Making REITs a success story

Written by Ajit Krishnan | Ajit Krishnan | Updated: Aug 29 2014, 07:24am hrs
Real Estate Investment Trusts (REITs) were introduced in the US markets in 1960 as a vehicle that allowed investors to participate in large-scale diversified portfolio of income generating real estate assets, much like they would invest in other listed securities such as debt or equity instruments. Their introduction in India marks the coming of age of the real estate sector and is a recognition of the fact that there is enough stock of real estate assets which are REIT-able in India. A REIT is a trust that acts as a pooling vehicle through which capital is deployed to own real estate assets. Its objective is to provide a steady source of annuity income in the nature of rent from ownership of assets. Real estate as an asset class has traditionally given returns above inflation, thus acting as a good hedge against inflation for the investor. REIT is the vehicle of choice that provides the investor an ability to participate in the real estate ownership with a low ticket size of investment and, at the same time, gain from the large and diversified corpus of a REIT as opposed to having a single asset exposure.

The growth in the middle and high networth class of India has resulted in a growing demand for investment products that provide annuity returns. The universe of investment products available to an average investor in India is restricted. It is either a low-risk product such as a bank deposit or tax-free bonds, or a high-risk product such as equity, and the moderation of the risk profile is achieved by investing through mutual funds. Real estate as an investment product is somewhere in the middle as it provides opportunity for capital appreciation in addition to recurring annuity income in the form of rent. But the average investment size for investing in real estate is very high, being a function of capital value and size of the real estate which makes it inaccessible for the wider diaspora. The lack of an institutional buyer or seller market for such types of real estate assets makes them unviable for institutional capital to participate. Therefore, introduction of REITs as an investment product is a step in the right direction to address the investment needs of the wider working population.

Take the example of the Indian employee provident fund, which has a corpus of $68 billion, ranks 39 in the list of top 300 pension funds globally, yet has no exposure to real estate. For its sustainability, it becomes imperative for the provident fund to allocate at least 10% of its portfolio towards real estate assets that would provide a recurring annuity income and also a hedge against inflation. Similarly, as a global benchmark, insurance companies would invest a portion of their corpus towards real estate, which, in itself, in the Indian context, would be a sizeable amount. But currently the exposure of Indian insurance companies is in direct real estate; for example, LIC has direct ownership of several commercial assets. Such direct exposure has a significant risk of being illiquid as there are no or very limited institutional buyers who are able to purchase such large ticket assets. The introduction of REIT would facilitate an institutional platform for acquisition and sale of large value assets as also make the investment in real estate more liquid as it would be transactable through the units on a stock exchange.

For REITs to become a reality in India, there are certain key issues that need to be resolved. Indian pension funds and insurance companies need to be permitted to invest in such securities while also permitting FDI in REITs up to 100% under the automatic route. Currently, the proposed tax treatment of REITs differentiates between a resident unit holder and a non-resident unit holder in relation to income in the nature of interest by providing a lower rate of tax of 5% for non-residents. This discrimination makes the structure unviable as the sponsor, being a resident, would not have the same effective tax impact and this would influence the capitalisation structure for the REIT and its SPVs. To address this, it is imperative to provide for an exemption from DDT on dividends distributed by an SPV to a REIT.

The Indian sponsors of real estate would be either real estate owners or real estate developers. However, Sebi regulations require the sponsor to have a real estate experience of five years, which, therefore, makes it impossible for a corporate real estate owner to do a sale and leaseback of their real estate assets to a REIT sponsored by it. A special dispensation to this effect should be made in relation to sale and leaseback transactions, thereby opening up the avenue for a lot of other businesses in the service sector as also manufacturing sector to raise equity capital by monetising their non-core but valuable assets such as factory premises, warehouses, corporate offices, etc.

As regards real estate developers who have built assets to lease, there are other alternatives available, such as lease rent discounting or raising capital through a Commercial Mortgage Backed Security offering or simply doing equity IPO of the company which owns these assets. Some of these alternatives are already tried and tested and have a path of least resistance. Therefore, the government needs to provide an impetus for real estate developers to sponsor and offer their commercial assets under a REIT structure to the markets, which could very well be in the form of tax equality with non-resident investors in relation to interest income and also permitting the flow of both domestic and international capital into this investment product.

As is typical, all investment products would carry a risk disclosure and disclaimer in their prospectus. It is, therefore, critical to provide for investor education about REITs as an investment product. This has to be more specifically geared towards essential elements such as how to evaluate a REIT performance, how to evaluate the assets owned by a REIT and how to evaluate the performance of a REIT manager, etc. As the hype around introduction of REITs dies down, it will be incumbent for all stakeholders including professionals to build skills around these aspects. This could clearly be the last chance available for the real estate sector to access markets and is incumbent for the sector to ensure its success for the long term.

The author is tax partner & real estate leader, EY. Views are personal