By Chaahat Khattar

Edited by Shambhavi Singh, Senior Editor, The Indian Economist

“I intend to provide necessary incentives for REITs, which will have pass through for the purpose of taxation” – Mr. Arun Jaitley, Minister of Finance for India

On 10th August 2014, Securities and Exchange Board of India (SEBI) approved the much awaited guidelines on Real Estate Investment Trust (REIT). The Union Budget 2014-15 of India introduced various tax incentives and relaxation in Foreign Direct Investment (FDI) limits for REITs. Ever since, all eyes have been on SEBI to officially unveil REITs.

 In the simplest form, REITs are real estate equivalents of mutual funds. An investor here will put in an investment (minimum INR 2 lakhs) in a fund (REIT), and the fund manager will decide which properties to buy or sell and when to do so.

 Parties to a REIT:

 Investor:

An investor will be a retail customer looking out to have a foothold in commercial property with a minimum investment of INR 2 lakhs.

Sponsors:

Every REIT will have a sponsor to it (maximum 3 sponsors permitted per REIT). Sponsors to a REIT will collectively hold at least 25% of the units for first three years.

Manager:

A manager will be responsible to invest the corpus of a REIT in real estate projects and managing other investments of the REIT.

Trustee:

A trustee will be a watchdog of the respective REIT. A trustee cannot be a sponsor or manager of the REIT. Trustee will have to oversee the activities of the REIT and will have to ensure that the manager acts and takes decision in best interest of the investors.

A REIT will own a real estate project directly and it may also own mortgages. The assets will be sub-divided into equal units and will be later sold to investors.

 It is important to note that REIT will not give ownership of any property to the investors; instead, the major sources of income for an investor in REIT will be:

  • Rentals from the owned properties and/or
  • Interest on mortgages.

 As per SEBI guidelines, at least 80% of the corpus must be invested in projects that generate income and the rest 20% can invested in realty stocks, bonds and unfinished projects. This means that REITs pave way for investments in Mortgage Backed Securities (MBS) in the country. [1]

 Under REITs, investments are permitted only in commercial properties. Minimum size of a REIT should be INR 500 crores and size of the IPO must be at least INR 250 crores. Also, assets have to be valued and the net asset value must be updated at least twice in every financial year. Principal valuator will be entrusted with the responsibility to ensure fair and transparent valuation of underlying assets. 90% of rental income as dividends has to be distributed to investors. Source: The Economic Times

As elaborated in the Union Budget 2014-15, the tax treatment for REITs will be pass-through i.e., no tax will be levied on income being distributed by REITs. While REITs reduce the lumpy nature of real estate exposure, it also provides liquidity to investors in the same fashion as mutual funds do.

As per analysts, there may be 80-100 million square feet of REIT-able offices which would generate over INR 6,000 crore of annual rental income and in such a case REITs may well prove to be a game changer in the real estate sector.

From taxation perspective, as discussed above, the distribution of income by REITs will be tax free, but from the investors’ front, the gains on sale of investment in REIT will be taxed in a similar fashion to taxation on sale of listed shares except that units in REIT would qualify as long term capital asset if held for more than 36 months. Income from interest will be subject to tax in the hands of unit holders only. REITs would be taxed in the same way as corporates. On rental income (considered just like dividend), there will be full tax, corporate tax plus the dividend tax. Dividends paid by a domestic company are subject to the dividend distribution tax at an effective rate of 16.995%. Dividend subject to DDT is exempt from tax in the hands of the investors. SEBI is expected to notify REIT norms from October 12.

From a common man’s perspective, REIT provides avenues to not only invest in big ticket real estate investment, but also permits investment in low risk, completed, revenue generating projects as against high risk, non-revenue generating, developing projects. Whereas, for developers/real estate owners it may provide the required avenue to exit a project and fund new project/repay the high cost debt taken.

For real estate developers, there is plenty of unsold, semi-developed commercial property across India. Once REITs get rolling, some of that should come on the market. This will allow developers to complete stalled projects and exit. The infrastructure variation on the REIT, where the investment trust holds infrastructure project assets has similar but broader applicability.

REITs very well tackle the problem of high initial capital requirements in the real estate sector, high cost of capital, hassles of managing properties, uncertainty of income, rigid exit formalities and taxation issues but it still has some issues to deal with:

  •  Equity mutual funds operate the way they do because the stocks they invest in are the ones that are traded in an active and liquid markets and high-quality information about the underlying businesses is widely available. However, none of this is true for real estate3;
  •  Indians invest in real estate primarily for capital gains. We tend to buy property which we think will appreciate in the future, and wait, opportunistically looking for good deals as the market booms. REIT will only be investing in commercial properties and investors will not have any ownership over the same and will continue to receive just rental income or interest income throughout the period;
  •  Globally REIT offers a return in the range of 6% to 9% to the investors. REIT is a success in developed countries wherein the return to investors on bank fixed deposits or in Government securities/bonds is much lower, say 3% to 5%, however, in the Indian context generally bank fixed deposits and Government securities/bonds offer a return in range of 7% to 8%. Investing in REIT may not be as lucrative unless the investor looks at an upside in value of commercial property over a period of time4;
  • A REIT will tend to accentuate the effect of real estate bubble. The trading in MBS can also encourage over speculation in the real estate market and can rewind the tape played during the subprime crisis; and
  • REITs will also have to take adequate insurance cover for their realty assets and to protect investors from any unforeseen loss but again there might be a case where the REITs will go one step further and get every other asset insured. In such a case, REITs will not be too worried about the quality of assets they are holding because at the end of the day, their interests are protected. Insurance companies will need to have separate guidelines for REITs to make sure they do not become AIG of India.

 The success of REIT in India will largely depend upon certain key factors like an enforcement of investor protection norms, SEBI’s regulation, a much similar process for regulatory approvals and REITs meeting the expectations of investors by providing them with high and stable yield ensuring better returns than other instruments such as government securities and bonds.

REITS can be expected to take off after 01 April 2014 only and SEBI must ensure that only good quality assets are brought for investment, valuations are right and transactions are well regulated in order to achievement the fundamental objectives laid down by SEBI and Ministry of Finance to multiply growth and development in the real estate sector.

 (1) http://www.sebi.gov.in/cms/sebi_data/pdffiles/28905_t.pdf

http://profit.ndtv.com/news/cheat-sheet/article-reits-what-investors-need-to-know-631115

(2) http://profit.ndtv.com/news/cheat-sheet/article-reits-what-investors-need-to-know-631115

(3) http://articles.economictimes.indiatimes.com/2014-08-18/news/52942087_1_indian-reits-real-estate-investment-trusts-equity-mutual-funds

(4)http://firstbiz.firstpost.com/corporate/explained-what-reits-will-offer-retail-investors-93732.html


Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller. He has keen interest and experience in authoring research papers and case studies and have contributed to various renowned journals. Chaahat can be reached at ckhattar@gmail.com

 

Posted by The Indian Economist | For the Curious Mind