Our Fortnightly Real Estate Commentary: March 2019

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I. All you need to know about REITs, whether to invest, expected returns and tax on returns


  • Though REITs are less volatile, there is no historical data for comparison in India

  • REITs shall be tax exempt except the interest income received from the SPV and rental income from property owned directly by REITs

What are REITs?


REITs are securities linked to real estate that can be traded on stock exchanges once they get listed. The structure of REITs is similar to that of a mutual fund. Just like mutual funds, there are sponsors, trustees, fund managers and unit holders in REITs. However, unlike mutual funds, where the underlying asset is bonds, stocks and gold, REITs invest in physical real estate. The money collected is deployed in income-generating real estate. This income gets distributed among the unit holders. Besides regular income from rents and leases, gains from capital appreciation of real estate also form an income for the unit holders. REITs provide all investors the chance to own valuable real estate and earn dividend based income and total returns.


Backdrop


REITs have been in the making for more than a decade in India, but it was only in October 2013 that a draft guideline was issued by the Securities and Exchange Board of India (Sebi). However, lack of clarity on the tax implications on the income earned and some other related aspects were holding back the instrument from becoming a reality. Though there was some movement in the 2015 Budget to overcome the issues, lack of clarity on a few things still remained. In the last few years, several amendments were made to make REITs more attractive. In the latest amendment on 1 March 2019, Sebi reduced the minimum investment limit in REIT to Rs. 50,000 from Rs. 2 lakh.


Should you invest?


Real estate as an asset class has always attracted investors, but the high ticket size made it out of reach for many. Investing in grade A office space or prime real estate location is out of the question even for many wealthy individuals. But REITs can provide an option to the retail investors to invest in high end commercial real estate, as the minimum investment has been kept very low. Investment in commercial real estate is a highly capital intensive affair. REITs are a very viable addition to investment portfolios as they allow investors to participate in an asset class previously reserved only for the affluent few.


After recent amendments in the REIT regulations, rating agency ICRA Ltd stated in its press release, Current investment avenues for retail investors in income generating infrastructure and real estate projects are limited due to high minimum investment requirements for Alternate Investment Funds (AIFs) and other pooled funds. Listed Infrastructure Investment Trusts (InvITs) and REITs can be a transparent and stable investment option for retail investors due to the various regulatory stipulations.


REITs Embassy Office Parks IPO Real Estate Sector:


India’s first real estate investment trust (REIT) is the first REIT initial public offering (IPO) by Embassy Office Parks, a Bangalore-based real estate developer backed by Blackstone Group LP, a global private equity firm, The Embassy Office Parks REIT plans to raise Rs. 4,570 crore through the IPO. The per unit price of the REIT has been kept in the range of Rs. 299-300, with the minimum application bid of 800 units. This means that an investor will have to invest at least Rs. 2.4 lakh in this product. Thereafter, one can increase the lot size in multiples of 400 units.


Since Embassy Office Parks REIT is the first REIT in India, there is no history of REITs performance or risks.


Once Embassy Office Parks REIT gets listed on stock exchange, it is expected that more REITs will follow. The listing and its subsequent performance would be closely monitored by various stakeholders viz developers, institutional funds, corporate houses, etc. A successful REIT listing might result in multiple offerings by various other sponsors, including office, retail, warehousing, hospitality etc.


Expected return


Typically, commercial real estate provides returns between 8% and 10% per annum. However, grade A office space and commercial space in prime locations can provide even better returns. The projected return on investments are anywhere between 8% and 14% in the short to medium term (post adjustment of the fund management fee), with minimum risks.


But one may need to stay invested for a longer period. As in any asset class, one needs to keep a long term horizon, and be patient in riding out the real estate cycles that do last long. Expectations in the current market would be of low to mid level double-digit returns.


Typically, commercial leases are of long periods like six or nine years or even more, with rent escalation clause. Experts believe that this make REITs less volatile than other investment avenues. REITs are far less volatile than the stock market, FDs, mutual funds and gold as regulations maintain that 80% of the REITs listings must be of rent generating assets.


Tax on returns


Before considering investments in REITs, make sure that you are aware of the tax ability on returns. According to Sebi rules, REITs are to distribute 90% or more of its earnings be it dividend, interest or rent to investors or unit holders at least twice a year. Such income received by the investor under the Income Tax Act, 1961, shall be treated in the same nature and the same proportion as it had been received or accrued. Thus, income received by the REITs in the nature of dividend, rent, interest and distributed to its unit holder shall be deemed as dividend/rental/ interest income, respectively, in the hands of the unit holder. Also, according to section 10(23FD) read with section 115UA of the Act, all the incomes received from REITs shall be exempt from taxation except the interest income received from the special purpose vehicle by the REIT and rental income from the property that is owned directly by the REITs. Largely, REITs will distribute most of their income in the form of dividend, which is tax free in the hand of the investor.


