Real Estate is one of the most sought after asset classes for investments, especially in India. You’d often hear our parents/grandparents talk about the importance of owning property, right? What’s their rationale behind such advice, you ask? Well, regular income in the form of rent, and handsome appreciation in the property value over time – both lead to real estate being one of the most popular investments in the country. But there’s a bit of an issue with such investments as well – the initial investment required, in most cases, is huge – and hence out of reach, at least for most millennials. Moreover, real estate is illiquid – its hard to sell the property quickly, even more so at the right price. Then came about a financial instrument, addressing exactly these issues, while also appreciating the importance of having real estate as part of your portfolio. They’re called Real Estate Investment Trusts (REITs).
India’s second REIT got listed on the stock exchanges this month, and we thought it would be the right time to tear down this rather unexplored financial product, that in my opinion has the potential of being a powerful one.
What are REITs?
The most popular definition of REITs goes something like this – REITs are companies that own and operate income-generating real estate. Basically, these trusts pool in money from different avenues – like institutional investors, retail investors (individuals like you and me), endowment funds, mutual funds, etc and then use this money to invest in properties. These properties are rented out – hence they’re called income-generating real estate. And the rents are distributed to the shareholders (also called unit-holders) in the form of dividends.
It’s actually best to understand the structure and concept of REITs using an example. While the inner workings of REITs are a little more complicated than the example that follows, I think it captures the gist of REITs appropriately.
Let’s take a hypothetical scenario wherein you and 3 of your friends are of the opinion that due to the widely expected positive business environment in the future, demand for office spaces is going to go up – and as prudent investors, you think it will be wise to buy an office space and rent it out. 4 of you pool in a corpus of ₹2 crore (₹50 lac contribution by each of you), and buy an office space of your choice. You rent this out to a company for ₹20 lac per year (i.e. 10% rental yield). After deducting the costs (maintenance, staff salaries, etc), let’s say you are left with ₹16 lac. This money is then free to be distributed equally (₹4 lac each), among the 4 of you. This is the basic framework on which the model of REITs is based.
REITs were first introduced in 1960, in the U.S, when Congress was of the opinion that all investors should get the opportunity to invest in large-scale, diversified portfolios real estate. Since then REITs have gained a lot of popularity across the developed world, and recently so, in India as well.REITs were introduced in 1960, in the U.S, to give all investors a chance to invest in large-scale, diversified portfolios real estate. Since then REITs have gained a lot of popularity across the world, and recently so, in India too. Click To Tweet
How do REITs work?
The REIT model is simple – these trusts pool in money from different investors (much like mutual funds) looking to gain exposure to the real estate market. This money is used to invest in income-generating property and such income is then distributed to the investors. So if you own 1% of the shares of the REIT, you will be eligible to get 1% of the total distributions to the shareholders – intuitive right?
Okay, apart from the investors, there are 3 main stakeholders in the structure of REITs:
- Sponsors: Sponsors are individuals who set-up the REIT. SEBI regulations direct that sponsors should own at least 25% of the units of the REIT for a minimum period of 3 years from the date of listing.
- Manager: Think of the REIT manager as a mutual fund manager. The main role of the manager is to allocate funds into different income-generating properties and other projects that the manager deems fit.
- Trustee: The Trustee is like the Board of Directors of a company. The main role of the trustee is to oversee the functioning of the REIT and make sure that the managers are acting in the best interest of the unit-holders.
REITs in India
India became the 31st country in the world to enact REIT legislation following action by the SEBI in 2014. However, India’s first REIT was launched as recently as 2019. It was a joint venture between Bangalore-based real estate developer Embassy Group and the US-based private equity giant Blackstone (the 2 firms are the sponsors of the REIT). Together, they formed the Embassy Office Parks REIT which raised close to ₹4750 crore from its IPO. Even more recently, the Mindspace Business Parks REIT IPO concluded in August 2020 through which the company raised about ₹4500 crore.
Investing in REITs
The 2 REITs in India that I mentioned above, trade on the stock exchange daily – just like other stocks on the exchange – with 1 slight difference. Investment in REITs requires a minimum amount of ₹50,000. When REITs started out in 2019, it was ₹1 lac. But working towards making REIT trading akin to stock trading – and in-line with global best practices – regulators are looking at making the minimum investment amount to just a single share – exactly how we trade other stocks. This move is going to improve liquidity for small investors which will in-turn help drive household investment into commercial realty.
Where does your money go?
As mentioned earlier, REITs invest most of the money in income-generating real estate. Most… not all. How much and where else, you ask? By law, REITs are required to have 80% or more of their assets invested in completed and revenue-generating properties. The balance can be invested in properties that are under construction, equity shares of companies that derive at most of their income from real estate, corporate debt of real estate companies, government bonds, etc.
