REITs – Tapping into India’s Real Estate Potential

Real Estate Investment Trusts (REITs) are a convenient investment option allowing investors to access real estate assets through publicly traded units, bypassing direct ownership of the properties. These vehicles are traded on exchanges such as NSE & BSE, akin to regular stocks. A REIT generates revenue by leasing out its properties and collecting rent from tenants. After deducting expenses like property tax, insurance, interest, and income taxes, among others, the remaining cash flows, known as net distributable cash flows (NDCF), are distributed to unit holders. These properties span various sectors including office spaces, retail malls, residential complexes, data centers, and hotels. Globally, there are over 1,000 listed REITs in more than 40 countries, boasting a combined market capitalization of $2 trillion, representing approximately 60% of the global real estate market. The inaugural REIT listing occurred in the US in 1960, and in India's in 2019.

AN EVOLVING LANDSCAPE:

In the past, the Indian real estate market has been characterized by low liquidity and a predominant focus on residential properties. However, the four Indian REITs listed on the exchange comprise of three office spaces and one retail mall, marking a shift in the market landscape. The combined market capitalization of these REITs now exceeds INR 80,000 crores, encompassing a total area of 115 million square feet and boasting a gross Asset Under Management (AUM) surpassing INR 130,000 crores. Additionally, Indian REITs feature prominently in major global indices such as FTSE, MSCI, and S&P, underscoring their significance in the international investment landscape.

STRUCTURE AND KEY REGULATIONS GOVERNING REITS:

REITs are registered as a business trust with three parties managing it:

Governance:

SEBI has mandated regulations that significantly reduce risk in investing in REITs:

• 80% of the value of REITs must be in completed and income generating assets, thus limiting risk emanating from acquiring land and construction.
• The debt of a REIT cannot exceed 49% of the asset value and a majority unit holder’s approval is required to exceed 25%. This limits the leverage on balance sheet.
• 90% of the cash flow must be distributed at least semi-annually. In reality, the distributions have been much higher than 90% and the frequency has been quarterly. This helps in treating the REIT as a regular income product, instilling prudent financial management.
• 50% of the directors on the board of the REIT Manager must be independent.
• Sponsors are not allowed to vote on any related party transactions.
• Unit holder approvals are also required for the acquisition or disposal of assets exceeding 10% of the REIT's value.

HOW DO REITS GENERATE RETURNS?

There are only two components of returns: Distribution of cash flows and capital appreciation of the underlying property value. The combination of the two needs to be looked at on a post-tax basis.

1. Components of Distributions, Capital Gains, and their Taxation:

Distributions are comprised of dividends, interest, the amortization of the debt received from the Special Purpose Vehicle (SPV), and other income. While the REIT itself is a pass-through vehicle and does not pay any tax, each of these components is taxed differently for the unit holders.

• Dividend income is exempt from tax in the hands of the unit holders as long as the underlying SPVs of the REIT remain in the old tax regime.
• Interest income is taxable at marginal tax rate and the applicable withholding tax is deducted on this component when it is paid out.
• Capital repayment is another component which is paid out when the SPV repays its loans to the REIT. This is not taxable at receipt by the unit holder. However, such amounts need to be reduced from the cost of acquisition of the units.
• Capital gains when you sell at a price above your purchase price. Currently the REIT units are taxed at 10% for long-term capital gains and 15% for short-term capital gains. The holding period for long term capital gains tax applicability is 3 years.

Here’s a quick snapshot of the payout breakup for the last 12 months:

Please note:

Dividend income may be fully taxed in the hands of investors if no tax is paid by the SPVs. While calculating the cost of acquisition for capital gains, capital repayment received must be deducted from the original cost of acquisition. Once the capital repayment becomes more than IPO issue price, this component will also be fully taxed. This may happen a few years from now.

2. Drivers for Revenue growth:

• Contractual minimum guaranteed escalations: Contractual rent escalations are embedded in lease contracts, for instance, an escalation of 15% every three years
• Occupancy ramp-up: REITs may have vacant areas in their assets, which they may lease to tenants.
• Mark-to-market on renewals: This is basically the gap between market rent and the current realized rent of a certain area, which is coming up for renewal. REITs will lease the upcoming area at market rent, which is generally higher than the current rent for that area, and this upside is called mark-to-market on renewals.
• Revenue share: This component is primarily a growth driver for REITs owning shopping malls, where tenants pay a certain percentage of their sales as revenue share, in addition to the minimum guaranteed rentals.
• Organic-inorganic growth: Increase in income by developing or acquiring new assets, either from sponsors or third parties.

HOW DO REITS COMPARE WITH PHYSICAL REAL ESTATE?

There are several advantages of holding REITs versus investing directly in real estate:

• Accessibility – Ownership in professionally managed real estate assets, even with a small ticket size.
• Liquidity – Units are traded on stock markets just like equity shares.
• Transparency – Regulated by SEBI with strong governance frameworks and disclosure requirements.
• Cashflow – Offer regular and tax-efficient yields by distributing at least 90% of the cash flow, while providing long term capital appreciation.
• Structure – Allows for a tax-efficient distribution mechanism for investors. REITs also enable an investor to participate in the growth upside via organic and inorganic growth opportunities.
• Diversification – Provided through a high-quality real estate portfolio across sectors, cities and tenants which is difficult to manage through direct real estate.

