Are REITs the remedy the real estate sector needs?

For developers, it offers liquid funds to reduce debt and grow new categories, investors get a toehold in premium commercial property, and the markets move towards better management and realistic valuation of property.

Though commercial real estate currently accounts for only 22-25 per cent of the total real estate in India, including IT parks, commercial offices, and data centres, it has managed to unlock significant value for the sector.

India’s Real Estate Investment Trust (REIT) space has seen action since the Securities and Exchange Board of India (SEBI) gave the go-ahead to it in India in 2014. In the beginning, it opened the relatively illiquid commercial real estate assets to a mutual fund-like category, but by insisting on Grade A commercial property with 80 per cent pre-leased and rent earning, it reduced risk. By making 90 per cent of the rental and other returns to be distributed as dividends, it ensured that REITs were off the corporate taxation structure.

The entry of international financial institutions boosted the profile of REITS. Some of these firms that invested in Indian REITs are: Blackstone (Embassy REITs), Brookfield (Candor and Powai), and GIC in DLF as it prepares for a new REIT. Among national firms, the Mindspace REIT is funded by the parent group K Raheja Corp. Many developers have used this money to reduce debt, expand operations into new categories, and consolidate.

To further encourage small investors, SEBI has allowed the purchase of single units of REITs. Though it is early days, a small investor with limited means can invest in REITs and partake in the growth of India’s real estate sector.

Asset value unlocked

REITs have unlocked institutional, corporate, and individual investor wealth to fund operations and management of corporate real estate. With the pressure to perform, management partners in these special purpose vehicles (SPVs) have improved the quality of their management, and this is reflected in every part of the corporate real estate sector. This category evolved further when in December, Blackstone offloaded its entire 23.5 per cent stake in Embassy Office Parks to a clutch of financial institutions; this included new investors like SBI Mutual Fund, and existing investors like Capital Group, Fidelity, Bain Capital, ICICI Mutual Fund, and HDFC Mutual Fund.

In any case, it is the value of the asset that is being unlocked. For large developers with substantial income-generating assets, a REIT is a means of cashing out a percentage of the completed assets to either put down debt or invest in newer asset creation. For the institutional REIT manager, since valuations are to be made every six months by two approved institutions, it is imperative to keep the returns steady through best practices.

In the world of REITs, it is good assets that yield more returns for the manager. Of the income generated, 90 per cent is to be distributed among shareholders every six months, leaving just 10 per cent to play with in other assets. However, by maintaining trust, the REIT manager has the option of raising funds from the market through an IPO, or even private rounds of fundraising.

This is a far cry from the days when only banks lent capital to developers. Today, funds chase well-managed REITs. The sale and purchase of assets is undertaken by the REITs manager who is paid 3.5 per cent of rent as management fees and 0.5 per cent of the distribution as fund management fee. All this is under the watchful eye of SEBI. The investor simply invests in REITs and gets market-linked returns.

Small REITs

SEBI has gone further by opening REITs to smaller companies. First it allowed fractional ownership for smaller companies, and in May released a discussion paper proposing that smaller managers with asset values of Rs 50 crore could register as SPVs to invest in smaller projects. In November, the board decided to create a regulatory framework for small and medium (SM) REITs.

When regulations set in, market forces get working, and the valuation of different segments of the sector emerge. Earlier this month, global brokerage firm Jeffries chipped in saying residential real estate needed to reflect a realistic valuation. Arbitrary price rises without understanding of shifting demand patterns will adversely affect the stock prices of listed real estate companies. Residential real estate has ridden the premium category demand over the past couple of years, but now, with lower mortgage rates expected, we could expect the comeback of the middle income and affordable housing segment. In such a scenario the well-managed SM REITs stand to gain.

A major change REITs is bringing about in India’s real estate sector is the phasing out of arbitrary price hikes; these are replaced with scientific demand and supply studies. REITs help in democratising investor participation in that even small investments can be made, and free cash flow is brought into an otherwise illiquid sector.

(E Jayashree Kurup is a writer-researcher in real estate, and Director, Real Estate & Cities, Wordmeister Editorial Services. Views are personal.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.