A new addition to our Realty Tracker – REITs

The Real Estate sector is one of the most important sectors in the economy from an economic point of view. The sector, directly or indirectly, is the second-largest employer and its well being is key to employment generation, infrastructure growth and overall economic strength.

The Realty Tracker smallcase consists of formidable real estate companies and helps investors track the growth of this sector efficiently. Recently, we included REITs or Real Estate Investment Trusts as part of the realty tracker. Since these instruments are a little different from common stocks, we thought of explaining what they are, their benefits, structures and what it could mean to have them as part of one’s portfolio.

Let’s begin!

What are REITs?

As noted in a previous blog, REITs are companies that own and operate income-generating real estate. Basically, REITs pool in money from different avenues like institutional investors, retail investors (individuals like you and me), endowment funds, mutual funds, etc and then use this money to invest in properties. These properties are rented out — hence they’re called income-generating real estate. And the rents are distributed to the investors (also called unit-holders) in the form of dividends. So if you own 1% of the shares of the REIT, you will be eligible to get 1% of the total distributions to the shareholders.

It’s actually best to understand the structure and concept of REITs using an example. While the inner workings of REITs are a little more complicated than the example that follows, it captures the gist well.

Let’s take a hypothetical scenario wherein you and 3 of your friends are of the opinion that due to the widely expected positive business environment in the future, demand for office spaces is going to go up – and as prudent investors, you think it will be wise to buy an office space and rent it out. 4 of you pool in a corpus of ₹2 crore (₹50 lac contribution by each of you), and buy an office space of your choice. You rent this out to a company for ₹20 lac per year (i.e. 10% rental yield). After deducting the costs (maintenance, staff salaries, etc), let’s say you are left with ₹16 lac. This money is then free to be distributed equally (₹4 lac each), among the 4 of you. 

This is the basic framework on which the model of REITs is based.

REITs – A basic structure

Apart from the investors (also called unitholders), there are 4 main stakeholders in the structure of REITs:

• Sponsors: Sponsors are individuals who set up the REIT. SEBI regulations direct that sponsors should own at least 15% of the units of the REIT for a minimum period of 3 years from the date of listing.
• Manager: Think of the REIT manager as a mutual fund manager. The main role of the manager is to allocate funds into different income-generating properties and other projects that the manager deems fit.
• Trustee: The Trustee is like the Board of Directors of a company. The main role of the trustee is to oversee the functioning of the REIT and make sure that the managers are acting in the best interest of the unit-holders.
• Special Purpose Vehicles: An SPV is a seperate business entity created by the REIT itself in order to hold property in the SPV’s name. Some tax and other benefits are associated with such a structure.

The Securities and Exchange Board of India (SEBI) lays down the rules and regulations that guide any investments into financial instruments. REIT investments are no different. The business and financial risk profile of REITs is governed by the REIT regulations, which were initially notified in September 2014 and modified through multiple amendments over the subsequent years. Let’s look at some of the rules that govern the functioning of REITs, including its investment in assets (real estate), how it will distribute the money amongst its investors (also called unitholders) and rules for raising debt capital if required.

Now that we have the rules out of the way, let’s understand the nuances of investing in REITs, how investors make money, and how it works…

Investing in REITs – how it works!

REITs trade on the stock exchange daily – just like other stocks on the exchange – with only a slight difference. When REITs were first introduced, there was a minimum investment amount of ₹1 lac. Later on, it was reduced to ₹50,000 and now it has further reduced to a range of ₹10,000 – ₹15,000. Moreover, REITs needed a minimum lot size of 200, meaning that you needed to buy a minimum of 200 units to invest in REITs. However, working towards making REITs investing akin to stock investing, SEBI has relaxed that rule and now you can invest even in a single unit of a REIT, just like stocks.

This move is expected to give the much-needed impetus to the REIT market as it makes it more accessible to all investors — big and small. Moreover, it will give a liquidity boost to the market, which might incentivise other real estate developers to enter the REIT business model as well. Also, it is because of this liquidity boost that REITs were now eligible to be part of smallcases as well.

