The Securities and Exchange Board of India outlined regulations for real estate investment trusts in 2014, but it has taken four years to finally get a REIT listing on the Indian bourses with Embassy-Blackstone filing a draft red herring prospectus. However, two other Indian companies had previously launched REITs in Singapore: Indiabulls in 2008 and Religare Healthcare Trust in 2012.
Apart from REITs, seven infrastructure investment trusts (InvITs) have also registered with SEBI in the past couple of years. A recent transaction announced by OMERS into IndInfravit Trust and past private deals signal that investor interest is still alive in the infrastructure sector. In general, too, investors are optimistic about the India growth story. This is despite the escalation in tensions with Pakistan in recent weeks.
However, coming to the REITs, is the ‘Josh’ still alive for investors to punt on this asset class? Let's analyse this ‘Josh’ in terms of regulations, taxation, accounting standards for lease, returns to investors, asset quality, REIT sponsors, timing and other variables. A quick caveat: many of our references are based on the performance and experience of US REITs.
REIT regulations in India
SEBI's regulations are primarily for equity REITs. Mortgage and hybrid (equity and mortgage) REITs are not yet allowed. We hope other types of REITs are also allowed in future.
When compared with major markets such as Singapore and the US, the regulations in India are far more stringent in terms of legal structure, minimum capital requirements, listing requirements, restrictions on the assets invested and distribution of income to the REIT investors. To garner strong institutional investor interest, the regulations need to be relaxed and made comparable to other international REIT destinations.
Josh Quotient: Neutral
Tax calculation in the hands of the investor
Depending on how the REIT is structured, it may distribute a substantial amount of distributable income as capital gains, interest or dividends and each has a different taxation treatment in the hands of the investor. For example, capital gains from sale of assets are to be paid by the SPV / REIT. Therefore, any income distributed as capital gains from a sale of assets is not taxed in the hands of the investor whereas any interest income distributed by the REIT to the investor will get taxed as an interest income in the hands of the investor.
Therefore, every distribution has to be clearly marked and followed by the investor for proper tax filings. Moreover, the withholding taxes (for interest income from SPV) vary depending on whether the investor is a domestic or an international investor, which further complicates the matters.
Josh Quotient: Negative
New accounting norms for property lease
From 2019-20, principles for the recognition, measurement, presentation and disclosure of leases should be under the Indian Account Standards 116. The objective is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions in the REITs.
This information gives a basis for users of financial statements to assess the effect that leases will have on the financial position, financial performance and cash flows of the entity. This is positive from the perspective of international investors in terms of reporting, transparency and risks.
Josh Quotient: Positive
Returns from REITs to investors
The US is one of the most developed REIT markets globally. NAREIT, the benchmark for REITs in the US, as well as US Office REITs have underperformed US S&P 500. Therefore, Indian office REITs need to perform better than US Office REITs to attract institutional investors. Current 10-year treasury bonds in India are going at 7.5%.
Josh Quotient: Neutral
Interest rate
Interest rates are inversely related to the REIT sector and returns from REITs. A drop in interest rates has a two-fold impact on REITs.
First, it leads to a drop in borrowing costs, which positively impacts REITs’ profitability and ability to make acquisitions. Second, as REITs are dividend-yielding investments, a drop in interest rates leads to widening of spreads between treasury yields and dividend yields, making REITs more attractive as an investment option.
However, given the current leverage crisis and inflation outlook with uncertainty in Indian political system, the interest rates may be edging higher. In this case, there could be a two-fold negative impact on REITs (borrowing costs and dividend yield spread).
Josh Quotient: Neutral
Timing of REIT listing
The great learning from the US REITs is the timing of listing. REIT returns are great when it is not listed at the height of real asset bubbles. Indian realty sector, particularly commercial office space is at a bubble stage. Therefore, the timing of REIT listing is very critical.
With the upcoming general elections and other geopolitical risks, we expect the short-term outlook to be a bit choppy for a REIT listing.
Josh Quotient: Negative
REITs' relationship with other real estate and traditional variables
Tenant diversity: So far, Indian REITs and InvITs have not seen a diversity of assets underwritten by the REIT sponsors. Embassy REIT, for example, owns buildings being acquired, developed and owned by Embassy and Blackstone. Similarly, Religare Health Trust only owned hospitals from Fortis. This exposes the REIT sponsors to other risks inherent in the assets being underwritten to a single entity’s business as tenants.
Asset quality: Investors in REITs also look at the grade of real estate assets (A or B Grade) in addition to cities, location, and quality and stickiness of the tenants in terms of lease tenure and lock-in to determine the premium/risk of the real estate quality.
In the US, there is a different class of REITs and investments into Grade C industrial and other real estate which is priced very differently. Single-tenant buildings would command a higher risk than multi-tenant buildings.
Stock market index: Traditionally, REITs are considered not correlated to stock indices. As per an analysis by Citi Private Bank, from 1980 through 2006, the performance of US REITs moved in tandem with the broader US stock market only 47% of the time.
However, since the global financial crisis, that correlation has jumped to about 80%. This jump in correlation has been due to the US Federal Reserve keeping the short-term rates extremely low, which has helped equities of all types stage a robust recovery.
Now that the Fed policy has shifted in the past two years and interest rates have risen substantially, it will be difficult to keep up the amount of dividend growth in broader equities. Therefore, the correlation will reduce.
The FTSE NAREIT All Equity REITs Index, which tracks 145 US-listed stocks across 10 major sectors, has been yielding slightly less than 4%, which still is almost double the S&P 500's payout, a point that hasn't been lost on investors. In our opinion, as the Fed increases rates, the correlation should reduce from its current levels.
Currency movement: If the home currency becomes stronger, returns from foreign investments become higher. For example, as a US investor, if the US dollar becomes weaker versus the Indian rupee, then the returns from the Indian REITs will be impacted positively and vice versa.
For any foreign institutional investor investing into Indian REITs, rupee depreciation of 1% a year is to be priced in. The rupee weakened in the past 12 months. If the rupee is stable or seen as strengthening, more international investors will be interested in REITs.
Employment rate: The strength of the job market fuels demand for the housing, office and hotel industries. Strong job growth can drive higher occupancy rates and lead to a rise in the unit rental revenue. In contrast, high unemployment and slow job growth can result in falling occupancy rates and lower revenue per unit.
Josh Quotient: Negative
So, how is the 'Josh' for REIT investment as an asset class in India? Our discussions with investors from around the world indicate heightened interest in Indian REITs over the next few years thanks to easing regulations and REITs diversifying into different sub-sectors.
If the Embassy REIT succeeds, it would set out others planning for an REIT listing. Else, we would see more private transactions and retail investors would never get to participate in this asset class.
Kapil Khandelwal is managing partner at Toro Finserve LLP, sponsor to India Healthcare Opportunities Fund (REIT sponsor), and director at EquNev Capital Pvt. Ltd.
