Veeru was engaged in a heated political discussion with his friends at Nair's Tea Stall when Gabbar and Basanti found him looking all hot and bothered.
Gabbar: Veeru, let me get you some lassi. Take a chill pill and let's talk of something more useful like investments.
Veeru (grumpily): What do you want to discuss now? I thought I and Jai gave you the Ramayana and Mahabharata of mutual funds in our last emergency meeting.
Gabbar: No, no, I have something that you too may struggle with, Veeru bhai - REITs. Basanti just told me that she invested in the Embassy REIT IPO and has got allotment, too. It listed at just 4 per cent above offer price.
Veeru: Wow Basanti, you are a real HNI. I heard the minimum investment amount for the Embassy REIT IPO was Rs 2.4 lakh.
Basanti: Yes, it was. But I wanted to buy it because I felt it was better than buying plots of land, Veeru. I have so many plots in this town and they are so hard to protect from rowdies like Gabbar's friend Kalia!
Gabbar: Veeru, I am kicking myself for missing this IPO. Kalia was telling me that it will give an 8-9 per cent assured return every year and I can get big capital gains, too.
Veeru: I am not an expert on REITs, but I find that hard to believe. As far as I know, REITs invest in a bunch of properties, earn rent from them and distribute dividends out of the rental income to their investors. I have rented out my flat in Mumbai and I can tell you that the rent every year is peanuts - it's about 2 per cent of the property value. My friends in other cities also make the same return. Then how can an Indian REIT give you 8-9 per cent dividend?
Basanti: You are talking of rental yields on residential property, Veeru, which are quite low in India. But on commercial properties, rental yields are ruling at 6-10 per cent. That's what Embassy REIT (and most Indian REITs) will be doing - leasing out commercial property.
Gabbar: Hey, my mamaji also rents out shops, but the tenants give him so much trouble every month. He keeps sending me and Kalia to collect his rent money. REITs must be facing the same problem, isn't it, Basanti?
Basanti: Very funny, Gabbar. No, REITs operate on a much larger and more professional scale than your mamaji. For instance, Embassy REIT owns 75 office buildings across Bengaluru, Mumbai, Pune and Noida, which have 33 million square feet of space. It earns rent by leasing out these super-posh buildings mainly to MNCs like Google, Microsoft, IBM and Accenture. Your mamaji may have to struggle for good tenants and negotiate all day for rent increases. But there's a shortage of good-quality office space in India. The Embassy REIT has a 95 per cent occupancy and is able to lock into long-term lease contracts with rent increases of 10-15 per cent every three or five years.
Gabbar: But all this is very different from the normal IPOs I invest in. I may get dividend from the rent that the REIT earns, but where will I get my capital gains?
Basanti: REITs are required to get their property portfolio valued from time to time and calculate their NAV. So, if the price of the commercial property that the REIT holds appreciates in the market, then you too will get capital appreciation on your NAV, Gabbar. The NAV will also be affected by any purchases or sales of property and the borrowings made by the REIT. The Embassy REIT, for example, calculated its NAV as Rs 376 per unit and sold its IPO at a discount - Rs 299-300 per unit.
Gabbar: That's good, but I know how slowly property prices go up, Basanti. So, I feel we mustn't expect big capital gains from REITs, like the ones we get from shares or equity funds.
Basanti: You are quite right, Gabbar. In the last three years, commercial-property prices in India have appreciated quite a bit. So, some advisors marketing Embassy REIT are projecting a 4-5 per cent capital appreciation every year, along with the dividends. But who can predict property prices? And those returns will certainly not happen in a straight line, Gabbar.
Gabbar: Yes, better not to count any chickens before they hatch. But who is the regulator for these REITs to take care of investors?
Basanti: SEBI is the regulator. REITs have a three-tier structure which is a lot like that for mutual funds, Gabbar. Every REIT has a sponsor, who promotes the REIT. Sponsors in India are mostly likely to be real-estate companies or private-equity investors who have commercial property that they want to park in the REIT. The investment manager of the REIT, like your mutual fund AMC, manages its portfolio. Fund managers hired by this AMC make decisions on buying or selling property, entering into rental agreements and overseeing the maintenance of the property. They earn a fee for this. Just like a mutual fund, there's a trustee whom the AMC reports to in order to make sure that investor interests are protected.
