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Real Estate Mutual Funds: A Step Forward?

REITs have been designed not to create something investors are looking for, but to solve financing problems of real estate developers & banks that fund them


We are writing about a fundamentally new kind of fund. However, before we get to details of the structure of Real Estate Investment Trusts, as these funds are called, let's arrive upon a simple understanding of what they are and what they aren't. At their simplest, REITs are a real estate equivalent of equity mutual funds. In equity mutual funds, the investor can buy a diversified mutual fund and leave the actual investment management to the fund manager. The fund manager decides which stocks to buy and sell and when to do so.

In the above description, replace 'equity' with 'real estate' and 'stocks' with 'properties' and you have a REIT. Except, not quite. Equity mutual funds operate the way they do because stocks they invest in are traded actively in a liquid market, with high quality information about the underlying businesses widely available. And I'm sure you know well that none of this is true for real estate.

And therein lies the practical difference between mutual funds that you are used to as investors and what you will get when you start investing in REITs. Indians invest in real estate primarily for capital gains. Our standard model is to buy property and sell it opportunistically for capital gains. SEBI's conceptualisation of Indian REITs is that of the property investor who buys and holds, looking for rental income. While you can read our analysis from page 30 onwards, one pertinent question is whether this model find enough takers?

Well, one must say that the starting point of the design of Indian REITs is not to create something investors are looking for, but rather to solve the financing problem of real estate developers and banks that fund them. The finance minister actually made this clear in his budget speech. He said that REITs (and the similar InvITs, which will operate in infrastructure), “...would reduce the pressure on the banking system while also making available fresh equity. I am confident these two instruments would attract long term finance from foreign and domestic sources including the NRIs.”

That, frankly, is the government's motivation. They need to find a replacement source for bank funds that are stuck in real estate. The idea is that developers will use their own and banks' funds to create earning assets and then sell them to REITs, thus freeing funds for further projects. That's the need that the government is trying to meet. Do REITs fulfil a valid investment need for individuals? In my view it does, but not that of the property trader kind of person. Instead, they hold the promise of generating inflation-adjusted income. Unlike other types of income generating funds, REIT's rental income should escalate with inflation. That's a unique quality. One would expect that as REITs actually get going, a new category of real estate investors will start appreciating this quality.

There will be many pitfalls along the way, and much activity from the kind of con artists who infest the Indian real estate industry. But fundamentally I believe the creation of REITs are a step forward for the Indian investor.