Invest in REITs for regular income

While experts expect this new asset class to give annual returns of 12-14%, investors should temper their expectations in view of cyclicality in commercial real estate

While experts expect this new asset class to give annual returns of 12-14%, investors should temper their expectations in view of cyclicality in commercial real estate. SANJAY KUMAR SINGH & TINESH BHASIN write

The initial public offer (IPO) of Embassy Office Parks real estate investment trust (Reit), backed by private equity giant Blackstone Group and Bengaluru-based developer Embassy Property Developments, opens for subscription today. This is the country’s first Reit issue, with plans to raise ~4,750 crore. Before you make up your mind to invest in this offer, carefully weigh the pros and cons of this entirely new asset class.

Reits make commercial real estate accessible: If a retail investor wishes to take exposure to commercial real estate directly, he would find it very difficult. The investment required is very high — ~5 crore and above for grade A commercial property. Investors could face titlerelated issues for which they may not be able to do the due diligence themselves. Exiting such large investments can be time taking. “Many of these challenges get taken care of when an investor takes the Reit route. Investors can enter Reits with just ~2 lakh of initial investment and be able to diversify their portfolios,” says Prateek Pant, head-products and solutions, Sanctum Wealth Management. Exiting these investments should also be less difficult as units will be listed on the stock exchanges. Investors will also get the benefit of professional management of office properties.

Ensuring investor safety: The Securities and Exchange Board of India (Sebi) has taken a number of steps to make this new asset class safe. “Since this is a listed instrument, Sebi requires a long list of disclosures by the sponsors in the offer document, to ensure a high level of transparency,” says Vamshi KK Nakirekanti, executive director and head–valuation services, India, CBRE South Asia. Also, 80 per cent of the commercial real estate portfolio held by a Reit will have to consist of developed, income-generating properties. “Promoters will not be permitted to launch a Reit with just a land bank,” says Somy Thomas, managing director–valuation and advisory and co-head–capital markets, Cushman & Wakefield India. This provision will minimise development risk.

Furthermore, 90 per cent of the net income after expenses will have to be paid out as dividend. Payouts have to be made at least twice yearly. “This will reduce the risk of sponsors misusing rental income from properties,” says Thomas.

Sebi has ensured that sponsors of Reits continue to have skin in the game. “Sponsors will have to maintain at least 25 per cent stake in the Reit even after its listing. They can not list and exit,” says Nakirekanti. One risk in a Reit arises from its novelty. It remains to be seen whether it will function in India as it has in developed markets like the UK, Singapore, Canada and Australia, where it serves as a stable, income-generating asset.

Returns you can expect: Rental yield from commercial properties is in the range of 8-9.5 per cent. In addition, there is capital appreciation. These two components will together determine the return from this product (less costs). Capital appreciation will depend on a few factors. First, the lease agreements with existing tenants have an escalation clause. Second, when leases expire and are renewed, the old rental rates rise to existing market rates. And third, the 20 per cent or so under-construction portion will become ready and get leased. As a Reit’s rental income appreciates, it will get reflected in the capital value of its assets, and hence in the price of units. Real estate experts expect REITs to give an annualised return of 12-14 per cent.

Financial advisors are not so sure if such high returns will be forthcoming. A variety of factors can prevent rentals from rising rapidly. Economic downturns affect the demand for commercial real estate, causing rental rates to stagnate and vacancy levels to rise. Influx of new supply in a geography can also affect the rate at which rentals rise. “Treat Reit primarily as an income-generating asset that will give you returns close to the rental yield, with some upside coming from capital appreciation. By expecting a very high rate of capital appreciation, you could set yourself up for disappointment,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisor.

Do the due diligence: Check the track record of the sponsor, specifically, how much commercial real estate he has developed and its quality. Next, the quality of buildings needs to be checked. Since it will be difficult for retail investors to do so, they should use the quality of tenants in those buildings as a proxy (information on tenants is available in the prospectus). “If a Reit has mostly MNC and blue-chip companies as tenants, investors can rest assured that the quality of buildings will be good, since these companies have their own standards and do not rent buildings that do not meet their specifications,” says Thomas.

Reits will be listed on the exchanges. However, the price at which the units trade — at a premium or discount to NAV — remains to be seen. This will depend on factors like level of investor interest, rate at which dividend income appreciates, and so on.

Who should invest? Those in need of a regular income may invest in these new instruments. Both risk and return from this asset class is expected to be higher than from fixed-income instruments. Well-to-do retirees with some risk appetite may invest in them. “For retirees Reits should be one of the several instruments they use to generate income,” says Dhawan. Income from Reits should initially be 5 per cent of their total income. This figure can rise to 25 per cent if the asset class lives up to expectations. Keep your overall exposure to real estate in mind. Whatever your exposure to growth assets, roughly a third of it should be in real estate, and your REIT exposure should be a part of that allocation.

Taxation of Reit: When a resident Indian sells Reit units at a profit, he will have to pay capital gains tax. “If the holding period is over three years, the investor will pay 10 per cent of the gains as tax, subject to payment of securities transaction tax (STT). If the units are held for less than three years, the gains will be taxable at 15 per cent, subject to payment of STT,” says Gaurav Karnik, partner and national leader (real estate practice), EY India.

The dividend paid by a Reit is taxfree in the hands of investors. A trust can also earn interest from SPVs, which could be passed on to investors. “The interest income earned by a domestic investor is subject to withholding tax at 10 per cent by the Reit and taxed at marginal rates,” says Karnik. For a nonresident, the interest income is taxed at 5 per cent, and capital gains tax rate depends on the treaty India has signed with the investor’s country of residence.