SEBI, in it’s board meeting, approved regulations for Real Estate Investment Trusts (REITs). These are entities which own property and get rental income and/or income from selling the property. Here’s how the structure will work in India:

The What

Each REIT will have 80% of its assets as owned property. This might consist of property directly owned, or owned through a Special Purpose Vehicle (SPV) in which it owns 50% or more. (An SPV makes sense when the land owners may jointly own the assets with a builder, but the builder holds more than 50%)

This 80% must be completed properties, ready and revenue generating. And right now, only commercial properties. And a minimum of 2 properties, with max 60% in one.

The remaining 20% can be used to buy under-development properties (max 10%), debt to builders or government / money market securities.

This is good regulation – using the money to fund real estate companies through debt would have been a disaster.

REITs can raise funds through an IPO. For this the REIT will have to be at least Rs. 500 cr. in size. (Companies will less can pool together, max 3 in a REIT) It will offer units for sale, and investors can buy a minimum of Rs. 2 lakh worth. The issue should be for 25% public holding at least.

REITs must distribute 90% of the income they get. It can’t be reinvested. Also, if the underlying assets are sold the income generated must be distributed too. 

In Budget 2014 we saw REITs getting a tax-pass-through status. This doesn’t actually mean that much. What it means is:

  • For rental income, the REIT will pay 30% tax, then distribute. Unitholders don’t pay further tax.
  • For interest received, the REIT pays no tax. It’s taxed in the hands of the unit holder. TDS is 5% for foreigners, 10% for Indians.
  • Dividends received by the REIT (from SPVs) are anyhow tax free. (though the SPV will pay dividend distribution tax if it’s a company, or not at all if it’s an LLP). Further distribution of this to unitholders attracts no tax.
  • Capital Gains is taxed at the REIT level (20% LTCG). The post-tax money distributed is not taxed in the hands of the unit holder

Also read this note by Nishith Desai . This really means that the main basis of income for the REIT – rental income – gets taxed at 30%. Which, as we’ll see later, reduces the attractiveness.

NAV Declaration: REITs must get their properties valued every year, and update their Net Asset Value within 15 days.

Skin in the game: The “Sponsors” of the REIT, who are effectively the promoters, will own 25% of the project of 3 years after listing and then on, 15%. They can’t just ditch and run.

Our View

Assume there is a property generating rents. Why will the owner attempt to sell it, and yet, retain 25%? When the price is high, or when it is not apparent that the rental yield will continue to be this high.

Either ways it’s unlikely you get high yield REITs. Most commercial yields are of the order of 2% to 6%, (Note: See Update below) so we can safely assume that companies will put stuff into REITs when the yields are of the order of about 4%. (Remember, there will be a service cost for the REIT to operate – which could take another 1% away from the yield)

A 4% yield is horribly low. However, it is indexed to inflation in many cases – let’s assume a 6% rise in rents each year; how much would that be? Even after 10 years, that’s a yield of 7.16%. Again, way too less to be of consequence.

This does not include property taxes, property upgradation, idle cost (if you aren’t able to find companies that will rent it out, the property maintenance fees have to be paid) and REIT service fees. 

Worse, it doesn’t include income taxes – which as we’ve seen above, are taxed at 30% at the REIT level. A 4% yield is effectively a 2.8% yield.

The bet then is on capital appreciation, which can increase the Net Asset Value and the price in teh market. But don’t bet on money coming in from sales. Because it’s not apparent why any REIT would want to sell. Remember, an REIT collects rents. If it sold properties, it would have to return money to shareholders, and its asset value will drop. It will then have lesser income, and this becomes an existential crisis.

The only time they will sell is if prices are too low and no rents are being realized. Which is not a good bet to take in the first place. So it’s a bet on the greater fool, who bets on the higher “NAV” and a lower yield. (Which in India has been a great bet to take!)

Another risk is that builders will alter the maintenance-rental mix. When you rent from the builder, they put a certain amount as rent, and a certain price per square foot as the maintenance cost. This is unregulated for the most part. So they could charge you Rs. 5 per square foot, or Rs. 15 per square foot. Promoters who are scoundrels can do this – sell the property at a yield of (say) Rs. 100 per square foot to the REIT, and then, after a year, change the maintenance cost to Rs. 40 per square foot, forcing down the rentals to compensate. The builder has thus sold a good portion of the property to the REIT, but makes a higher revenue per square foot on maintenance.

This is not usually done because it invites the wrath of property owners. But here, since the REIT is owned piecemeal, and managed by the builder, the incentives are all for the builder to maximise his own revenue. It’s always dangerous to set up misaligned incentives. (As in, have REITs that are not managed by the builder or anyone related, but that’s not going to fly)

REITs will be marketed with a vengeance. Imagine, you can buy a part of a property and get rentals and own it and have someone else manage it! Our love for property is only next to our love for Gold. So you can bet your left eyeball they will make attractive pitches. But how much it’s useful is largely dependant on pricing, the kind of properties in the pool, related party transactions.

Assuming REITs are a success, the concept is great for real estate folks. But it’s bigger for banks. Banks are up to their eyeballs in lending to commercial real estate. They will be able to get some of their money back. With that exposure cut, they can lend to builders for other kinds of property, or for other reasons.

If you ask me what I would do, the answer is: it depends. What’s the point speculating if you don’t know the price of an REIT, and the specific properties it owns? But yes, marketing teams should dust off their “IPO” presentations, because this could be the next big thing.

Who’ll buy?

  • Domestic Institutions: Perhaps. If the return is decent.
  • Foreign Institutions: Not quite so sure about them as some of their tax situations could get complex. India doesn’t tax certain income from REITs in customers hands but other country’s will. But many countries are lower tax so there’s going to be a lot of interest from them.
  • Individuals: With a 200,000 rupee lower limit, this will be restricted to a few HNIs. But again, post tax yield will determine interest.

Update

Apparently, rental yields for commercial property are 10%+. And price increases are 15% in three years, which is about 4.8% per year. This has come through in a couple of articles. (though I’m not sure where, as yields where I look are lower).

Let’s check this thing out with 11% yield. Taxes take out 3% (30% tax) so you’re left with 8%. A post tax yield of 8%, growing at about 5% a year, isn’t too bad really.

The pain then moves on to: property taxes, idle cost, longer term maintenance and fees. That would probably eat up 1% to 2% or so. So the effective yield would be 6.5% to 7% post tax.

Which is more attractive, I agree, plus the 5% increase each year will take yields higher. (though at this point, even that post-tax yield won’t cover inflation, and tax-free bonds are at 8%)

Like I said, it’s all going to be about yields – so the higher the effective yield and the lower the likelihood of idle costs, the REIT will be more attractive. I just hope the effective return beats inflation!

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