Gabbar: REITs may need to buy and sell property often. But in India, projects suffer such long delays and the money gets stuck with the developer...
Basanti: To reduce that risk, SEBI rules require REITs to invest at least 80 per cent of their portfolio in completed and rent-earning properties. The rest can be in under-construction properties, bonds and shares, etc. Plus, 90 per cent of the cash flows earned by the REIT have to be compulsorily distributed to its investors every six months. REITs have to appoint independent valuers to assess the NAV of their portfolios.
Veeru: I feel calculating NAV for REITs is a very tricky thing. In stock markets, all transactions happen on the exchange and so anyone can check the price of a Hindustan Unilever or ITC. But with property, prices vary a lot between one locality and another. Transactions happen at widely differing prices within the same locality, too. Better to treat the REIT NAV as a guesstimate.
Basanti: Quite right. That's probably why the market price of Embassy on listing was still at a discount to its NAV. In developed markets, people buy REITs for regular income and not for capital gains.
Veeru: Incidentally, in the real-estate business, there's so much wrongdoing. So, what safeguards has SEBI put in to avoid these sponsors ripping off investors?
Basanti: Sponsors are required to eat their own cooking. At least 25 per cent of REIT shares have to be held by the sponsors for the first three years. Sponsors also cannot vote on related-party deals. The REIT cannot borrow more than 49 per cent of its asset value. Plus, whenever the REIT wants to sell property exceeding 10 per cent of its portfolio, it needs the approval of its unitholders. The board of directors of the investment company needs to have at least 50 per cent independent directors.
Gabbar: So where did Kalia get that 8-9 per cent dividend that he was mentioning?
Basanti: That may be overstated, Gabbar. Based on the rents and other income they are receiving, Embassy has projected a distributable cash flow of Rs 1,910 crore in FY20. That comes to about Rs 24.75 per unit, based on the 77 crore units that they have outstanding after the IPO. On the offer price of Rs 300, that works out to an 8.25 percent yield. But there can be additional expenses and interest payouts that reduce the return in the hands of investors.
Veeru: Also remember that rents are not as predictable as interest on bonds. What if the REITs tenants don't renew their lease and move out? Or if too many posh offices come up and reduce the rent?
Basanti: Yes, the dividend from a REIT is not as fixed as the interest on a bank FD.
Gabbar: What about taxation? Do I get indexation benefits like debt funds?
Basanti: No, dividend income from REITs is tax-free, but if they distribute rent or interest, that is taxable at your slab rate. Basically, REITs are pass-through vehicles. So, if they receive something as 'dividend' from their special-purpose vehicles holding real estate and that is passed on, it doesn't get taxed with investors. But if they directly own property or investments and receive rent or interest, that gets taxed with the investor.
Veeru: But all this seems to be a lot of complication for a FD-type return, Basanti! Why did you invest in it then?
Basanti: As I told you at the beginning, it's just a substitute for my real-estate investments. If I was buying property on my own, I would have to put a lot of my money in one piece of land. This helps me invest in real estate with as little as Rs 2.4 lakh and also get diversified exposure to multiple commercial properties which I can never buy on my own. If I get a regular income of 6-7 per cent and can sell it with a small gain, I'll be happy.
Veeru: Yeah, that was something I wanted to ask you. Buying a REIT in an IPO is easy but how do you exit the investment?
Basanti: Through the stock market, Veeru. The REIT units will be listed and will hopefully trade around the declared NAV, so I can exit them when I want.
Gabbar: We need to see how many people understand this new animal and buy it on the stock exchange. It may not be as actively traded as normal shares surely.
Veeru: Well said. I feel that REITs are fine for real-estate tycoons like our Basanti. But for ordinary people like us, it is best to wait and see how the first REIT IPO performs before we take the plunge.