The benefits of investing in REITs

Last week I've mentioned about some of the instruments which based on debt as an underlying asset but can't be equated to debt or replacement of debt instruments. Today would like to explore about another such mezzanine investment avenue, the Real Estate Investment Trusts. An old adage says, "land doesn't grow, so invest in it" and hence Indians have invested in real estate for generations but it does need large lump-sums to acquire good chunk of land/property. The traditional structure of lending and borrowing restricts capital to be raised, deployed and distributed easily, dependent heavily on the conventional channels to execute projects in real estate. While residential properties are the first choice among many investors, some veer into commercial spaces like that of shops, office spaces etc. but do need huge initial investments, not reachable for all.

A Real Estate Investment Trust (REIT) is an entity that finances, owns and operates real assets to generate cash flows or income to the investors in these vehicles. They could simply be compared as a mutual funds (MF) investing in real estate, allowing the investors to pool capital to earn income from real estate without having to directly trade, finance any properties by themselves. This excludes the various exercises of identification, valuation, negotiation, buy or finance and maintain, etc. while enjoying the returns from transacting in these assets. Investors could comfortably gain exposure to real estate without having to go through all these hurdles and yet enjoy the benefits of returns through rental income, etc.

All REITs are governed by the Securities Exchange Board of India (SEBI) that offers a framework on registration and regulation of REITs in India. Operationally, they seem like that of the MF where the pooled capital is invested in listed entities (stocks), debt, etc. through the exchanges, REITs collect money from retail and institutional investors to transact in real estate assets like commercial spaces (shopping malls), office spaces, etc. to generate regular rental income. Another popular offering is the mortgage REITs which participates in securitised loans where the interest received on these loans translates to an income.

REITs are structured in a three-tier comprising of a Sponsor, a Manager and a Trustee with different roles and responsibilities. Sponsor is the original owner of the asset prior to the creation of the entity, REIT. Sponsor along with the sponsor group are mandatorily required to hold 25 per cent of units for the first 3 years from the formation of REIT. They're later allowed to reduce to 15 per cent of the total outstanding REIT units. REIT manager is typically a company that specialises in facility management. These are responsible for managing the assets of the REITs, managing the assets (lease agreement, tenancy management, etc.), investing decisions, record keeping and reporting as disclosed in the REIT. The Trustee are the ones who hold the assets of the REIT in the benefit of the unitholders (investors). Also, they are responsible to oversee the activity of the manager and ensure the timely distribution of the dividends.

The biggest advantage of REITs is the professional management like that of the MF, allowing right valuations of the assets, better negotiation of lease rentals, etc. to the table. This also economises the asset acquisition costs while making transaction seamless for the investor unlike directly dealing in physical property. This provides for much needed diversification for the investors in a very simple and convenient manner. SEBI has directed the REITs to at least have 80 per cent of investments made into commercial properties that could be rented out to generate income while the remaining (up to 20 per cent) can be held in the form of stocks, bonds, cash or under-construction commercial assets.

These are designed to distribute nearly 90 per cent of their earnings in the form of dividends to the REIT investors. This provides for an enhanced and assured higher income yields. The new regulations allow for a pass-through status making them tax efficient. When REITs receive rentals and is distributed to its shareholder, it will be treated as pass-through flow and not taxed.

The financialization of an otherwise cumbersome asset investing brings in ease of investment while also providing for a longer term cashflows for the investors. The very nature of the leases being long term provides a predictable income for a longer period. With the securitisation of hard assets and listing on the exchanges allows, simplifies the transaction. The listing on the exchange, however, is mandatory as per the SEBI regulations. The sale of these instruments attracts capital gains and over time as the trend catches up in this avenue, these instruments become highly liquid.

The biggest challenge REITs in India face is the very attractive feature of distribution of income. With majority portion of its income is distributed, it restricts the ability to reinvest and hence become impediments to future growth. The other detrimental factor is the prevailing low rental yields. Of course, they are still in nascent stages of operation in India and are subject to risk of regulatory changes like that of the introduction of 10 per cent tax on dividends at the source of distribution. The global experience has shown that the extensive debt on their balance sheet could be prone to economic shocks and thus end up in losses. Allocation to these should be in-line with the risk appetite, timelines and cash flow requirements of the investor while not exceeding 20 per cent of the portfolio.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at [email protected])