The Beginning of REIT Regime in India

CA Mayur P. Kharche

Introduction

Seeing the rising investors’ sentimental towards holding interest in physical assets, Honorable Finance Minister of the Government of India Mr. Arun Jaitely, through Financial Act, 2014 (what we usually know as a ‘Financial Budget’), introduced tax incentives for the incomes and gains generated from investments made in Real Estate Investment Trust, generally known as REIT in commercial world. Since then in India, we have come across various discussions referring to REIT. Though this concept is new to Indian investor community, REITs are operating in the United States since 1960 and so is in Singapore, Australia and Hong Kong.

Let’s try to understand this concept and its intricacies.

So, what is Real Estate Investment Trust (so called REIT)?

Real Estate Investment Trust is like a mutual fund, where a special purpose vehicle collects investment amount from investor community and invests them in large scale, income producing real estate assets, such as warehouse, commercial properties, shopping malls, residential projects. Unlike a real estate company, a REIT does not develop real estate properties to sell them. Instead, REIT buys, maintains and operates the real estate property to them as a part of its investment portfolio. These investments generate rental income and capital gains from sales of the properties they own for the long-term. REIT declares dividends to distribute the earned income to unit-holders / investors.

Simply putting, REIT is a specialized mutual fund which invests in real estate companies that build, own and operate commercial real estate properties. Hence, an investor gets a chance to own small slices of shopping centers, hospitals, parking facilities, factories, etc.

Understanding the structure of REIT

Securities Exchange Board of India (SEBI) enacted REIT regulations in India on September 26, 2014. Those regulations have provided guideline for the set-up of REIT and dictated procedural norms regarding working of REIT.

Firstly, the Sponsor (also known as the Promoter), I will say an Initiator, establishes a private trust under Indian Trust Act, 1882 and registers it under REIT regulations of 2014. Sponsor invests capital in REIT and is required to hold a minimum of 15% of the total outstanding units of the REIT at all times. The Manager manages the REIT, after it has been established by the Sponsor. The parties to REIT include –

• the Trustee,
• the Sponsor,
• the Manager,
• the principal valuation officer and
• Investors / unit-holders.

The trusts (REITs) are listed in stock exchanges so that investors can trade in the units of the trust. The assets of an REIT are held by an independent trustee on behalf of unit holders. Duties of the trustees include ensuring compliance with laws and regulations and protecting the interest of investors. While, the day-to-day operational decisions and investment

decisions are made by professional investment advisors, in this case, the Manager who are appointed by the Sponsor.

Generally, the Manager is an Asset Management Company formed under the Companies Act. Once REIT is established, money is raised from the investors and is used by the Manager to purchase a pool of real estate properties. When these properties are leased out to tenants, from the rental income generated from these leased properties, income is distributed among the investors. Investors are referred to as unit-holders because when an investor invests amount in REIT, he receives units of a specified face value. These units are just like shares of a company. These units are available for trading on stock exchanges to provide liquidity to the investments of the investors.

Primary Objectives of REIT –

REITs are set up with the primary objective of distributing dividends, usually generated as rental income from the leased real estate properties and sometimes, out of the capital gains generated from the sale of long term held real estate property.

A Look at regulations around REIT –

• As mentioned earlier, the Sponsors are required to hold a minimum of 15% (25% for the first 3 years) of the total outstanding units of the REIT at all times.

• Assets made by the Manager may be hold by REIT directly or through a Special Purpose Vehicle (SPV). REIT shall hold majority interest in the Special Purpose Vehicle.

• REIT has to compulsorily list its units on at least one recognized stock exchange.

• REIT Regulations 2014 expects the Managers to invest principally in the income-generating completed real estate assets only. And hence, the main income stream for a REIT is rental income, while capital gains can arise on certain occasions whenever the real assets are sold at above its cost. Completed property means the property for which occupancy certificate has been granted by the relevant authority.

• Retail investors are required to put in a minimum capital of Rs.200,000 in REIT. As per SEBI regulations on REIT, a unit of REIT will be valued Rs.100,000 each and every unit will enjoy a voting right.

• Now about taxation laws, as like mutual funds, REIT is exempted from the Dividend Distribution Tax. Short term capital gains are taxed at 15%. Long term capital gains from the sale of units of REIT are exempted.

• In case of dividend distribution by REIT to its unit-holders, SEBI has prescribed mandatory distribution of at least 90% of the net distributable cash flows to the investors on a half yearly basis and also 90% of the sale proceeds received from the sale of assets, unless invested in another property.

• In Year 2016, Government of India allowed NRI, Foreign Direct Investments (FDI) and Foreign Portfolio Investors (FPI) to invest in REIT without any approval requirement.

Valuation of REIT Units –

The Manager is required to conduct full-fledged valuation of all REIT assets held by the trust on annual basis. Semi-annual review of the valuations is also made mandatory by the regulations. These valuation results are required to be made public within 15 days of date of valuation by the Principal Valuer.

