Looking for regular income? You might want to start investing in Reits

Derive 5% of your regular income from Reit initially. Raise this figure to 25% if the asset class does well

The initial public offer (IPO) of Embassy Office Parks Reit, backed by private equity giant Blackstone Group LP and Bengaluru-based developer Embassy Property Developments, opens for subscription on Monday. This is the country’s first real estate investment trust (Reit) listing, with plans to raise Rs 4,750 crore. About 158.6 million units will be available for subscription at a price of Rs 299-300 per unit. The Reit portfolio consists of 33 million sq ft of office space. Before investors make up their minds about investing in this offer, they should understand the pros and cons of this entirely new asset class in India.    

Reits make commercial real estate accessible: It is difficult for a retail investor to get exposure to commercial real estate directly as the investment required is very high. For grade-A commercial property, it could be Rs 5 crore and above. Investors may also face title-related issues for which they may not be in a position to do the due diligence themselves. Exiting such large investments can also be time-consuming. Many of these challenges of investing in commercial real estate get taken care of when an investor takes the Reit route. Investors can enter Reits with just Rs two lakh of initial investment. Exiting these investments should also be less difficult as units of Reits will be listed on the stock exchanges. Investors will also get the benefit of professional management and be able to diversify their portfolios.

Ensuring investor safety: The Securities and Exchange Board of India (Sebi) has taken a few steps to make this new asset class safe for investors. One, 80 per cent of the commercial real estate portfolio held by a Reit will have to consist of developed, income-generating properties. “Promoters will not be permitted to launch a Reit with just a land bank,” says Somy Thomas, managing director–valuation and advisory and co-head–capital markets, Cushman & Wakefield India. This provision will minimise development risk.

Two, 90 per cent of the net income after expenses will have to be paid out as dividend (payable twice a year). “This will reduce the risk of sponsors misusing rental income from properties,” says Thomas.

A key risk in Reit arises from its novelty. It remains to be seen whether it will function in India as it has in developed markets like the UK, Singapore, Canada and Australia, where it serves as a stable, income-generating asset.

Returns you can expect: Rental yield from commercial properties is in the range of 7-9 per cent. In addition, there will be capital appreciation. Together the two components will determine the return from this product (less costs). Capital appreciation depends on a few factors. The lease agreement with the existing tenants has an escalation clause. Second, when leases expire and are renewed, the old rental rates come up to existing market rates. Third, the 20 per cent or so under-construction portion will become ready and get leased. As the rental income of the Reit appreciates, it will get reflected in the capital value of the assets, and hence in the price of its units. Real estate experts expect Reits to give an annualised return of 14-15 per cent.

Financial advisors are not so sure if such high returns will be forthcoming. A variety of factors can prevent rentals from rising. Economic downturns affect the demand for commercial real estate. Rental rates stagnate and vacancy levels rise. Influx of new supply in a geography can affects the rate at which rental rates rise. “Treat it primarily as an income-generating asset that will give you around 7-9 per cent return from rental income, with some kicker from capital appreciation. By expecting a very high rate of capital appreciation, you could set yourself up for disappointment,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisor.  

Do the due diligence: Investors need to carry out several checks before betting on a Reit. First, check the quality of the sponsor, specifically, how much commercial real estate he has developed and its quality. Next, the quality of buildings needs to be checked. Since doing so would be difficult for a lay investor to do, he should use the quality of tenants in those buildings as a proxy (this information is available in the prospectus). “If a Reit has mostly MNC and bluechip companies as tenants in its building, investors can rest assured that the quality of buildings will be decent, since these companies have their own standards and checklists. They will not rent a building that does not meet their minimum specifications,” says Thomas.        

Reits will be listed on the exchanges. However, the level at which it trades remains to be seen.

Who should invest: Those in need of a regular income should invest in Reits. Investors should be aware that both the risks and returns in this asset class are expected to be higher than from fixed-income instruments. “If a well-to-do retiree with some risk appetite invests in Reits, then it should be one of his several income-generating assets,” says Dhawan. Keep your overall exposure to real estate in mind. Whatever your exposure to growth assets, roughly a third of it should be in real estate, and your REIT exposure should be part of that allocation. Initially Reit can account for 5 per cent of your total income source. This can be raised to 25 per cent if the asset class lives up to expectations.

Taxation of Reit: When a resident Indian sells Reit units at a profit, he will have to pay capital gains tax. “If the holding period is over three years, the investor will pay 10 per cent of the gains as tax, subject to payment of securities transaction tax (STT). If the units are held for less than three years, the gains will be taxable at 15 per cent, subject to payment of STT,” says Gaurav Karnik, partner and national leader (real estate practice), EY India.

The dividend paid by a Reit is tax-free in the hands of investors. A trust can also earn interest from SPVs, which could be passed on to investors. “The interest income earned by a domestic investor is subject to withholding tax at 10 per cent by the Reit and taxed at marginal rates,” says Karnik. For a non-resident, the interest income is taxed at 5 per cent, and capital gains tax rate depends on the treaty India has signed with the investor’s country of residence.

Advantages of Reits

• Low entry barrier
• Professional management of assets
• Low development risk

Disadvantages and risks

• New, untested asset class
• Economic downturns can affect rental rates and vacancy levels
• Higher supply vis-à-vis demand can also affect rental rate revision