Should you Invest in REITs?

The advent of Real Estate Investment Trusts (REITs) in India has been greeted with a lot of enthusiasm by many market players. Real estate consulting firms have welcomed the move, hoping it will provide $20 billion in funding to the sector over the next 5 years. Wealth managers are happy about soon having a brand-new asset class to peddle to their clients. And stock markets are optimistic that cash-strapped realty companies can now 'monetise' their commercial property assets.

True, REITs over the last twenty years, have been quite a hit in developed markets. Globally, REITs are now present across 30 countries, manage over $1 trillion in assets and account for a fifth of all property market transactions. With global markets recovering from the US housing crisis of 2008, REITs have delivered a 10 per cent annual return in the last five years.

But what's a great investment vehicle for global investors isn't always a superlative option for Indians. So before pulling out their chequebooks, investors must gain an understanding of REITs as they will operate in the Indian markets and how they will stack up on returns, safety, liquidity and taxation. Here is the analysis.

Safety
It is comforting to know that REITs in India will be regulated by SEBI, one of the more proactive Indian regulators.

This is especially so because the sponsors who will come forward to manage REITs are not likely to emerge from the traditional Indian mutual fund or insurance companies, but from the corporate and real estate sectors. One would hesitate to accord the Indian real estate sector high marks on corporate governance. For one, it is well -known that most real estate transactions are subject to a grey market component due to the incidence of stamp duty. And most property deals, unlike those for stocks and bonds, take place behind a veil of opacity. Two, given the nexus between real estate and politics, and the multiple approvals needed to launch projects, the sector is riddled with corruption too. These are precisely the reasons why many Indian mutual fund houses are wary of launching REITs, though SEBI has thrown open the asset class.

But having said this, SEBI has put in place three safeguards in its new REIT regulations to protect your interests. One, all REITs are required to register with SEBI; thus allowing it to weed out non-serious players or those with a doubtful governance record at the very outset. Two, the investment restrictions on REITs (80 per cent in completed property, 90 per cent dividend payout, investments in at least 2 projects, approval for related party deals and so on), put in place a basic governance structure to prevent mis-utilisation of funds. Three, REITs are required to start off with a minimum asset size of ₹500 crore which is already invested into identified property assets. What is more, the sponsors are required have their own 'skin in the game' by investing 25 per cent of the initial corpus. Disclosure requirements such as the filing of a prospectus, financial statements and half-yearly NAV calculations by an independent valuer, usher in some transparency into the vehicle.

Given the nature of the market itself, whether these regulations deliver good governance in practise remains to be seen. Until then, investors will have to exercise considerable due diligence on the sponsors of the upcoming REITs.

The regulatory aspect apart, how safe will REITs be in terms of the volatility of returns? Because they will own a diversified portfolio of properties, they may turn out to be safer than direct bets on land or property. After all, these properties are also to be selected and regularly monitored by expert professionals. The requirement that REITs pay out regular dividends from completed, income-generating properties also reduces risks to investors as this ensures a minimum return.

But this is not to say that REITs will not suffer from any NAV volatility. Though most Indian investors seem to believe that property prices head only one way (Up!), that's not really true. In fact, the commercial sector (malls, office space, multiplexes), which REITs will focus on, has been far more sensitive to the economic downturn than the residential sector. A study by FICCI jointly with real estate consulting firm Knight Frank, shows that while residential property prices in Chennai, Mumbai and NCR have appreciated by anywhere between 38 and 55 per cent from early 2009, office rents in the same markets are today below 2009 levels. Industry statistics also show that commercial property prices, which were at record highs in 2008, tanked sharply thereafter and even today languish 20-25 per cent lower than levels five years ago. The valuations of listed REITs, obviously, will reflect such swings in their portfolio value.

Returns
That brings us to the next aspect that will decide your interest in REITs-their returns. The investment portfolio specified for REITs shows that you will receive your returns from the REIT in two forms. One, you will receive regular dividends paid out from the rents or capital gains that the REIT makes on its properties. Two, you could make a capital gain if the price of your listed REIT unit appreciates on the exchanges. Of course, when the REIT's long tenure ends, you will also realise the gains that the holdings generate.

Now, the first aspect-dividends-are mainly a function of the rental yields (rent as a function of price) on the properties that the REIT owns. Rental yields for commercial property move up or down depending on factors such as the supply, absorption and the fortunes of user sectors such as IT/BPO, financial services and retail.