Tax treatment for REITs
REITs enjoy special treatment from a tax perspective. While tax laws are subject to change in the country, REITs have something called a pass-through status. The implications of that are interesting. You see, like individuals, businesses pay taxes too. So in effect, a business pays taxes when it makes money – at the corporate tax level that prevails at the time, and then when it distributes dividends to its shareholders, the shareholders pay taxes too! Ergo, taxes are, in effect, paid twice – at the company as well as shareholder level. With REITs however, the pass-through status means that the REITs are exempt from paying taxes and only the shareholders are required to pay taxes on the income received from REITs.
How do you make money?
REIT investors make money in 2 broad ways…
First – dividends. The money that a REIT generates after deducting expenses – also called Net Distributable Cash Flows (NDCF) is the money that is leftover for the REIT to distribute to its unit-holders. By law, a REIT is required to distribute at least 90% of the NDFC to its unit-holders at least twice a year.
Second, capital appreciation. Just like how the price of stocks rise/fall over time, the units of the REIT also appreciate/depreciate in value. Since unit-holders indirectly own a portion of the property that REITs buy, the investments grow in tandem with the value of the properties that the REIT holds. Think about the example we spoke about earlier where you and your friends buy an office space for ₹2 crore. Over time, not only will you make money by way of rent, but in the event that you guys want to sell the property, after say 10 years, chances are you will get more money than just the 2 crore that was initially invested.
So, REITs give us the best of both worlds – fixed income in the form of dividends (just like how you get fixed interest on loans) as well as scope for capital gains (as in the case with normal equity shares of companies that grow over time).
The above graph shows the relative price performance of the Embassy Office Parks REIT with the Real Estate Index (Nifty Realty) and the broader stock market (Nifty 500).
What are the advantages of REITs?
There are a host of compelling reasons as to why it might be prudent to add REITs as part of your investment portfolio. Here are a few of them…
- Steady returns – As a REIT unit-holder, you are entitled to steady returns in the form of dividends from the firm. Unlike other companies that might choose to retain cash to reinvest in future growth prospects, REITs, by law, are required to distribute 90% of their net-earnings to shareholders.
- Diversification – REITs provide retail investors with a great opportunity to diversify their portfolio. While the most common avenues for investment are equities, fixed income, gold etc, real estate has proved to be a robust investment over the long haul. Moreover, in the absence of REITs, if one wanted to invest in real estate, it would have to be a direct investment in a single property. REITs own multiple properties spanning different locations, which makes REITs inherently less risky than direct investments.
- Liquidity – One of the drawbacks of direct investment in property is that real estate is illiquid, i.e. it cannot be bought and sold easily. It takes time to find the right buyer willing and able to buy the property at the right price. REITs however, trade on the stock exchanges daily and can be easily bought or sold.
- Professional Expertise – REIT properties are managed by professionals who are seasoned experts in the real estate industry. This ensures that your money is in the hands of people who understand the market and know the kind of properties to buy/sell. Returns are hence more optimal than would otherwise be.
- Ease of investment – The procedure behind direct investment in property can be long and cumbersome. It goes something like this… you first find a property that suits your needs and your wallet, pay a lump sum amount and, if required arrange for loans for the balance, prepare and register a sales deed, take the handover of the property and then also take care of the maintenance going forward. It’s just too much hassle… especially considering how seamless investments in REITs are – simply invest a lump sum into the trust and the rest is taken care of by the managers of the REIT.
What are some of the disadvantages of REITs?
While REITs provide an excellent opportunity for all investors to tap into the real estate market, there are some considerations you might want to look at before investing in REITs:
- Limited growth prospects – A major contributor to the growth of conventional businesses is re-investment. The money that a business makes via its operations is used to invest back into the business for future growth/expansion. REITs don’t have that privilege since they have to distribute 90% of the NDCF as dividends to its investors. It can only use up the remaining 10% to invest in future growth prospects.
- Sector specific risk – Risks of investing in REITs is very similar to that of the overall real estate market. The real estate market is sensitive to the sentiment prevailing in the economy and generally follows a close trend which is in-line with the general economic environment.
- Lack of control – The REIT managers have full control over how investors’ money is managed, without any obligations to consider investor opinion or make any unnecessary disclosures to the investors – and this setup is very similar to a mutual fund. Hence, investors lack transparency and control.
In a nutshell…
In June 2016, the global market capitalization of publicly traded REITs passed the $1 trillion mark for the first time. Needless to say, India has a long way to go on that front. However, if the global growth of REITs over the years is any indication of its potential, the REITs story in India has just begun. While still in its nascent stage, the market presents itself as a good opportunity for investors looking to get exposure to the real estate market in the country. If you are looking to invest in real estate, REITs should definitely be on your list of considerations. If you have never thought about investing in real estate, especially because of the huge one-time outflow of funds that it requires, you must definitely look at REITs as an instrument that overcomes the problem of liquidity and quantum of investment required while also providing the much needed diversity to your portfolio.
Disclaimer: None of the opinions in this article should be construed as investment advice. For more details regarding investing in REITs, please consult your financial advisor.
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