What are REITs?
Different Types of REITs
Based on the type of Real Estate holdings, the following are the different types of REITs available globally:
Retail REITs:
These REITs are required to invest at least 24% of their assets into
commercial retail such as shopping malls and freestanding retail stores.
Residential REITs: These are Real Estate Investment Trusts that own and operate manufactured housing as well as rental apartment buildings.
Healthcare REITs:
As suggested by the name, these trusts primarily invest in and operate
healthcare-focused Real Estates such as hospitals, nursing facilities,
retirement homes, and medical centers.
Office REITs:
These primarily invest in and operate office space. Their main source
of income for this type of REIT is thus rental received from tenants
with long-term leases.
Mortgage REITs: In the case of these REITs, an estimated 10% of investments are made into mortgages instead of physical Real Estate.
Now that we have covered some basic details of REITs, let’s how REITs in India operate.
REITs in India
In India, the concept of Real Estate Investment Trust is relatively
new and the first guidelines were introduced by SEBI (Securities
Exchange Board of India) in 2007. The current SEBI guidelines related to
REITs in India were approved in September 2014.
There are
currently only 3 REITs available for investment in India – Embassy
Office Parks REIT, Mindspace Business Parks REIT, and Brookfield India
Real Estate Trust. Going forward, other leading names in the Real Estate
Sector like DLF and Godrej are also expected to introduce REITs.
In
India, a REIT has a 3 tiered structure comprising a Sponsor, a Manager,
and a Trustee each of whom performs key functions for the Trust. Their
key roles and responsibilities, as specified by SEBI, are as follows:
Sponsor – This
is usually a Real Estate company that owned the assets prior to the
creation of the REIT. For example, BSREP India Office Holdings V Pte.
Ltd., an Indian subsidiary of US-based Brookfield Assets Management
Inc., acts as the sponsor for the Brookfield REIT. The Sponsor is
responsible for setting up the REIT and appointing the Trustee. The REIT
Sponsor along with the sponsor group are also mandatorily required to
hold 25% of units for the first 3 years after the formation of a REIT.
After completion of 3 years, the sponsor stake can be decreased to 15%
of total outstanding REIT units.
Manager – A REIT Manager
is typically a company that specializes in Facilities Management. For
example in the case of the Brookfield REIT, Brookprop Management
Services Pvt. Ltd. has been designated as the manager. Responsible for
managing the assets of the REIT, making investment decisions, and
ensuring timely reporting as well as disclosure by the REIT.
Trustee – Those
chosen to be a REIT Trustee are typically companies that specialize in
providing Trusteeship services. For example, Axis Trustee Services
Limited operates as the trustee for both Embassy Parks REIT and
Brookfield REIT. The Trustee is responsible for holding the assets of
the REIT in a Trusteeship for the benefit of unitholders. Additionally,
they are required to oversee the activity of the manager and ensure the
timely distribution of dividends.
Additional key SEBI-mandated criteria that REITs in India need to fulfill in order to qualify are as follows:
At
least 80% of investments made by a REIT need to be in commercial
properties that can be rented out to generate income. The remaining
assets of the trust (up to the 20% limit) can be held in the form of
stocks, bonds, cash, or under-construction commercial property.
At least 90% of the rental income earned by the REIT has to be distributed to its unitholders as dividends or interest.
Stock market listing of REIT is mandatory
In the next section, we will discuss how Real Estate companies benefit from the creation of REITs.
Why are REITs Created?
It is clear that REITs allow investors to invest in and profit from
Commercial Real Estate, which is not otherwise easily accessible to
small retail investors. But, here are also a few benefits to Real Estate
companies that form a REIT. In India too, REITs get a few key tax
exemptions that are not available to other types of Real Estate
companies:
Interest payments and dividends received by a REIT
from a Special Purpose Vehicle or SPV are exempt from tax. In this
context, SPV is a domestic company in which at least a 50% stake is held
by the REIT. A REIT can theoretically hold a 50% or higher stake in
multiple SPVs that own individual Real Estate properties on behalf of
the REIT.
These tax benefits can
allow Real Estate companies to reduce tax liability and generate higher
income. Additionally, by listing a REIT on the stock market, a Real
Estate company can also get access to additional funds for future
projects through the IPO. The goal of any investment is to generate
returns for the investor so let us take a closer look at how REITs do
this.
How Do REITs Generate Returns for Investors?
The goal of any investment is to generate wealth for investors and/or
provide regular income. REITs provide both these benefits to
unitholders. Investors can receive periodic dividends and/or interest
payouts that provide regular income and at the same time, the sale of
REIT units on stock markets can provide Capital Gains to the investor.