Presently, rental yields on good commercial properties in India average 9 to 11 per cent. But these yields vary widely based on location and the quality of the property. Assuming the REIT charges a fee of 2-3 per cent for managing these assets, the net returns distributable to investors by way of dividends will therefore be in the range of 6 to 9 per cent, before taxes.

Yes, REITs can bump up those returns by buying and selling property and making capital gains. But this may not be easy in a portfolio made up mainly of commercial properties. The commercial property market in India lacks liquidity; which is why large developers such as DLF, Unitech, Phoenix Mills and so on have found it difficult to sell commercial assets to reduce debt on their balance sheets. The prolonged downturn in the commercial market since 2008 has only aggravated this problem. Therefore, desi REITs, if they find high rent yielding properties, are more likely to hang on to them, rather than try and generate capital gains by 'trading' on prime assets.

As to capital gains to the investor from the listed units, the lack of valuation benchmarks for domestic property makes the situation complicated. Yes, REITs are supposed to get their assets valued by a third party even six months. But given that property prices vary so widely between different localities and swing sharply between one deal and the next, most property market experts admit that the calculated NAV for a REIT would be only a guesstimate, not a water-tight measure like the NAV of a mutual fund. Given that these NAVs would be disseminated only once in six months, the daily prices of REITs may deviate quite sharply from their book value.

These facts show that it will not be very easy for Indian REITs to earn double-digit returns. REIT managers who are particularly savvy in picking up prime properties at beaten-down valuations may manage it. But high valuations at entry or poor selection of property can very easily decimate returns too.

On this count, Indian REITs will have a far harder time attracting investors than their global counterparts. REITs in developed markets appear quite attractive to investors even with a 6-7 per cent income, because interest rates in those markets hover at 2-3 per cent. But Indian REITs will be attractive to investors only if they manage dividend income that is higher than bank deposits (9 per cent), small savings schemes (8-8.5 per cent) and debt mutual funds (historically 8-8.5 per cent).

However, investors must keep in mind that REITs dividends are not comparable to the others above because there is a separate capital appreciation component too. This means that the rental income will also likely be a percentage of the appreciating capital value in a good REIT, as rents escalate. In fact, REITs could actually turn out to be the best way to generate inflation-adjusted regular returns, which is a rarity in India.

Liquidity
With SEBI mandating all Indian REITs to be listed, investors can be assured of anytime exit by selling their units. The availability of six-monthly NAVs will also ensure a reasonable basis for price discovery. Therefore, REITs may offer far better liquidity than direct investments in property or plots. We all know how difficult it is to gauge the fair price, leave alone actually buy or sell property in India.

But you should bear in mind that REITs, despite listing, may be far less liquid than stocks or mutual funds, because of the very nature of their underlying investments. In the last five years, the supply of commercial space in key cities has far outpaced demand, leading to significant unsold 'inventory' of office and mall space and vacancies of 18-20 per cent. While this will create opportunities for newly launched REITs to acquire assets at attractive prices, exit from these assets is likely to prove difficult. The illiquidity in underlying assets can cause distortions in the traded price of REITs in the secondary market.

Further, though REITs are to be listed, the minimum lot for trading is at ₹1 lakh; the high outlay may restrict their trading volumes on the bourses. Given the close end nature of the vehicle, REITS may also trade at sizeable discounts to the NAV, based on market conditions. For instance, Singapore listed REITs (which include REITs sponsored by firms such as Ascendas and Indiabulls who are active in India) traded at discounts if anywhere between 25-30 per cent to their NAVs two years ago; with the markets recovering a few have now moved into a premium.

Taxation
The evaluation of any investment option cannot be complete without factoring in what you give away to the taxman. Going by clarifications in the recent budget, Indian REITs are likely to enjoy pass-through status on their taxation. Just like mutual funds, the REITs may therefore be required to pay no tax on their capital gains or rents earned from property. But there are other tax aspects to be unravelled before REITs can become as tax-efficient as say, equity funds. For one, while the REIT itself pays no tax, the entities or firms from which it collects rent will have to shell out taxes. Two, the world over, investors do pay taxes on the dividends as well as capital gains they make on their REIT investments.

That poses yet another challenge for the upcoming Indian REITs. Not only do they have to navigate the tricky commercial property market and compete with other ultra-safe investments on returns, they also have to deliver a good post-tax return to the investor, compared to long term debt funds, tax-free bonds and the public provident fund.

This article was originally published on October 28, 2014.