This blog was originally published in April 2021. We are republishing it for the benefit of our newer subscribers .
This is the first of our three-part series on how Real Estate Investment Trusts or REITs work in India. This article introduces the product class and talks about how they work and what to expect from them. Subsequent articles will talk about how to analyze them, and how they are taxed.
Real Estate Investment Trusts, also known as REITs, are attracting quite a bit of attention lately from Indian investors, who have a known fetish for real estate. Can REITs deliver land-like capital gains, while saving us of the concentration risks and the high maintenance required in property investments? Can they substitute for equities or mutual funds in one’s portfolio, in terms of wealth creation?
The answer in short is no, but this product has other uses. REITs are hybrid assets that cannot substitute for either equities or property in your portfolio. Yes, they can be acquired in byte-sized lots like shares and offer far better divisibility and liquidity than real estate. But their very structure makes them more suitable for regular income generation than outsized capital gains.
Now that three REITs have successfully completed IPOs and now trade on the stock exchanges – Embassy Office Parks REIT, Mindspace Business Parks REIT and Brookfield India Real Estate Trust – here’s a deep-dive into why we think REITs ought to only occupy a place between stocks and bonds in your portfolio.
What are REITs?
Before we get into the world of REITs with its truckloads of jargon, it is useful to understand how they work in India.
Globally, REITs are pooled investment vehicles that own, operate and finance income-producing real estate assets. Like mutual funds own stocks, REITs own a collection of real estate assets in a portfolio. Units in this portfolio are then sold to investors through a public offer. Once the REIT lists, unitholders can buy or sell the units at the traded price in the secondary market.
The key difference between a REIT and a mutual fund, is that while mutual funds aim at returns mainly through appreciation in the prices of the shares or bonds they own, REITs try to deliver most of their returns by way of income distribution. This is why REITs generally invest in rent-producing apartment buildings and office blocks, to hotels, malls, medical facilities, warehouses and even data centers. REIT returns are usually expressed in terms of yield and compared to government securities or bonds, rather than equity shares.
How REITs in India work
The Indian real estate market has certain peculiarities. This leads to certain unique features for Indian REITs, partly driven by SEBI regulations and partly by investor preference.
- SEBI requires REITs in India to have a three-tier structure like mutual funds. The sponsor sets up the REIT, the manager runs the portfolio and the trustee is supposed to watch over both, to ensure there’s no funny business. Embassy Office Parks REIT, for example, has the Blackstone group and the Bangalore-based Embassy group as its sponsors, Embassy Office Parks Management Services as its investment manager and Axis Trustee as its trustee.
- The sponsors transfer an initial portfolio of real estate assets to the REIT. To ensure that the sponsor does not extract an unfair price, the transfer has to be based on an independent valuation. SEBI also requires sponsors to have skin in the game, by holding at least 25% of the REIT’s units for three years after the IPO and 15% after that.
- The investment management company is responsible for your REIT returns. It buys or sells assets, gets the assets independently valued and audited, negotiates rental agreements with clients and makes sure the assets are well-maintained.
- For the above services, Indian REIT managers charge a percentage fee usually broken up into two components – a fund management fee and a property management. The manager of Mindspace REIT in India, for instance, charges 3.5% of rent as property management fees and 0.5% of distributions as fund management fee.
- To ensure that doubtful entities don’t promote REITs, sponsors need to have a minimum net worth of Rs 100 crore and at least 5 years of experience in the real estate industry. Managers need Rs 10 crore net worth and five years’ experience.
- REITs list on the bourses through an IPO process that is very similar to ordinary shares with a thick offer document, a book building exercise and fixing of a cutoff price.
- The minimum application size for a REIT in an IPO is Rs 50,000 and the minimum trading lot in the secondary market is 100 units.
- Once listed, REITs trade based on their expected distributions and the Net Asset Value of their portfolio. REITs do not calculate or declare NAVs on a daily basis and are declare them every six months. Note though that real estate valuation is a less precise science than stock or bond valuation and different valuers can arrive at different prices for the same property.
Where they invest
One of the biggest risks in real estate investing for Indians is that the developer can simply drag on the project for years, while swallowing up your money. A lot of property transactions also involve a ‘black’ component. To prevent REITs from getting saddled with these problems, SEBI regulations specify the following.
- Indian REITs can only own constructed commercial property. They cannot own vacant land, agricultural land or mortgages.
