REITS – An Al­ter­na­tive In­vest­ment Op­por­tu­nity

Accommodation Times - - Editorial - By Dr Sanjay Chaturvedi

Areal es­tate in­vest­ment trust (REIT) is a real es­tate com­pany that of­fers com­mon shares to the public. In this way, a REIT stock is sim­i­lar to any other stock that rep­re­sents own­er­ship in an op­er­at­ing busi­ness. But a REIT has two unique fea­tures:

1. Its pri­mary busi­ness is man­ag­ing groups of in­come­pro­duc­ing prop­er­ties

2. It must dis­trib­ute most of its prof­its as div­i­dends. Here we take a look at REITs, their char­ac­ter­is­tics and how they are an­a­lyzed.

The REIT Sta­tus

To qual­ify as a REIT, a real es­tate com­pany must agree to pay out in div­i­dends at least 90% of its tax­able profit (and ful­fill ad­di­tional but less im­por­tant re­quire­ments). By having REIT sta­tus, a com­pany avoids cor­po­rate in­come tax. A reg­u­lar cor­po­ra­tion makes a profit and pays taxes on the en­tire prof­its, and then de­cides how to al­lo­cate its af­ter- tax prof­its between div­i­dends and rein­vest­ment; but a REIT sim­ply dis­trib­utes all or al­most all of its prof­its and gets to skip the tax­a­tion.

Types of REITs

Fewer than 10% of REITs fall into a spe­cial class called mort­gage REITs. Th­ese REITs make loans se­cured by real es­tate, but they do not gen­er­ally own or op­er­ate real es­tate.

Mort­gage REITs re­quire spe­cial anal­y­sis. They are fi­nance com­pa­nies that use sev­eral hedg­ing in­stru­ments to man­age their in­ter­est rate ex­po­sure. While a hand­ful of hy­brid REITs run both real es­tate op­er­a­tions and trans­act in mort­gage loans, most REITs fo­cus on the 'hard as­set' busi­ness of real es­tate op­er­a­tions. Th­ese are called eq­uity REITs.


When pur­chas­ing a REIT, one is not only tak­ing a real stake in the own­er­ship of prop­erty via in­creases and de­creases in value, but one is also par­tic­i­pat­ing in the in­come gen­er­ated by the prop­erty.

This cre­ates a bit of a safety net for in­vestors as they will always have rights to the prop­erty un­der­ly­ing the trust while en­joy­ing the ben­e­fits of their in­come. An­other ad­van­tage that this prod­uct pro­vides to the av­er­age in­vestor is the abil­ity to in­vest in real es­tate with­out the nor­mally as­so­ci­ated large cap­i­tal and la­bor re­quire­ments.

Fur­ther­more, as the funds of this trust are pooled to­gether, a greater amount of di­ver­si­fi­ca­tion is gen­er­ated as the trust com­pa­nies are able to buy nu­mer­ous prop­er­ties and re­duce the neg­a­tive ef­fects of prob­lems with a sin­gle as­set. In­di­vid­ual in­vestors try­ing to mimic a REIT would need to buy and main­tain a large num­ber of in­vest­ment prop­er­ties, and this gen­er­ally en­tails a sub­stan­tial amount of time and money in an in­vest­ment that is not eas­ily liq­ui­dated. When buy­ing a REIT, the cap­i­tal in­vest­ment is limited to the price of the unit, the amount of la­bor in­vested is con­strained to the amount of re­search needed to make the right in­vest­ment, and the shares are liq­uid on reg­u­lar stock ex­changes.

The fi­nal, and prob­a­bly the most im­por­tant, ad­van­tage that REITs pro­vide is their re­quire­ment to dis­trib­ute nearly 90% of their yearly tax­able in­come, cre­ated by in­come pro­duc­ing real es­tate, to their share­hold­ers. This amount is de­ductible on a cor­po­rate level and gen­er­ally taxed at the per­sonal level. So, un­like with div­i­dends, there is only one level of tax­a­tion for the dis­tri­bu­tions paid to in­vestors. This high rate of dis­tri­bu­tion means that the holder of a REIT is greatly par­tic­i­pat­ing in the prof­itabil­ity of man­age­ment and prop­erty within the trust, un­like in com­mon stock own­er­ship where the cor­po­ra­tion and its board de­cide whether or not ex­cess cash is dis­trib­uted to the share­holder.