How do REIT unitholders/investors make money?

REIT investors make money in 2 broad ways…

First – fixed income (in the form of dividend/interest). The money that a REIT generates after deducting expenses – also called Net Distributable Cash Flows (NDCF) is the money that is leftover for the REIT to distribute to its unitholders. By law, a REIT is required to distribute at least 90% of the NDFC to its unitholders at least twice a year.

The second is capital appreciation. Just like how the price of stocks rises/fallsl over time, the units of the REIT also appreciate/depreciate in value. Since unit-holders indirectly own a portion of the property that REITs buy, the investments grow in tandem with the value of the properties that the REIT holds. Think about the example we spoke about earlier where you and your friends buy office space for ₹2 crores. Over time, not only will you make money by way of rent, but in the event that you guys want to sell the property, after say 10 years, chances are you will get more money than just the 2 crores that was initially invested.

So, REITs give us the best of both worlds – fixed income in the form of dividends (just like how you get fixed interest on loans) as well as scope for capital gains (as in the case with normal equity shares of companies that grow over time).

REITs have certain tax treatments that investors should be aware of…

Tax treatment of REITs

• Dividend received by REIT or InvIT from SPVs and distributed to unitholders: Taxability of dividend in hands of unitholders shall be dependent on if the underlying SPV (from which the REIT or InvIT has received such dividends) has opted for a beneficial tax rate.
  • In case the SPV has not opted for the beneficial tax rate, the dividend received by the unitholders from the REIT or InvIT is exempt from tax. Further, no withholding tax shall be deducted by the REIT or InvIT in such a case.
  • In case the SPV has opted for the beneficial tax rate, then in such a case, the dividend is taxable in hands of the unitholders. For resident unitholders, such dividend is taxable at rates applicable under the provisions of income tax and for the non-residents, the dividend is taxable @ 20% or rate as per the relevant tax treaty, whichever is more beneficial. Consequently, the REIT or InvIT is required to withhold taxes @ 10% under section 194LBA of the Act, whether the unitholder is a resident or a non-resident.

• Interest received by REIT or InvIT from SPVs and distributed to unit Holders: Interest distributed by REIT or InvIT to the unitholders shall be taxable in hands of the unitholders at applicable rates in hands of resident unitholders and @ 5% in hands of non-resident unitholders. Accordingly, taxes are required to be withheld by REIT or InvIT @ 10% for a resident unitholder and @ 5% for a non-resident unitholder.

• Rental income (in case of REITs): Income earned by REIT from renting or leasing or letting out any real estate asset directly owned by such REIT is exempt from tax in the hands of the REIT. Consequently, there is an exemption provided to tenants from withholding taxes at the time of making rental payments to the REIT.

Rental income distributed by REIT to unitholders is taxable in the hands of unitholders at the applicable rates. Accordingly, taxes are to be withheld @ 10% where the distributions are made to a resident unitholder and at applicable rates (Act or Treaty) where distributions are made to a non-resident unitholder. In the case of a non-resident unitholder, there is a controversy on whether the maximum marginal rate of tax @ 40% (plus surcharge plus cess) would apply in case such income is in the nature of income from immovable property situated in India in which case a treaty benefit may be challenging.

Note: REITs specify how much of the distribution received by unitholders tax-free while declaring it.

There are 3 REITs currently active in India. Let’s look at a comparison of the key metrics between these.

A comparison of REITs in India

Additions to the Realty Tracker

As is already evidenced by the above comparison (and some more technical in-depth research), Embassy and Mindspace REIT are well-positioned to capture the growth of the promising REIT and wider real estate market. As compared to them, Brookfield has certain operational hiccups – very concentrated portfolio (check % owned by top 10 clients), high debt financing (which makes its projects a little riskier), lower rentals as compared to peers and also the lowest occupancy rate among the 3 players.

Thus, we have decided to include the Embassy and Mindspace REIT as part of the Realty Tracker.

Realty Tracker smallcase by Windmill Capital

That’s a wrap. Take care, and happy investing! 🙂

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