Although property is a popular investment option in India, it is widely recognized that real estate investing is challenging and typically requires a significant investment. As a result, retail investors have limited access to this asset class. Traditionally, investors have either bought physical property or invested in shares of companies in the real estate sector. However, real estate investment trusts (REITs) are now emerging as a new investment option. REITs were first introduced in the US in the 1960s and have been adopted in many other countries. In India, Securities and Exchange Board of India (SEBI) introduced the concept of Real Estate Investment Trusts (REITs) in 2014 under SEBI (REITs) Regulations. Initially, all REIT units were required to be listed on a recognized stock exchange, but SEBI has now eliminated this mandatory listing requirement. This article delves into the concept of REITs, how they operate and whether they are a viable investment opportunity for you.
What are REITs?
A REIT is a trust that is created and sponsored by a real estate company with an aim to raise capital for the operation, functioning or ownership of real estate in order to generate income for its investors. The structure of REITs is similar to that of mutual funds, where a sponsor is responsible for promoting the REIT with its own capital. REITs, like mutual funds, offer diversification benefits since they invest in a variety of properties. They own or finance income-producing real estate in different sectors, including residential, industrial, office, retail, mortgage and hotels. The investing mechanism for REITs remains the same as investing in shares, mutual funds or exchange-traded funds (ETFs).
How do REITs operate?
A REIT may establish one or more special purpose vehicles (SPV) in which it holds a controlling stake and the SPV holds the properties on behalf of the REIT. The REIT portfolio is managed by a professional manager who makes all the investing decisions and charges a fee for the services provided.
REITs can be private, public but non-traded, or publicly traded on a stock exchange. Publicly traded REITs are accessible to all investors, who can earn real estate income without directly purchasing, managing or financing property. These companies generate income by leasing their real estate and collecting rent, which is then paid out to shareholders as dividends. REITs are structured to distribute at least 90% of their income to unit-holders in the form of dividends or interest income.
What do REITs invest in?
REITs have a broad investment scope covering a variety of real estate properties such as offices, apartments, warehouses, retail centers, medical facilities, data centers, cell towers, infrastructure and hotels. Most REITs focus on a specific property type, however, some also hold multiple types of properties in their portfolios. For instance, Office REITs manage and rent office real estate, Industrial REITs manage and rent industrial facilities while Retail REITs specialize in large malls, outlet centers, grocery-anchored shopping centers and so on, Residential REITs focus on different types of residential properties like apartment buildings, student housing, manufactured homes and single-family homes.
Although REITs can invest in various types of income-generating real estate assets such as residences, offices, hotels, malls, and warehouses, in India, they are primarily focused on commercial real estate.
Why to invest in REITs?
Real estate has long been a favored investment option in India, perhaps due to its tangible nature. While considered a traditional investment, real estate remains a valuable diversification tool for many investors portfolios.
Investing in a REIT is a straightforward way to gain exposure to real estate and its structure is akin to that of mutual funds. It provides the advantage of diversification and the potential for long-term wealth creation.
Including REITS in your portfolio can generate capital appreciation and help minimize downside risk and improve portfolio diversification. REIT-backed investments offer a tax-efficient alternative for investors to hold a portfolio of income-generating real estate assets, primarily office spaces, with the potential for two types of returns - dividends (90 percent of distributable cash flows must be paid out) and capital appreciation.
How investing in REITs is better than investing in physical real estate?
Convenience: Investing in REITs relieves investors from problems such as the hassle of rent collection, property maintenance and dealing with tenants, which are generally faced by residential real estate investors.
Inflation beating returns: Real estate rents and values usually increase with inflation, which is partly due to many leases being tied to inflation. This, in turn, supports the growth of REIT dividends by boosting the stream of income during periods of rising inflation. As such, REITs offer a higher return of around 9 to 10 percent, including both dividend payouts and capital appreciation over the long term as compared to the rental yield in residential properties of around 2-3 percent. REITs thus serve as an effective hedge against inflation. They protect an investor's return from inflation due to escalation clauses embedded in their rent agreements.
Regular income: Regulations require that REITs invest at least 80% of their funds in completed properties that generate revenue. Additionally, they are required to distribute at least 90% of their income net of expenses to investors in the form of dividends on a semi-annual basis. Therefore, REITs can be rewarding for regular income seekers, delivering 5-6 per cent per annum post-tax income returns, which compares well with safe fixed-income investment avenues available in the market.
Tax-efficient: REITs in India enjoy a pass-through status, which means the rental income received by them from their SPVs is tax-exempt to avoid double taxation. However, if the SPV has opted for a concessional corporate tax rate, the dividend distributed to unitholders may not be tax-exempt. REITs charge a withholding tax of 10 per cent on distributed income that is taxable in the hands of unitholders as per the law.
Liquidity: Another benefit of investing in REITs is the ability to add real estate returns to a portfolio without the liquidity risk associated with direct real estate investments. Since REITs are listed on exchanges, they provide investors with a quick and easy entry and exit option. Although the underlying assets may not be as liquid as mutual funds, the trading structure of REITs allows for greater liquidity. In contrast, selling a residential property can take anywhere from three to six months or even longer.
Transparency and accountability: SEBI regulates REITs in India and requires them to disclose their operations, portfolio and distributions to unitholders, among other relevant information. This strong governance framework ensures transparency and accountability. Unitholders can access all relevant information they need through the REITs' annual reports and website disclosures.
Capital appreciation: REITs are also required to periodically value their property portfolio and calculate their net asset value (NAV). Investors may realize capital gains if the underlying property value increases, which would be reflected in the REIT's NAV and price. Investors can therefore benefit from capital appreciation by investing in REITs.