Dividend and Interest Payouts:
Dividends and Interest are paid out by REITs from their Net Rental
Income. This refers to income that a REIT receives by renting out and
leasing Commercial Real Estate after deduction of some key expenses
related to management and maintenance of the facilities. Some of the
charges that are deducted from Gross Rental Income to arrive at the Net
Income of a REIT include management fees, depreciation, maintenance
charges, etc. The current SEBI mandate states that at least 90% of net
rental income received by REITs need to be paid out as dividends and
interest to investors.
Capital Gains: REITs are listed
and traded on stock exchanges, so the price of individual units changes
depending upon their performance as well as market demand. Just like
Equity Stocks and Mutual Funds, good performance by a REIT leads to an
increase in the price of REIT units, that can be sold at a profit and
provide Capital Gains to the investor. Next, let’s take a closer look at
the key benefits and limitations of investing in the units of a Real
Estate Investment Trust.
Benefits and Limitations of Investing in REITs
The following are some key benefits of investing in REITs:
Diversification: REITs
allow you to diversify your investment portfolio through exposure to
Real Estate without the hassles related to owning and managing
commercial property. This diversification allows you to go beyond the
usual asset classes of Equity, Debt, and Gold as part of your overall Asset Allocation Strategy.
Small Initial Investment: As
mentioned earlier, one of the key problems associated with making Real
Estate investments is the large ticket size especially in the case of
commercial properties. REITs require a much smaller initial investment
of around Rs. 50,000 to provide similar portfolio diversification
benefits.
Professional Management: Properties owned by a
REIT are managed professionally. This ensures smooth operations and with
no effort on your part towards managing Commercial Real Estate.
Regular Income Generation: REITs
generate income from rental collections and are required to mandatorily
distribute 90% of this income to investors as dividends and interest
payments. In this way, REITs provide regular income to investors.
Capital Gains: REITs
are listed and traded on Stock Markets and their price depends on their
performance. A REIT that performs well can thus potentially increase in
value over time and be sold at a profit. This provides Capital Gains to
the investor.
There are also a few limitations of REITs that you should be aware of:
Limited Options: Currently
there are only 3 REITs and 1 International REIT Fund of Fund in India.
This significantly limits the choices for investors.
Low Liquidity: While
REITs are listed and traded on Stock Markets, the number of market
participants is currently low especially with respect to retail
investors. As a result, selling REIT investments profitably might be a
challenge especially in an emergency. This results in low liquidity of
the investment.
Taxable Dividend: Any dividend or
interest earned from REITs is completely taxable in the hands of the
investor according to the applicable slab rate. Thus those in the 30%
tax slab will lose a substantial portion of their dividend income as
taxes. Another important aspect to consider before investing in REITs
are the taxation rules and that is discussed next.
Taxation Rules for REITs
As investors obtain different types of income from REITs, two
different taxation rules are applicable – one for dividend income and
one for Capital Gains. Moreover, the tax treatment is also different in
the case of redemption of investments made through an International
REITs Fund of Fund. The applicable taxation rules are as follows:
Taxation of Dividends:
As per current rules, dividends obtained from REITs are completely
taxable in the hands of the investor. Dividend payouts from REITs are
included in the annual income of the investor and taxed according to the
investor’s slab rate for the applicable Financial Year.
Taxation of Capital Gains: Capital
Gains from the sale of REITs units are covered by Short Term Capital
Gains (STCG) and Long Term Capital Gains (LTCG) applicable to equity
investments. STCG is applicable if the holding period of units is 1 year
or less from the date of unit allocation. The STCG tax rate is 15% of
capital gains obtained from the sale of units. If the holding period
exceeds 1 year from the date of unit allocation, LTCG taxation rules are
applicable. The LTCG tax rate is 10% of gains in excess of Rs. 1 lakh
(across all equity investments for the applicable FY) with no indexation
benefit.
Taxation of Capital Gains for International REIT Fund of Funds: If
Capital Gains are obtained from the sale of units of International
REITs Fund of Funds, non-equity Capital Gains taxation rules are
applicable. In this case, Short Term Capital Gains are applicable if the
holding period is 3 years or shorter (calculated from the date of unit
allocation). STCG in this case is as per the applicable slab rate of the
investor for the FY. LTCG tax is applicable on units held for over 3
years calculated from the date of unit allocation and is 20% of indexed
Capital Gains. Next, let us see how you can invest in REITs.
How to Invest in REITs
Should You Invest in REITs?
The primary reason to invest in REITs is to diversify your investment
portfolio through exposure to commercial Real Estate without the
hassles related to purchasing and maintaining one or more immovable
property. Additional benefits of investing in REITs include professional
management of assets and relatively small ticket size for making the
investment.
While these are undoubtedly significant positives, key
limitations such as very few investment options and limited liquidity
of REITs can impact your ability to monetize the investment even in an
emergency. As a result, it is recommended that REITs should only form a
minor part of your portfolio (ideally no more than 10%). Your decision
to invest in REITs should ideally depend on whether or not you have
already optimized asset allocation across Equity, Debt, and Gold and are
now looking to invest in Real Estate.