The REIT Way To Invest

Real estate has always been the Indian investor’s preferred choice, even if it means investing in just a plot of land. The sharp rise in prices of both residential and commercial real estate over the past few years, however, has made investing in property a difficult proposition for most ordinary Indian investors.

To be sure, the real estate market as it exists today is meant primarily for one class of investors — the rich. Even during the 2008-10 boom in real estate prices, the big investors gained the most. It is this nexus that has prevented real estate investing from becoming broad based. So what is the way out?

What is probably needed is an investment product like REIT, or real estate investment trust. Simply put, a REIT can operate as a company that owns and operates income-producing real estate like office, apartment buildings, warehouses, hospitals, malls and hotels among others.

The REIT works as a mutual fund by pooling funds from several investors and investing in real estate on their behalf. Income earned by it could be through rentals or capital gains or both and gets distributed to unit holders.

Opportunities & Reach
To developers, a REIT can take the form of a special purpose vehicle (SPV) or a standalone trust where it can bring in the rental it receives from its commercial properties. By launching a REIT Fund, developers can mobilise resources for further development or may use the proceeds to repay debt.

Globally, REITs are operational in over 30 countries providing high dividend yields along with moderate long-term capital appreciation. According to a KPMG report of September 2014, about 500 REITs were present in 22 countries with a market cap of over $800 billion.

A KPMG report estimates that India has close to 400 million sq. ft of commercial office space of which about 100 million sq. ft is ready to be let out, while Indian commercial real estate which is REIT compliant is worth $10-20 billion.

A Non-starter
Although market watchdog SEBI came out with guidelines for REITs in September 2014, not a single REIT offering has so far come from any player. According to Hemant Tikoo, Chairman, Experion Developers, three or four things if implemented can push REITs. “REITs should be made a pass through structure. While rental income is a pass through, capital gains on sale of assets/SPV is not a pass through. Stamp duty on transfer of shares of SPV or commercial assets from developer to REIT should be exempted,” says Tikoo whose Experion is a FDI-funded developer. He says the Dividend Distribution Tax by SPVs to REITs should also be exempted and transfer of assets in lieu of units of REITs should have tax deferral provisions.

The SEBI (Real Estate Investment Trusts) Regulations, 2014 instruct that REITs shall invest only in commercial real estate assets, either directly or through SPVs. If the investment is through a SPV, the controlling interest in it should still be with the REIT. It appears that REITs will be kept away from many retail investors as the minimum investment has been fixed at Rs 2 lakh. However, they will be listed and trading is allowed in lots of Rs 1 lakh. This brings in liquidity to real estate investments that otherwise are highly illiquid in physical form.

According to SEBI, at least 80 per cent of the value of the REIT assets shall be in completed and revenue generating properties and the balance 20 per cent may be in developmental properties, mortgage-backed securities, corporate debt of the real estate sector, equity shares of companies deriving not less than 75 per cent of their operating income from real estate activity, government securities and money market instruments or cash equivalents. It also rules that REITs shall distribute not less than 90 per cent of the net distributable cash flows to their investors at least on a half yearly basis.

Rescuing REITs
Budget 2015 tried to do its bit by allowing the sponsor the same tax treatment on offloading of units under an initial offer on listing of units as would be available on offloading the underlying shareholding through an initial public offer. It also exempted REITs from long-term capital gains tax. Another important concession was in the form of pass through to the rental income arising to REIT from real estate property directly held by it. However, the distributed income in the hands of the unit holder would be taxable. But other taxation concerns remain.

Concerns Galore
The Dividend Distribution Tax (DDT) is the biggest concern. Rajesh Narain Gupta, Managing Partner, SNG & Partners says, “If DDT is applied and thereafter the withholding tax is also applied as per the current norms there will not be any interest in REITs.”

In the current form, the SPV will pay tax on its profit which is corporate tax. Out of the balance profit, if a dividend of another 22 per cent is to be paid, what remains is almost half of the original cash flows. Alternatively, if the asset is first moved into a trust, then stamp duty has to be paid on asset sale which is around 7-10 percent. On the balance, DDT gets paid.

Saurabh Chawla, senior executive director, Finance, DLF, says, “When 40-50 per cent of cash flows are being taxed, why should one launch REITs in their current form.”

Suresh Surana, founder, RSM Astute Consulting Group echoes the same sentiment. “The SPV structure for REITs is not tax efficient in case the SPV is a company since, the rental income earned by the SPV would be subjected to corporate tax (@34.6 per cent) and subsequent distribution would be subject to DDT (@20.36 per cent).”

In October 2014, the Ministry of Corporate Affairs said a REIT under SEBI rules is not barred from becoming a partner in a limited liability partnership (LLP). “While SEBI regulations permit SPV to be an LLP, there are no corresponding provisions under the Income-tax Act for SPV being an LLP,” Surana points out.
Furthermore, although taxation in REITs is at par with equity mutual funds, the holding period is still a concern. An equity MF is tax exempt after it is held for 12 months but for a REIT to be so, it must be held for 36 months. Says Surana, “A clarification or an amendment is required to bring the units of a REIT at par with equity oriented mutual funds.”

Moreover, the road map for foreign investment in REITs might require more clarity. “A major deterrent is the lack of guidelines for foreign investments in REITs. Under the extant norms, FDI is not permitted in entities carrying on real estate business. Although the Union cabinet gave its approval for foreign investments in REITs on 6 May 2015, no formal notification under the FDI policy has been issued so far”, says Surana.

DLF’s Chawla also sees taxation as a roadblock. “Worldwide there is no taxation on the cash flow that an asset earns to the unit holder. Some countries do have the tax if the asset is owned by an entity. But after that it’s just a pass through. We are not saying don’t tax, but let’s tax it at only one level and not at both levels.”

According to Chawla, there is resistance within the tax department on easing of DDT. “An exercise needs to be done to establish as to how much of dividend is earned from these assets and what’s the revenue foregone,” he says.
The trade-off then is between loss of tax revenue on dividends and opening up a new channel of fund mobilisation by getting Indian investors to participate in the real estate sector too.

REITs may serve as an alternate investment avenue for thousands of investors who want to have a share of the real estate pie. The government should remove anomalies and come up with rules that help not only the investor but give a helping hand to sector as well. If the revenue loss on account of DDT in the initial few years can be beneficial in the long run, the delay then is unwarranted.

TAX WOES OF REITS
Like equity mutual funds, equity shares and bonds, REITs offer not just an alternate investment avenue for investors but have the potential to add substantial value to one’s portfolio. Here how:

Diversification: Holding real estate in one’s portfolio helps achieve diversification and reduce overall risk. Traditionally, the co-relation between equity, debt and real estate sectors and also with other sectors has been low as per studies done in the past. However, interest rate plays an important role in its performance as will the growth of economy.

Liquidity: Unlike owning a plot of land or property where liquidity is less, REITs offer partial or full liquidity through exchanges.

Returns: The rental yields on commercial properties may differ across geographies. The escalation clause in rent agreement could also contribute to rising returns for unit holders over the years. For instance, in commercial assets, there are nine-year leases and once fixed they are reset every three years thus giving a compounding effect. After nine years, the rent is fixed again, usually at a higher value, and the cycle of revision every three years is followed once again. Capital gains could accrue upon transfer of the asset thus boosting returns. Chawla says, “Returns can be expected around 14-15 per cent. Fees could be at most 2 per cent.” The risks involved in REITs should however be evaluated before considering them as an investment option.

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(This story was published in BW | Businessworld Issue Dated 14-12-2015)