You need to have a demat account to invest in these products. Retail investors may need to wait till mutual funds begin to provide these products as a part of their offering. But that is at least a few years away


Returns on REITs accrue from yield as well as appreciation in the unit price. In Canada, average return on REITs was 10% in 2017, while in the UK, it was between 8-10% from a commercial and residential asset mix. In India,it could be higher. Note that commercial realty has withstood the challenges faced by the industry, and has fared much better than the residential segment.But, then, returns hinge on continuation of the upswing. During an upturn, lease rentals increase and so does demand for REIT units, which in turn leads to an increase in the price per unit.


Supply of A grade office space holds the key to sustainable investor returns.This apart, revenue of REIT companies might contract due to pre term lease cancellations or a drop in market rents. In large office complexes, though, property management expenses may not shrink in line with decrease in revenue, which would upset cash flows. This again may affect cash flows and dampen investor returns, which then can reflect on the unit price.Given that REIT returns over a three to five year period are estimated to surpass those from debt funds and fixed deposits, there should be adequate demand for theREITs. Of course, compared to fixed deposits, investors need to be willing to take slightly more risks as well.


Conclusion:


REITs are allowed to invest in residential real estate in most of the foreign countries. But in India, investment in this segment is not permitted. Whether one should put money in REIT depends on Investment Outlook. For aggressive investors, this may not be an attractive investment option. However, for the risk averse investors, it is a good option to place money.


II. Getting a piece of realty on paper (Source - The Hindu)


What is a Real Estate Investment Trust (REIT)?


A Real Estate Investment Trust or REIT is an investment vehicle that provides an opportunity to invest in various projects by only investing in the units of a sponsor entity that will manage the paperwork and may be, even the hindrances of investing in the real estate market. Look at it like a mutual fund through which you can invest small amounts and own units representing shares of various large companies. REIT will offer you an opportunity to own units of commercial real estate. The sponsor entity launches an REIT that owns the properties and then leases them to earn rental income, which is then distributed among the unit holders.


What are the benefits?


The biggest benefit is the ease of investment as investing in REIT is just like investing in direct equity that can be done through a demat account. The other big advantage is getting an opportunity to invest in commercial properties that will earn rental income. This is a significant advantage as commercial properties typically earn more rent than residential properties with built-in clauses of rent hikes at fixed intervals. Moreover, REIT regulations mandate the distribution of 90% of the rental income to unit holders. The remaining 10% can be used for business purposes. Also, since REIT is a publicly listed and traded instrument, liquidity should ideally not be a concern. Apart from the rental income, any increase in the value of units will also add to overall capital appreciation.


Are investors ready to accept REIT as an option?


If the response to the first ever public issue of a REIT is anything to go by, then there surely is a demand for such a product. The initial public offering of Embassy Office Parks REIT, which closed recently, was subscribed nearly 2.6 times with bids received for 18.35 crore units as against 7.11 crore units on offer in the price band of Rs. 299 to Rs. 300. Though the minimum application size was 800 units or Rs. 2.40 lakh, the non-institutional portion was subscribed more than three times that shows that there is indeed investor interest in REIT though there is no guarantee that forthcoming REIT offerings would see similar or better response from investors.


What are the risks involved in investing in REIT?


Every investment has an element of risk and REIT is no exception. A downturn in the real estate sector would impact rental income and also, capital appreciation. Rentals would also be under pressure if the real estate inventory is huge due to lack of demand.Also, real estate has been a preferred personal investment avenue for Indian investors for many years so most people would already have an exposure to the sector and increasing the exposure through REIT might not serve any purpose.Also, REIT in India is at a nascent stage and as the segment evolves, the regulatory environment could be tightened.Real estate sector also suffers from a host of litigation and compliance issues like title dispute, settlement of project affected people, environment clearance, state & central laws and political interference among others that can enhance the investment risks.


How are REITs taxed?


It is mandatory for a REIT to distribute 90% of its rental income among its unit holders.


This income will be added to the overall income of the investor and will be taxed at the applicable rates.


REIT also involves a tax deducted at source component that is 10% for resident investors and 40% for non-resident investors. Further, if a unit holder sells his/her REIT units on the stock exchange platform then capital gains tax would also be applicable based on the period of holding. If the units are sold after three years, then a capital gains tax of 10% along with applicable surcharge and fees would be levied. Selling REIT units within three years would entail short term capital gains tax of 15% plus surcharge and cess. The post-tax returns and capital appreciation will be the big factors in ascertaining whether REITs are here to stay.


Hope you enjoyed reading this edition of our newsletter.


Disclaimer:


The views of the authors/publishers should not be construed as advice. Investors must make their own investment decisions based on their specific investment objectives and financial positions and using qualified advisors as may be necessary. Opinions expressed in various articles are not necessarily those of Wealthmax Enterprises Management Private Limited(WEMPL) or any of its directors, officers, employees and personnel. Consequently, WEMPL or any of its directors, officers, employees and personnel do not accept any responsibility for the editorial content or its accuracy, completeness or reliability and hereby disclaim any liability with regard to the same. Stock picks and mutual fund snapshots are not exhaustive and should not be construed as recommendations.