Risks associated with investing in REITs:
Investors should be aware of the risks associated with investing in this relatively new asset class before making any investment decisions.
There is a risk that some commercial buildings, such as office complexes, could remain unoccupied or be rented out at lower rates.
REITs carry the risk of fluctuating net asset values (NAVs), which may sometimes decline. Additionally, there is a risk that REITs may not make dividend payouts or may reduce them from previous levels. This implies that REITs may not be a dependable source of regular income, unlike fixed-income instruments such as Senior Citizens' Savings Scheme.
In order to mitigate the above risks associated with investing in REITs, investors should evaluate factors such as REIT's occupancy rate, tenants' diversification, lease period, quality of assets, financials, etc. by studying REITs' annual reports and other statutory disclosures available on their website.
What is the minimum requirement for REIT investment?
A demat account is necessary for investment in REITs, since REITs are listed and traded on the stock market, just like equity shares. The minimum investment for investment through initial public offerings (IPOs) and follow-on offers (FPOs) in REITs is in the range of ₹10,000 to ₹15,000 while the lot size of REITs traded is 1 unit. Therefore, you can invest in REITs as low as ₹10,000 in IPO or FPO or purchase just 1 listed unit at the prevailing NAV from the stock exchange.
How to choose which REIT you should invest in?
Currently, there are three REITs listed with exchanges in India: Embassy REIT, Brookfield REIT, and Mindspace REIT which have been launched in 2017, 2019 and 2020 respectively. All three REITs are listed and traded on both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE).
# If the location is a crucial factor in your investment decision, then Embassy Office Parks and Brookfield India Real Estate Trust are good options to consider.
# If having a high concentration of tenants is a priority, then Embassy Office Parks or Mindspace Business Parks may be the better choices. Investment in these REITs is suitable for conservative investors as the lease outlook is relatively stable. Additionally, Mindspace Business Parks has a strong balance sheet with potential for leverage.
# On the other hand, if you are looking for growth and long-term wealth appreciation, then Brookfield India Real Estate Trust has the most potential, followed by Mindspace Business Parks.
To make informed investment decisions, investors should establish certain criteria. When it comes to real estate, the golden rule of "location, location, location" also applies to REITs. Investors should focus on REITs that own office complexes in prime areas of cities where demand for office space is consistently high. The buildings owned by the REIT should be of superior quality and it must be leased out to multinational or top-quality Indian companies. Additionally, the REITs portfolio should be geographically diversified across the country to ensure mitigation of the risk of downturns in a specific region. Evaluation of these factors can help investors choose the right REIT for investment.
Tax Implications of REITs for investors:
The income received by REITs in the form of dividends, rent and interest is distributed to its unitholders is received in the same capacity by them. This means that it is treated as dividend income, rental income or interest income in the hands of the unit holder. The tax implications of REITs for investors are as follows:
Rental Income: Investors receiving rental income distributed by REITs shall be liable to pay tax thereon as if they have earned such income directly by investing in real estate properties. The tax shall be charged in the hands of the investors at their applicable tax slab rate.
Interest Income: Investors receiving interest income distributed by REITs shall be liable to pay tax thereon at their applicable tax slab rate.
Dividend Income: If the SPV has opted for a concessional tax rate under Section 115BAA, then dividend received shall be taxed in the hands of the investors at their applicable tax slab rate. However, if SPV has not opted for taxation under Section 115BAA, then dividend is exempt in the hands of investors.
Capital Gains:
- Listed Units: Capital gains arising from the transfer of listed units of REITs would be subject to tax in the hands of the unitholder depending upon the period of holding. Where units of REITs are held for a period of less than 36 months, short-term capital gains will arise and shall be taxed at the rate of 15%. Where units of REITs are held for more than 36 months, the resultant long-term capital gains will be exempt from tax up to ₹1 lakh and any capital gains arising above ₹1 lakh would be taxable at the rate of 10% under Section 112A.
- Unlisted Units: Any capital gains arising from the transfer of unlisted units of REITs would be taxable as short-term capital gains if such units were held for a period of less than 36 months. Such short-term capital gains would be taxable as per the tax rates applicable in case of unit-holder. The profit arising from the transfer of units of REITs would be taxable as long- term capital gains where units were held for a period of more than 36 months. Such long- term capital gains would be taxable at the rate of 20% under Section 112 of the Act in case of a resident.
The taxability of income received by investors can be summarized as below:
Conclusion
REITs provide investors an opportunity to have exposure to the real estate market without actually having to purchase and manage physical properties themselves. REITs have the potential to offer attractive returns through a combination of rental income and capital appreciation and have liquidity benefits as they are listed and traded on stock exchanges. The growing demand for technology, global captives and flexible office spaces is expected to drive demand for REITs, making them a defensive asset class suitable for investors seeking stable income during periods of volatility. REITs have demonstrated lower volatility compared to equity or gold. Given the current inflationary trends and a possible rise in interest rates, investors would be wise to diversify their portfolio with negatively or low correlated alternative assets, of which REITs are one. Global inflationary pressures provide a favorable opportunity for REITs to outperform bonds and stocks. Investors can allocate a small part like 8-10 percent of their overall portfolio to REITs since investing in them can help to minimize downside risk and improve portfolio diversification and must consider investing in REITs only if they can stay invested for a long period of say seven years or more to weather the fluctuations that arise in NAVs of REITs. However, those who rely on investment cash flows to cover their household expenses and are not as financially well-off may be better off avoiding REITs.
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