- At least 80% of a REIT’s portfolio by value needs to be invested in completed and rent-generating properties.
- The remaining 20% can be in under-construction properties, listed or unlisted debt of real estate companies, listed or unlisted equity shares of real estate companies, mortgage-backed securities, g-secs and money market instruments.
- 51% of the REIT’s revenues should be from should be from renting real estate.
- Where REITs invest in property via SPVs or through a holding company that has SPVs, their ultimate holding in the SPV should be at least 26%.
- When a REIT sells or buys property amounting to 10% of its portfolio, it needs unitholder approval.
- Real estate firms usually get into hot water by over-borrowing. Indian REITs are allowed to take leverage only up to 49% of their total assets.
How they distribute returns
REITs make three kinds of returns.
- One, they receive rents from the commercial properties they’ve leased out.
- Two, they receive interest payments from their subsidiaries or SPVs which they have funded to develop property.
- Three, when market prices for the properties they own rise and this is captured in their NAV, they deliver capital appreciation. But market prices of REITs can run ahead or behind their NAVs, based on the market’s estimate of their income and potential.
Unlike companies or MFs, REITs can’t sit on the cash flows they earn in the hope of future capex. SEBI rules require REITs are required to distribute not less than 90% of the cash flows that they receive every year to their unitholders. These distributions are mandated once in every six months. Some REITs like Embassy however have committed to quarterly distributions. Where the REIT sells any property, it must reinvest the cash in other rent-generating properties within a year, failing which it must distribute 90% of it to unitholders.
What decides returns
Once you understand the REIT structure, its quite easy to figure out what decides its returns:
- The total commercial property that the REIT owns and additions in the pipeline. This decides its total revenue.
- The mix of assets between office space, malls, hotels etc. While residential property in India offers rental yield of just 2-3%, prime office property can generate 9-10% and malls 8-9%. This will decide its operating income.
- Quality of clients – the more Fortune 500 companies, MNCs and global IT firms on a REIT’s tenant list the more visible its revenues.
- Occupancy & commitment – the higher the occupancy at a REIT’s existing properties, the better the rent and prospects of renewing leases. Similarly, the longer the period of lease committed, the better the visibility.
- Acquisitions or sales – acquiring attractive rent-yielding assets and selling sub-par ones can bolster a REIT’s future revenues and incomes. But the price paid for acquisitions is key.
- The amount of fresh equity and debt it takes on to fund expansion.
- Rent increases for existing clients and for renewals. Higher the bump-up in rent, better the revenue and income growth
- Maintaining commercial property in pristine condition to earn high rents entails operating and capital costs. Borrowings for improvements or acquisitions carry interest costs. REITs also shell out property insurance premium and property taxes. How much income a REIT manages to retain after all these costs, decides its distributions.
- Distributions to unitholders are also net of the property management and fund management fee charged by the REIT.
- Commercial property price trends, based on the demand-supply equation in the micro-markets where a REIT is present, general economic trends and exogenous events (like Covid) that impact demand for commercial space, decide the capital appreciation you can hope for from a REIT’s listed units.
- Finally, REIT taxation is a complex thing and the tax incidence on various kinds of REIT returns decides how much you as an investor get to pocket from your REIT holdings. Read this article, ‘What has changed with REIT / InvIT taxation‘ to understand how REITs are taxed.
Where they fit in
Overall, the above explainer should tell you that Indian investors should not look at REITs as a replacement for investing in land or apartments. While most investors buy real estate for its long-term appreciation potential (which it sometimes delivers and sometimes doesn’t), REITs are designed to merely deliver regular income that keeps up with inflation. Unlike bonds, REITs are good vehicles to protect against inflation because rental values in an economy usually keep up with inflation. However, REITs are also riskier than bonds from high-quality issuers because their income distributions are subject to their own earnings and the capital values captured in their NAV can go up or down. The below are the REITs listed as of January 2024.
While this article gave you an introduction of how REITS are structured in India, the next two articles in this series will tell you how to analyze their financials and how they are taxed - how to choose the best REIT and how REITs are taxed. This article, 'What has changed with REIT / InvIT taxation' will tell you how the taxation of REITS was changed in 2023.
Further reading on related topics from our archives: Prime Review: Kotak International REIT FOF NFO – Should you invest? - PrimeInvestor
