12 Sep 2016 15:40 IST

Route to real estate

As REITs ready for their India debut, here’s what investors need to know

When Real Estate Investment Trusts (REITs) were first flagged off in 2014, there was much excitement about the availability of a brand new asset class for the real estate-hungry Indian investors. Both sponsors and investors proved quite reluctant to take the plunge.

But after many tweaks to their regulations and taxation, REITs are preparing for their India debut in early 2017. Here are the basics you need to know, before you consider them.

Who can set them up?

SEBI specifies that REITs must be set up as trusts and registered with it. REITs, just like mutual funds, are required to be backed by a three-tier structure comprising a sponsor, trustee and asset manager.

The sponsors must be participants or fund managers in the real estate sector with at least five years’ experience. If the sponsor is a developer, he must have at least two completed projects in his kitty. The fund manager should have ₹10 crore net worth and five years’ experience in fund or property management.

All three parties must be ‘fit and proper’ in SEBI’s eyes, without any regulatory misdoings marring their record.

Do they have skin in the game?

Yes, there are skin-in-the-game provisions for REITs. The sponsors are required to hold at least 25 per cent of the units after listing, which are to be locked in for three years. Thereafter, they can bring it down to 15 per cent, but not any lower. If there are many sponsors, each should hold at least 5 per cent.

Where will they invest?

REITs are expected to deploy their portfolio mainly in rent-generating property assets, the operative word being ‘rent-generating.’ This ensures that REITs don’t face the same risks as the individual property buyer – the risk of delayed or incomplete projects in which your money gets stuck! They are not allowed to own vacant land either.

As property developers are expected to sponsor the first set of Indian REITs, they may start off with a readymade portfolio of commercial assets acquired from their sponsors (at an independent valuation). Investors will then be invited to buy into their units.

A minimum 80 per cent of the REIT’s assets must be invested in completed and rent-generating properties. The balance can be parked in under-construction projects, non-rent generating ones, bonds or shares of real estate firms, government bonds, and money market instruments. At least 75 per cent of the REIT’s portfolio must be generating a rent. To diversify, a REIT must hold a minimum of two projects. Once it buys into a property, the REIT is expected to hold on for three years at least. SEBI has recently promised to rework some of its REIT regulations.

How can we invest?

The REIT will launch an IPO to attract subscriptions through a book-built offer. It will be listed on the stock exchange just like shares. A REIT is required to have a 25 per cent public holding with at least 200 investors.

The REIT has to file an offer document with SEBI with requisite disclosures. If the offer is over-subscribed, proportionate allotment kicks in. The units will then be listed on the stock exchanges, where you can buy/sell them.

Who can invest?

Both Indian investors and foreign ones can invest in REITs. To invest, you need to apply for a minimum subscription of Rs. 2 lakh in the IPO. You can trade in lots of ₹1 lakh on the stock exchanges, once they are listed.

What are the exit options?

You can sell your REIT in the stock market. The REIT may choose to buy back units if it has surplus funds. It can also initiate delisting of units, if it fails to meet public holding norms, has no projects on hand or at the request of a majority of investors.

How will I receive returns?

You should expect to receive your returns mainly by way of dividends. SEBI rules require REITs to distribute at least 90 per cent of their cash flows, after fees, to unitholders. REITs are required to declare dividends every six months.

Ninety per cent of both the rental income earned by the REIT and the proceeds from sale of any property is expected to be distributed, except where re-invested.

What about capital gains?

REITs are designed more to generate regular income from rent, rather than capital gains on property prices.

But it is likely that Indian REITs will have a capital gains component. These gains will be captured in its NAV (Net Asset Value).

Every REIT is required to have its assets valued by independent valuers by end of September and March each year. This valuation report, which will decide the NAV, has to be shared with investors and the exchanges.

How will my returns be taxed?

On capital gains, your investment in REITs will enjoy the same favourable tax treatment as equity shares. Short-term gains will be taxed at 15 per cent. Long-term gains are totally exempt. Dividends are tax-free in your hands. The interest income that REITs receive from any bond investments will, however, be taxed in your hands. The REIT may pay capital gains tax and stamp duty whenever it buys or sells property.

What disclosures can I expect?

Apart from an elaborate offer document that gives you all the details during the IPO, you can expect half-yearly and annual performance updates.

This apart, REITs also have to intimate the exchanges whenever they buy or sell large property (over 5 per cent of assets), borrow more than 5 per cent of their assets or issue more units. REITs are expected to hold annual general meetings every year where they share their latest accounts, auditor’s report, valuation reports and put up resolutions to vote.

What protection do I have from crooked promoters?

Apart from oversight by SEBI and Trustees, REITs are subject to a battery of rules on valuation and transacting with ‘related parties.’ REITs are allowed to buy, sell and lease properties from associates of the sponsors. But such transactions should be at ‘arm’s length’ and backed by independent valuation reports by two valuers. Just so that REITs aren’t tempted to inflate their book, their assets are to be estimated by independent valuers, who are rotated every four years. The REIT’s books are also subject to statutory audit.

What returns can I expect?

Now, that’s the tricky one! Given that REITs have to depend mainly on rental property, and that residential property in India seldom yields over 2-3 per cent in rent, Indian REITs are likely to focus mainly on office/commercial space. Now, if you wanted to get in on this opportunity at the best time, the extended slump in India’s commercial property market between 2012 and 2014 would have been a good time to invest. JLL India notes that the commercial property market has since merged from the slump with a strong rebound in demand for office space in 2015. Office space vacancies across India fell to a seven-year low of 15.9 per cent at the end of that year. With capital values rising, rental yields have been moderating.

Industry estimates suggest that commercial property offers estimated rental yields of 8.5-10.5 per cent in prime locations, which is the gross return that REITs can hope to earn, without budgeting for big capital gains. From this gross return, the REIT will deduct its management fees, operating costs and transaction costs, including taxes, before paying out your return. You can thus see why it will be a challenge for REITs to top the tax-free bond return of 7-7.5 per cent.

But given the fragmented and localised nature of the property market, high rent and capital gains may well be available in select regions and localities. But then, your REIT manager must be both low-cost and skilful enough to home in on such bets.

(The article was first published in BusinessLine.)

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