Investing - The "REIT" Way

When building an investment portfolio, the most feasible way is to put the money in various assets to spread the risk and ensure higher returns (Refer: all-weather portfolio). One such popular investment in India is real estate due to its hedge against inflation and significant capital appreciation. 

However, it also has its own challenges – no geographical diversification, considerable investment outflow, and limited liquidity. (will be discussed further).

It is a common misconception that purchasing a property directly is the easiest way to invest in a real estate asset. Doing so can yield desirable total returns and excellent tax benefits; however, not all real estate investors have the time, expertise, or resources needed for a direct purchase investment. 

REITs offer an alternative that allows investors to achieve the benefits of real estate ownership but without the hassle of finding, purchasing, and managing a property. But there are reasons why not to invest in REITs.

In this article, we are going to discuss what REITs are, how they operate, and why investors may and may not want to invest in them. By the end, you will have the information needed to determine if investing in a REIT is a good fit for your own investment objectives.

What are REITs in India?

The Real Estate Investment Trusts in India manage and/or own immovable assets – either the properties or their mortgages –for a steady source of income as leases and rents, along with capital appreciation.

Like units in mutual funds, REIT investors can purchase units and invest in a portfolio of diverse, income-producing properties. The REITs pool the investors’ money in the owned/managed real estate properties and distribute the income among the investors proportional to the units owned.

REITs can be traded on the exchange as per the REIT share price once they are listed. REIT investing allows higher diversification, ensures lower risk, and has the potential for better returns. As part of an investment portfolio, the capital appreciation and dividend income from REIT real estate creates a perfect balance against stock market volatility.

Factors To Consider While Investing in REITs

Property Location
Location is the most crucial element in real estate investing profitability. Residential property assessments heavily consider the status of the community, green space, scenic vistas, and proximity to amenities. For valuing commercial real estate, accessibility to markets, warehouses, transportation hubs, motorways, and tax-exempt regions is crucial.

Valuation of the Property
Real estate valuation is essential for financing the purchase as well as listing price, investment research, insurance, and taxation, all of which rely on it.

Investment Purpose
Lack of clarity regarding the aim may result in unanticipated outcomes, including financial distress, especially if the investment is mortgaged, given the low liquidity and high value of the real estate.

Expected Cash Flows and Profit Opportunities
Cash flow is the amount of money that remains after expenses. A strong rate of return on an investment property depends on having a positive cash flow.

Be Careful with Leverage
Loans are convenient, but they may come at a big cost. In exchange for today’s utility at a cost of interest spread over many years, you pledge your future earnings. Be sure you understand how to handle loans of this nature and avoid high levels of debt or what they call over-leverage. In times of challenging market conditions, even real estate specialists face challenges from excessive leverage, and the lack of liquidity combined with significant debt commitments can cause real estate ventures to fail.

Indian 'REITs" - 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.

       *MSF- Million Square feet

Indian Rules and 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 the 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.

Why Investors Like REITs

There are several potential benefits that investors may realize from a REIT investment. The most notable include:

1. 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.

2. Interest income is taxable at marginal tax rate and the applicable withholding tax is deducted on this component when it is paid out.

3. Capital repayment is another component that 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.

4. Capital gains when you sell at a price above your purchase price. Currently, the REIT units are taxed at 12.5% for long-term capital gains and 20% for short-term capital gains. The holding period for long-term capital gains tax applicability is 2 years.

5. Liquidity: Publicly traded REITs can be bought and sold on major stock exchanges with ease, making them far more liquid than direct property ownership.

6. Time: In a REIT structure, the REIT itself does all the hard work of finding, financing, and managing properties, saving individual investors a tremendous amount of time. REITs are truly a passive investment.

7. Fractional Ownership: Commercial properties are incredibly expensive, meaning they are typically out of reach for all but the most well-funded individual investors. In the REIT structure, investors can still gain exposure to institutional quality assets, but through a fractional ownership model.

Performance of Indian-Listed REITs

In FY24, yields for Embassy Office Parks, Mindspace Business Parks, and Brookfield India Real Estate Trust ranged between 5.8% and 7%, while their capital appreciation lagged significantly behind the Nifty Realty Index

     *Source Certus Capital; Data as of march'24

In FY24, the distribution per unit yield of the three office REITs – Embassy Office Parks, Mindspace Business Parks, and Brookfield India Real Estate Trust – ranged between 6 and 7 percent on a pre-tax basis and 5.8 to 6.1 percent post-tax.

Currently, the yield on a 10-year government securities paper is well above 7 percent.

The capital appreciation of the REITs has also been underwhelming. Embassy REIT’s units have appreciated a mere 4.3 percent from its IPO price to March 31, 2024, that of Mindspace REIT has gone up 6.4 percent, while units of Brookfield REIT have fallen 2.4 percent.

Compare this with the Nifty Realty Index which has nearly quadrupled over five years and more than doubled in one year.

REITs - The good, bad and Ugly

The good -  Structurally, REITs have a firm footing. Even though India's real estate is often dogged by cash crunch and project delays, REITs overcome these issues by having to put at least 80 percent of investors' money into completed and income-generating commercial projects. It ensures investors expecting a steady stream of income are not left stranded. Furthermore, they must distribute at least 90 percent of their post-tax earnings as dividends to shareholders. But note that the REIT decides when to distribute the dividends and, therefore, can be irregular. 

For bigger portfolios, REITs can be allocated a good 5-10% to provide a hedge against inflation, get regular incomes, and a low correlation with other assets in the portfolio. 

The bad - REITs and mutual funds have a few common genes. They collect money from investors and buy income-producing assets. But unlike the stocks owned by equity-oriented mutual funds, the properties bought by REITs are not tradable as easily as stocks. So, they may not be as liquid.

That said, REITs are also required to get their property portfolio valued from time to time and calculate their net asset value (NAV). Thus, there is also an element of capital appreciation that can be tracked. If the value of the underlying assets (properties) increases, NAV increases.

The Ugly - The total market cap of REITs is currently close to Rs 80,000 crore. On the face of it, REIT's total worth is substantial. But a closer inspection reveals that their trading volume is much lower than even an average small-cap stock.

In plain English, although the REIT industry is pretty large, they are not bought and sold very frequently. As such, there is a risk of investors getting stuck with a dud investment. Moreover, any big trade can make REITs highly volatile, a development that can muddy their low-risk investment image.

The underwhelming performance of top REITs in comparison to other asset classes and the overall realty sector is a point of concern.

What Should You Do- Conclusion

If you are a regular income seeker and want to invest in real estate for the same, you can allocate a small portion of your portfolio - 5 to 10 percent - to REITs.

If you do invest, do the due diligence by evaluating the REIT's occupancy rate, tenant diversification, lease period, quality of assets and financials.

For the rest, we'd suggest you look at other options, as REITs are too young, volatile and illiquid (not easy to buy and sell). There are a lot of unknowns at the moment.

With more and more investors looking to diversify their investments in real estate, REITs serve as the perfect avenue for a diversified and secure investment. However, just like any investment, REITs also require detailed research and due diligence before investing.