Posted in Finance Articles, Total Reads: 11622
, Published on 04 May 2012
The Indian government has realized that India’s real estate is a key component of economic growth and is on the verge of second boom. However, there are many issues with India’s real estate sector structure especially in financing. This article attempts to outline the working and basic structure of Real Estate Investment Trusts or REITs and how they can institutionalize India’s real estate sector, provide quicker financing to real estate projects and give investors an alternate source of investment by acting as best inflation hedge around. Finally, the article discusses the basic underlying problem with launching REITs in India and suggests alternative solutions.
What is an REIT?
An REIT(Real Estate Investment Trust), first introduced in the US in 1962, is a corporate structure which invests its assets in real estate holdings. One gets its share of earnings or losses from the REIT’s portfolio of real estate holdings. REITs distribute the profits earned through generation of rental income (more than 90% of annual income) to their investors in the form of dividends. This investment is comparatively more liquid as compared to traditional physical holding of real estate.
However, the downside is that one has no control over the buying/selling/holding or managing it. The reason REITs are liquid is that they can be traded on major exchanges, making it easier to buy and sell REIT assets/shares than to buy and sell real estate properties in physical market.The typical structure of an REIT is shown below in Exhibit 1.
Need for REITs in India:-
India’s real estate sector is highly unorganized.In fact, the construction sector did not even have an industry status till a few years ago, which it badly needed to get easier access to funds from banks and financial institutions. This resulted into inflow of a lot of black money into the sector.
Moreover, before 2005, government did not allow FDI into the sector. Even now, FDI allowed is only in construction development, partially blocking out the sector from financial markets.Development of new town and cities is on the anvil and India, because of its ever-growing population, requires them drastically. These new developments are in need for huge amount of investment and technical expertise, which cannot be achieved under present structure as most of the work is done in an unorganized manner.
Indian government has realized that real estate sector’s growth is key component of economic growth and any factors inhibiting its growth will have a negative impact on the economy. Introduction of REITs will help India overcome this problem in a big way by institutionalizing the real estate sector and will also provide foreign investors with ample of opportunities to invest.
REITs in India as investment opportunities
Real estate sector has provided the best return on investments in recent years and, with ever increasing real estate projects all across India, this trend will continue at least for a few years and REITs will act as a special vehicle for investment in the sector.REITs will provide investors with an alternative investment class and an access to ownership in a large high value Real Estate project at a low ticket size. Exhibit 2 shows the investment opportunity in India’s real estate sector.
Exhibit 3 shows that India provides a considerably good opportunity for REITs.
Along with liquidity REITs also provide the best inflation hedge, far better than that offered gold stocks.
As shown in Exhibit 4, the two assets providing the most dependable inflation protection since January 1978 have been commodities and equity REITs. Commodities led by exceeding the inflation 70.4%times during high inflation six month periods, while equity REITs followed close behind at 65.8%. Stocks and TIPS (Treasury Inflation Protection Securities) provided somewhat weaker inflation protection, with stock returns exceeding inflation 60.8%times and TIPS exceeding 53.8% times. The weakest inflation protector has been gold, with returns beating inflation during only 43.2% of high inflation six month period.
Exhibit 5 shows the returns when inflation is high. Best returns have come from commodities with gold coming second and REITs third. However during periods of low inflation commodities and gold have typically provided returns close to zero percent but listed equity REITs have historically provided strong returns when inflation is high also when inflation is low as shown in graph below.
Another characteristic that made REITs popular in United States of America is the tax benefits offered to companies incorporating REITs, provided they follow the set rules and regulations.
Issues with launching REITs in India and its recommended solutions
Launch of REITs in India has been delayed because SEBI (Securities and Exchange Board of India) feels that Indian property markets lack depth and liquidity required for proper functioning of REITs.
Other problems that exists with launching of REITs in India are-
Institutional grade space–For the purpose of comparison these Real estate properties are grouped into three classes Class A,Class B, and Class C with class A being the best class of real estate. These classes represent a subjective quality rating of buildings which indicates the competitive ability of each building to attract tenants and a combination of factors like rent, building amenities, location and market perception. Except for office space some of which can be classified as grade A, organized real estate space market for other property types like health care, retail storage, apartments and specialties do not exist in the form of income producing properties.
Valuation models-Currently there are no valuation models for audit and sales purposes, no requirements to be an evaluator and lack of specialized personnel in this domain.
Weak legal structure – Non uniform state taxes, title issues with land and stamp duty on every sale and purchase which can effect IRR that is Internal Rate of Return(the discount rate at which sum of your cash flows equals the initial cash investment) of REITs.
Lack of trained employee base - REITs require asset and portfolio management expertise along with development and leasing expertise whereas in India there is no Real Estate education at corporate or university level and is not looked as a career option.
The absence of any one of the above elements could lead to an inefficient REIT market and trigger a collapse in the entire system, rather than a failed attempt it would be wise to build up each element over time before initiating REITs in India.
But a quicker and better alternative would be to look for offshore listing of Indian real estate assets in destinations like Singapore Stock exchange SGX. The typical structure of an overseas REIT is as shown below.
However one must also consider the risks involved with overseas listing , a few of them are-
Currency risk – Sudden changes in the exchange rates can drastically change the price of the asset.
Legislative risk-Sudden changes in the regulatory and taxation frameworks.
Lack of BT or business trust between the participating companies.
But recent developments of a health care business trust of Indian assets being listed on SGX suggests that companies are unfazed by the risks involved and are willing to employ unconventional financial instruments like REITs for better financing of their projects.
This article has been authored by Sujit Khanna from NMIMS, Mumbai.