Real estate: Getting REIT right, says Kotak Institutional Equities

Updated: Jul 21 2014, 18:53pm hrs
Real Estate Investment TrustFinance Minister Arun Jaitley made a progressive announcement on REITs (Real Estate Investment Trust) in his budget speech. (Reuters)
REIT, a reality Not yet! Although the finance minister made a progressive announcement on REITs (Real Estate Investment Trust) in his budget speech, we believe work still needs to be done on the fine print and state-level issues need to be sorted for REITs to become a reality. Our discussions with accounting professionals, law firms and sponsors indicate hurdles that need to be overcome with respect to the current structure of a REIT. Also, even if some stakeholders take a hit on tax, high interest rates and a negative spread are still hurdles.

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Key announcement and on REITsdoes it really change anything The finance minister made two major announcements in the recent Union budget, which directly affect the tax structure for setting up a REIT.

o Capital gains tax on transfer of interest in an SPV to a REIT will be deferred until the sponsor monetises the investment.

Wish list. Most sponsors were seeking a one-time exemption in capital gains tax on transfer

of assets (in line with the practise in most successful global

REIT markets).

View. Globally, capital gains tax is exempt on transfer of shareholding. Change in the preferential tax regime in the finance bill makes its non-viable for the sponsor, we believe.

o The REITs dividend distribution tax is a pass-through if the income of the REIT is in the form of dividend from a subsidiary/SPV. Further, a 10% withholding tax for resident and 5% for non-resident unit-holders is applicable if interest earned by the REIT is distributed as dividend.

Wish list: Exemption in dividend distribution tax at the SPV level as 90% of the income would be distributed to investors.

View. This is not different from the existing structure for a developer with multiple subsidiaries/ SPVs holding such assets. In case a subsidiary is dividend paying, the tax is set off at the parent level, which is also paying dividend.

Assuming the current tax structure remains, is it viable for stakeholders

o We believe Indias property market is at a nascent stage compared with developed markets. Excluding a few deals in the trough of 2010-11, most pre-let commercial property acquisitions took place at negative spreads and at high single-digit/low double-digit yields, while the cost of borrowing is about 11.5%. In most developed markets the yield spread is positive. In India buyers and owners look for capital appreciation and cap-rate compression as rents are near all-time lows in most markets.

o Most sponsors with potential REIT offerings command a strong brand equity and thus better cost of borrowing versus others (11.5-12%, post-tax 7.5-8%). Ideally, a sponsor would look at monetising value, which is better than its existing funding options. If fund raising takes place at lower cap rates, it becomes unfavourable for the investor.

How do the tax announcements impact the current structure

Capital gains are deferred, not exempt: The government has proposed to defer and not exempt capital gains arising to a sponsor from tax until the units of a REIT are sold. The tax on transfer of the sponsors shares in an SPV to a REIT in lieu of units of the trust is deferred. The Finance Bill proposes to insert an additional proviso, which denies preferential capital gains regime available in respect of units of a business trust, to the sponsor of the SPV in respect of these units when they are disposed of by it. Thus, capital gains will be taxable at the time of the sale of units of business trust received in exchange of shares even if the transaction of sale of units is carried out on a recognised stock exchange. This makes it non-viable for sponsors.

A pass-through on Dividend Distribution Tax Not really: The government has proposed a pass-through on distribution tax when a REIT pays dividend to unitholders. But the SPV that owns the project is subject to corporate tax and the dividend paid by the SPV to the Trust is also subject to DDT. This makes it no different from the current structure in which a developer is holding projects in an SPV, which if pays dividends to the developer could be set-off if the developer in turn pays dividends to its investors. In fact the current structure is marginally better for the developer as investments in the SPVs are usually in the form of debt.

The government also proposed that in an investment of a REIT into an SPV, if in the form of debt, the interest income earned by the REIT will have a pass-through, that is, no tax on interest income of the REIT. But if such interest income is distributed to unit-holders as dividend (90% of the income of the REIT has to be distributed as dividend), it will have a 10% withholding tax for resident unit-holders and 5% for non-resident unit-holders. The resident unit holders will be charged at a maximum marginal tax rate with the benefit of setting off the 10% TDS cut. This structure is marginally better than the previous one with some saving at the SPV level.

Trusts are now taxed at a maximum marginal rate if they are discretionary trusts, or those engaged in business. Beneficiaries of these trusts are not taxed. This assumes that these taxes are all domestic trusts. This basic principle is sought to be retained, where the constitution of business trusts is concerned. Further, a new section is proposed to be inserted, which taxes income of the business trust at the maximum marginal rate. Various industry bodies and sponsors made the following representations to the government, which largely remain unaddressed.

o As 90% of the net income will be distributed to unit-holders/investors, DDT should be completely exempt. This practice is also followed in successful REIT markets.

o Complete tax exemption of capital gains to the sponsor and the REIT on disposal of assets as the net proceeds of the disposal of asset in a REIT is distributed to unit-holders.

o Stamp duty exemptions on transfer/purchase of properties directly by REITs: In India land is a state subject and stamp duty is levied by states. The five states which hold the majority of the assets which could potentially be listed in the form of REITs are Maharashtra, Karnataka, Haryana, UP and Tamil Nadu. The stamp duty on asset transfer varies from 6-9% in these states. Direct holding of a property by the REIT (going away with the step down SPV structure) will save some tax leakage (DDT). Separate representations will have to be made to the states for this.

Assuming current tax proposals are agreeable, its viable for whom

Should a Grade A developer with a strong balance sheet monetise through REIT Most banks, financial institutions are keen to lend to Grade A developers. Hence as evident, the cost of borrowing for a Grade A developer is already low and falling further. Besides, the introduction of Commercial Mortgage-Backed Securities (CMBS) like structures has improved the cost and structure of borrowing for the developer. The recent (maiden) fund raising, initiated by DLF, was at 10.9%, which makes the effective post-tax rate 7.3%. We believe a developer would be more comfortable raising debt and keeping the property appreciation for himself if debt is available at the current rate (11-12%).

Additionally, as the commercial property market is emerging from a low, with most rents being closer to the cost of construction (on a capitalised basis), a sponsor would want to keep the assets on books and earn benefits of an increase in capital values.

A sponsor will aim at lowering the cap rate to (i) raise more capital but more importantly (ii) achieve a better rate than the current cost of funds. Even at a 10% cap rate the spread for an investor is negative versus the relative investment vehicle, given high interest rates in India currently. As cap rates fall by 100 bps, so does the yield, which makes investment in such a vehicle unviable at the current interest rates.

Experts on the subject

Post-budget we attended a panel discussion at the Asia-Pacific Real Estate Association (APREA) conference on the budget implications. Key highlights:

o Panelists agreed that most global REITs do not have a tax structure of more than 20% and the budgets tax proposal makes it slightly more complex than what is proposed by the market regulator.

o The developer in the panel sounded optimistic about steps taken by the government; but opined that he has different options to raise funds and not necessarily a REIT, on the current dynamics.

o A lot of capital is chasing too few investible assets in India, due to which the yield spread is negative. The consultant in the panel validated, citing an example that over $2 bn of assets were being chased only in Mumbai with cap rate expectations of 9.5%.

o The sponsor expectations on the cap rates for listing are near 6% while those of investors are 10%. But in markets with REITs, the spread on yield with a 10-year treasury note is 200-300 bps.

Kotak Institutional Equities