REIT’s Investment Scope (Where can they invest?) –

REIT Regulations 2014 dictates that REIT managers are required to invest in real estate assets located in India only. Minimum of 80% investment shall be made in the completed real estate projects and shall be rent-generating. There are other restrictions on the investment made out of balance fund.

SEBI has considered the possibility of loss incurred on the devaluation / destruction of an asset, where REIT may hold significant ownership interest. Hence, to avoid any such major loss from a single property, SEBI has currently mandated to cap the maximum investment in a single real estate property up to 60% of the total value of assets owned by REIT. They are required to make investment in at least 2 projects.

Certain assets where REIT can invest include Transfer of Development Rights (TDRs), land and any permanently attached improvements to it (whether leasehold or freehold), etc. There are certain exclusions as to where REIT can’t invest. These exclusions include Hospitals, Hotels, agricultural land, mortgages, units of other REITs, etc.

Why an Investor will invest in REIT? –

Risk conscious investors who rather prefer not to invest in physical assets due to risks involved including liquidity, valuation loss, etc., REIT provides an alternative to such investors to participate in the real estate sector and also earn rental income in the form of dividends declared by REIT. Since REIT units are traded on recognized stock exchanges, it provides sufficient liquidity. REIT investment has been tested channel of investment for investors requiring regular earnings.

Let’s have a look at the benefits of REIT attributing to various stakeholders.

Stakeholder	Benefits accruing
Investors / Unit-holders	Participation in the real estate sector assets Sufficient liquidity in the trading of REIT units, allowing free entry and exit Diversification of the investor’s portfolio, with the exposure to physical assets Regular income by way of dividend declared by REIT and capital gains of property sales by REIT REIT providing detailed information and analysis leading to more transparency in the real estate dealings and consequently, investors can make more informed decisions and can speed up the capital movement in the real estate sector.
Real Estate Developers	Current liquidity strapped real estate sector can enjoy more liquidity because of the introduction of REIT. The developers and asset owners are monetize their assets because of increased entry and exit opportunities. Capital-raising opportunity for the small scale developers / companies Business structures will redefine themselves, from earlier being asset-heavy now adopting asset-light model. Some stalled projects, stopped due to liquidity crisis, might be well funded after the REIT managers start looking for better real estate opportunities.
Government and Overall Economy	Increased capital flow from the retail investors’ participation in REIT will facilitate speedier projects completion with more quality focus. An additional source of revenue generation through the securities transactions and other tax and cess levied on the REIT transactions. Improved, more transparent and well informed fair dealings in the real estate sector will boost up the vision set for smart cities, a renowned scheme launched by the Central Government, thus improving the standard of living of the citizens over the period of time. · Banks’ exposure to real estate sector will come down with the availability of long term equity capital provided by REIT funds. This will facilitate banks to diversify their loan portfolios and credit availability in other sectors. Increased employment opportunities in – – Project Management – Fund Management / Investment Advisories – Valuation Services – Trusteeship services – Risk management and Assurance Services and – Such other professional services.

Indian REIT format compared with International practices –

The concept of REIT was firstly coined in the United States in 1960 and very soon then, was adopted by Hong Kong, Australia and some other countries.

For India, REIT has been on the horizon for a while now. Largely, Indian REIT format is at par with the international REIT structure. It may be noted that the United States, Singapore has allowed their REIT funds to invest locally as well as outside their geographical boundaries. Since, India has recently witnessed very high real estate valuation growth, especially after year 2008, this is just a beginning phase for the real estate sector to witness the REIT regime and soon probably after a few years, Indian investors may get a chance to own real estate properties situated out of India after amended regulations.

Potential Risk involved –

Since REIT are just the medium through which the investments out of investors’ proceeds is made, the valuation of units and dividend income is prone to the risks attached to any real estate property and hence, the investor shall be aware of his underlying physical assets and shall also read the REIT fund documents carefully. And since any retail investor with minimum Rs.200,000 capital can participate in the REIT fund, large corporations and high net worth individuals who has potential to invest huge amounts in the REIT units, their entry in REIT and exit from the REIT fund may result in significant valuation variation, resulting in negative returns as well. As in mutual fund, the retail investors have no control over the investments and any investment or sale decisions are being made by the trust.

Conclusion–

Indian REIT platform has been rated amongst the best in the world. REIT will facilitate setting up affordable housing schemes on a large scale and will also act as a catalyst for the commercially growing needs certain real estate properties, such as warehousing, malls, etc. While the REIT market is relatively nascent in India, with the past asset performance seen in real estate sector, the growing middle class investor community and growing needs for housing in India, it can be reasonably expected that this investment vehicle, i.e., REIT, will propel the real estate sector liquidity and will witness considerable growth in the near future.