DIFFERENCE BETWEEN REITS AND INVITS

REITs and INVITs are formed with the idea of making investments in operational real estate for REITs and infrastructure assets for INVITs. Do note that there are defined cash flows in InvIT and hence the upside is limited. While choosing between the two, investors must carefully assess their investment objectives and risk appetite.

DR. EQUITY OR MR. FIXED INCOME?

There is a debate on whether REITs should be treated as Equity or Fixed Income. The argument for equity is due to capital appreciation and price volatility. Industry experts suggest REITs be treated as a high dividend paying stock.

On the flip side, the argument for fixed income is regular income on a quarterly basis and with limited upside.

At AWM, we treat REITs as Hybrid (or Alternate), due to its dual nature - Limitation of capital appreciation which is a feature of equity and stability of holding period return which is a feature of fixed income.

FACTORS IMPACTING THE PRICE OF A REIT:

1. An increase in interest rates can affect REITs in two ways. The value to cashflows and hence the value of REIT decreases due to higher discount factor. Conversely, an increase in interest rate increases refinance risk.
   
2. Hangover of sponsor selling can have an impact on price. This has been observed in the past where Embassy REIT always bore the hangover of Blackstone selling its stake.
   
3. A change in sponsor may have a positive or negative impact on the price depending on the perception of the market participants.
   
4. Occupancy and vacancies of the space.
   
5. Low float (liquidity) on the exchange increases volatility of price.
   
6. Acquiring new assets add to distributions and value.
   
7. Changes in taxation impact post tax returns for investor.
   
8. Share pledge from sponsor or major investor could cause an over hand on price
   

SO HOW HAVE REITS PERFORMED?

Current discount to NAV & expected distribution yield of REITs:

Listed REITs are currently trading at a discount to published NAV in the range of 3-24%. The distribution yield is between 4.7-5.7% of individuals. Mindspace REIT has low tax leakage for investors as it pays most in the form of dividend (that is tax free in hands of investor). Investment decision need to be made after considering distribution yield and potential capital appreciation over the holding period.

Payouts & returns since IPO:

Embassy REIT was the first to list in 2019 and has returned more than one third of capital back (105 of issue price of 300 per unit). It has generated 10.4% pa since IPO. Its standard deviation has been high at 19% which is higher than Nifty Index. Mindspace has also clocked over 10% return since IPO and payouts have been about a quarter of IPO price (61 of issue price of 275).

Correlation with Equity (Nifty 50 TRI) and within REITs:

Correlation to market has been low ranging from -0.07 to 0.35. It has been low between the REITs as well, auguring well for diversification.

INDIA’S REIT OPPORTUNITY

Although the market for REITs is still at a nascent stage in India, there are several factors that at play that could unleash its latent potential in the future.

Impact on REITs because of SEZ de-notification rule:

Back in 2015-16, around 50% of the demand in India used to be for Software Export Zones (SEZ). Today that demand has fallen to just 10% because of expiry of tax advantages and the fact that SEZs could be lent to non-SEZ players; both of which led to an increase in vacancy. Recently, the government has allowed de-notification of the SEZ area floor by floor, which will lead to an increase in occupancy This is a very positive development for the entire REITs space.

Latent potential:

There is a large pool of retail assets in India, which will lead the growth of REITs as a product. Across commercial offices, there is potential for 400 million sq. ft of assets, which is four times the size of current listed REITs. Across retail or shopping malls, there is a potential of 70 million square feet of retail assets, which is 7x of the current listed REITs.

Occupancy recovered post Covid:

REITs have seen improved occupancy post Covid. However, they are yet to achieve pre-covid occupancy levels. They are seeing strong growth particularly in Mumbai and Pune from BFSI and Manufacturing sectors, while the demand from BPO and IT sectors has been low due to the current slowdown in global demand.

In Summary:

REITs are great way to diversify financial portfolios as they provide regular income and capital appreciation. The space has seen a lot of activity in terms of regulations, policies, tax changes, sponsor behavior etc. This journey has made less risky compared to what we have seen so far. Considering low post tax returns from fixed income and low potential returns in equities, investors could look at an allocation of 5-10% to the asset class, in keeping with their risk appetites.

Sources:

• Company Financials
• Webinar conducted on 11th Mar’24 by Avendus Wealth with Indian REITs Association (IRA)
• IRA Presentation – “Introduction to REITs”
• Bloomberg
• Avendus Wealth Internal Research

Key terms:

Net Asset Value (NAV):

A REIT must get its assets valued every six months through an external valuer. This is published as Net Asset Value (NAV). It is an important benchmark for making investing decisions. One should aim to purchase REIT at a 5-10% discount to this value unless there is a huge growth component that could benefit the REIT. Similarly, if price overshoots the NAV, a sell decision may be considered.

Cap Rate (Capitalization Rate):

Cap Rate is a widely used term. It is calculated as Net Operating Income over Current Market Value. Cap rate should also be assessed before making investment decision as any changes to this impacts the distributions and capital appreciation.

Grade A asset:

Grade A asset is basically a good quality asset or building which is well maintained, has a large floor plate, air conditioning and power backup, and is institutionally owned.