries who subscribe to the units of the REIT and indirectly hold the REIT assets. The valuation of the REIT assets is done by a credible independent valuer who periodically values the assets of the REITs.
Though REITs have been adopted as an arena of investment rather slowly in India, it is emerging steadily as a formalized concept. Ever since SEBI has effectuated the REIT regulations and has brought about favorable changes to promote such investments, REITs are becoming increasingly popular. It is anticipated that many real estate companies will enter the REITs market in future. Currently, India has three REITs – Embassy Office Parks REIT, Mindspace Business Parks REIT and Brookfield India Real Estate Trust. Since the REIT market in India is still in a developing stage, the expected distribution yields of these REITs fall within a range of 6-9% starting from the financial year 2022 to 2024 along with a capital appreciation of 12-18% according to a report by ICICI Securities Limited.
Drawbacks of REITs
While REITs are a promising and lucrative domain for investment, there are certain drawbacks that an investor must also be mindful of. Firstly, from an investor standpoint, REITs do not offer any scope for tax savings. Rental income obtained from REITs are completely taxable in the hands of the investor and are taxed according to the slab rate applicable to the investors for the given financial year. REITs withhold tax as applicable to the investor depending upon their residential status and the slab rates.
Secondly, the capital gains from sale of REIT units are also taxable depending upon whether they are a long-term capital gain (LTCG) or a short-term capital gain (STCG). STCG tax is applicable when the holding period is less than 3 years at the rate of 15% of the gain obtained from the sale of the units. When the holding period is 3 years or more from the date of allotment of the unit, LTCG taxation rules are applicable and a lower rate of 10% is chargeable. REITs are also sensitive to interest rates. For example, if RBI increases interest rates to tighten up spending, REIT prices fall.
Lastly, REITs also have property specific risks. For example, during the pandemic, malls were completely shut during the lockdown period. Even when the lockdown was gradually lifted in phases, the footfall in malls were relatively low due to general reluctance among people as a natural consequence of the pandemic. As a result of stores shutting or rents getting deferred, the income of a REIT operating a mall naturally declined.
Why Should a Person Invest in REITs?
Real estate is often considered a dangerous class of assets for the purpose of investment due to information asymmetry in the sector and the size of investment that is required. Further, it is relatively less liquid as compared to shares or mutual funds. It is difficult to sell a property and not only look for a buyer but also ensure that the property is sold at the best possible price. Over and above, the transaction costs are fairly high since the stamp duty, registration charges and capital gains tax have to be borne by the parties. REITs rules out all these problems that occur while investing in real estate directly.
REITs are an indirect way of investing in real estate as opposed to directly entering the real estate market by buying a property. They pool in investment funds; they are managed by professionals and are monitored by a regulatory body. The advantage of this is that an investor can hold a stake in the most expensive real estate properties with minimal investment. For example, a property in Chanakyapuri, Delhi may have a market value in crores. For an investor wishing to invest INR 10 lakh in real estate in the Delhi/NCR region, holding a property in Chanakyapuri may not be a feasible option. However, if they invest through REITs, their money will be pooled in with other investors and they would also be able to indirectly invest in expensive real estate in prime locations.
REITs enable investors to diversify their investment. Using the example above, an investor willing to invest INR 10 lakh need not channelize the entire amount to invest in a single real estate. REITs often hold a portfolio of properties and an investor can use the amount to invest it in parts in various locations. Thus, REITs are a very efficient way of investing in real estate. An investor does not have to engage in the logistical technicalities, decision-making and legal work associated with direct investments.
Besides, with SEBI’s new regulations, REITs have become even more small-investor-friendly. Recently, the minimum application value for REITs was reduced from INR 50,000 to the range of INR 10,000-15,000 and the revised trading lot was made one unit. The reduction in minimum application amount not only allows for greater participation from newer pools of investors but also brings in more liquidity for the REITs market and makes it at par with other equity options in India. Above all, SEBI ensures that the interests of the unitholders are safeguarded.
The Indian real estate market, in general, is known for its lack of transparency. It may be extremely difficult for an investor to benefit from a potential arbitrage opportunity due to asymmetric information and predictability. However, while there are certain drawbacks, since REITs are overseen by SEBI and the regulations are drafted to protect the interests of unitholders, any risks due to poor regulation or misuse of information is substantially mitigated. In a nutshell, REITs are an attractive asset class for long-term growth and stable income. With more players entering the market soon and REITs becoming increasingly popular, REIT investments may see significant growth in the near future.