REITS – The In­dian Op­por­tu­nity

In­for­ma­tion tech­nol­ogy and in­for­ma­tion tech­nol­ogy en­abled ser­vices such as busi­ness process out­sourc­ing have helped in pow­er­ing the In­dian econ­omy to growth rates sec­ond

only to China. Al­though in­for­ma­tion tech­nol­ogy has been the driver, many other sec­tors of the In­dian econ­omy in­clud­ing real es­tate are rapidly de­vel­op­ing.

Since in­de­pen­dence from Great Bri­tain in 1947, In­dia has his­tor­i­cally pur­sued a so­cial­ist style planned econ­omy. For­eign di­rect in­vest­ment has there­fore been con­strained in most sec­tors of the In­dian econ­omy, in­clud­ing in the real es­tate sec­tor.

How­ever, in con­nec­tion with broad-based re­forms ini­tially adopted in 1991, the Gov­ern­ment of In­dia re­cently ap­proved mea­sures de­signed to en­cour­age greater for­eign di­rect in­vest­ment in the In­dian real es­tate sec­tor.

Pur­suant to a re­cent no­ti­fi­ca­tion by In­dia’s Min­istry of Com­merce, for­eign di­rect in­vest­ment in the In­dian real es­tate sec­tor is now per­mit­ted through the “au­to­matic route”, i.e., with­out re­quir­ing the ad­di­tional ap­proval of the For­eign In­vest­ment Pro­mo­tion Board. On a prac­ti­cal level, the for­eign in­vestor may now by-pass

some of the pre­vi­ously required ap­provals, mak­ing the in­vest­ment process less cum­ber­some.

REMF (Real Es­tate Mu­tual Funds) and REIT (Real Es­tate In­vest­ment Trust) will boost th­ese real es­tate in­vest­ments from the small in­vestors’ point of view. This will also al­low small in­vestors to en­ter the real es­tate mar­ket with con­tri­bu­tion as less as INR 10,000. There is also a de­mand and need from dif­fer­ent mar­ket play­ers of the prop­erty seg­ment to grad­u­ally re­lax cer­tain norms for FDI in this sec­tor. Th­ese for­eign in­vest­ments would then mean higher stan­dards of qual­ity in­fra­struc­ture and hence would change the en­tire mar­ket sce­nario in terms of com­pe­ti­tion and pro­fes­sion­al­ism of mar­ket play­ers.

En­try Strate­gies

There are pri­mar­ily three en­try strate­gies which have been con­sid­ered:

1. En­ter Green­field – In this type of en­try strat­egy, the for­eign in­vestor ac­quires land from in­vest­ment funds and then de­vel­ops it by hir­ing a de­vel­oper and a prop­erty man­ager etc. Af­ter com­ple­tion of the project, the prop­erty can be ei­ther sold or leased out.

The fall­out of such a strat­egy is that there is lack of lo­cal ex­per­tise and sev­eral is­sues like re­la­tion­ships with reg­u­la­tors, de­vel­op­ers and man­age­ment of prop­er­ties be­comes tough.

2. Par­tic­i­pa­tion with lo­cal de­vel­oper – There are two ways to go about this strat­egy -

a. In this type of strat­egy the lo­cal de­vel­oper trans­fers some of its “Un­der Con­struc­tion” prop­er­ties in a prop­erty SPV and the for­eign in­vestor takes an eq­uity stake in the prop­erty SPV.

The prop­erty SPV uses the funds to fur­ther de­velop prop­er­ties and sell/lease them. The ad­van­tages of this is lo­cal ex­per­tise and full par­tic­i­pa­tion.

b. The sec­ond way to go about this strat­egy is a late stage in­vest­ment into cer­tain pro­jects which for­eign in­vestor is in­ter­ested in. It is usu­ally for ‘re­tail mall’ pro­jects. In­vestors can choose to bring in funds only af­ter cer­tain per­cent­age of space se­cures a lease. Its ma­jor ad­van­tages are Less devel­op­ment risk In­vestor can cherry pick the pro­jects

Its ma­jor dis­ad­van­tage is lower rate of re­turn. sanjay@ac­com­mo­da­tion­

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