This post is going to be on REAL ESTATE INVESTMENT trusts or real estate investment trusts. What are they? How do they fit into your portfolio? What are the advantages that they have over buying traditional real estate?
The most simple question and a few people are familiar with it, but so that everyone’s on the same page, we’ll start with what are REAL ESTATE INVESTMENT trusts? What are real estate investment trusts?
So we’re all familiar with what is a mutual fund. I think by now, a mutual fund is something that many of us are investing in, and we have a fair amount of experience. So as far as the mutual fund is concerned, it is a tool to invest in equity. A mutual fund enables you to make a fractional investment in equity assets. Making it possible for even small investors, you could invest as low as, say, 5000 rupees or even less than that. Some mutual funds allow even less than that so that you can invest almost any amount of money. You can participate in many companies, you know, in a particular category such as with sectoral funds or in the large-cap category or that is a sectoral fund or whatever it is international fund so you can participate in that category for as low as something like 5000 rupees.
So now, precisely on the same lines as far as real estate is concerned, REAL ESTATE INVESTMENT TRUST is precisely the counterpart of mutual funds. As far as real estate investments are concerned, most people directly invest in real estate, either residential plots or residential property and sometimes commercial property.
So you all understand, you would have all invested at some point in time in real estate or know someone who did, so it’s a very chunky concentrated investment that we make in real estate. So it may be 50 lakhs one crore multiple crores. So that is tough for some people to make that investment and realize the returns from real estate and especially talking about commercial real estate, which is, I would say, the juiciest segment of the real estate market. Marquee clients of Real estate investment trusts such as MNCs, big Indian companies lease the commercial properties. These companies are looking for probably tens of thousands of square feet of property space to rent for an office. So if I have perhaps a gala of 2000- 3000 square feet, that’s not going to be picked up by a marquee company, and I’m not going to get the kind of rental that possibly a big company would be willing to pay. It’s a big-ticket item and probably costing tens of lakhs of tens of crores of rupees, probably hundreds of crores of rupees, and REAL ESTATE INVESTMENT trusts allow you to participate in this kind of marquee real estate which we all want to invest in, and we want to participate.
How does a ReITs work?
So here is a fractional investment opportunity to invest in high-quality real estate and get returns from the rental income you can get from these kinds of properties. So these are trusts which invest in this kind of properties, excellent properties across the country and they usually do it through special purpose vehicles. So they invest in these properties through special purpose vehicles, and asset managers manage the properties underlying. Just like a mutual fund, you have an asset management company here. Also, there are asset managers who will manage the property ensure that the rentals are in place. They will also ensure that they renegotiate the rentals at an appropriate rental level at the end of the term. So all those things they’ll be doing for a fee, so the good thing about REAL ESTATE INVESTMENT TRUSTSs is that it follows the same structure as a mutual fund, which should give an investor like you all confidence. So you have a sponsor who is somebody like the person who wants to who is proposing to start this REAL ESTATE INVESTMENT TRUSTSs, to give an example it may be Embassy or Blackstone, they will be the sponsor. The REAL ESTATE INVESTMENT TRUSTSs is the trust, and there will be somebody like a trustee; they get Embassy to access the trusteeship. So they are managing the activities of the sponsor and what is happening, the trust and asset management company, and then you have the asset management company itself, which manages the property and ensures everything goes with a clockwise position as far as the property is concerned.
So as far as REAL ESTATE INVESTMENT TRUST are concerned, one more quick thing I’ll share with you this is a place where you can get a regular income that would be passive, that is how it has been structured, so in the case of a real estate investment trusts, 90% of whatever revenues they are going to get is supposed to be distributed. I mean, this is as per the mandate; they are supposed to allocate about 90% or more of the income that they are getting, and so for people who are looking for good quality properties investing in good quality properties earning a consistent rental income or consistent income from these properties and they want also to have the liquidity which usually properties don’t have this is an ideal way of participating. Because liquidity is given through the stock exchange, it is listed on the units listed on the stock exchange. You can buy and sell units. So that is the typical structure of REAL ESTATE INVESTMENT TRUSTS excellent, and it gives a lot of confidence in ensuring that the real estate investment trusts will work in your best interest.
So one of the things by which you can get a return is, of course, the income which comes from the real estate investment trusts. The income typically comes in the form of a rental income. Usually, REAL ESTATE INVESTMENT TRUSTSs directly does not hold, it is coming through the specific particular purpose vehicle, so the payment comes in the form of a dividend. It comes in the form of loan repayment or interest, so some of these incomes are tax-free, and some of these incomes are taxable. So what proportion of the payment is taxable and tax-free, and following that, you will have to pay the tax. So this is an exciting new concept. The Real estate investment trust has the features of a debt product, and it also has the characteristics of an equity product.
It has the features of a debt product. Here, you get a consistent, reasonable income level like something like seven percent or that kind of thing and underlying since there are properties and properties also increase in value. Usually, they keep pace with inflation over some time. So you also potentially get a capital appreciation over a date of time, so it has the qualities of equity, unlike fixed deposits, which do not appreciate.
Here you have invested something you get a regular income also. At the same time, the underlying properties can also appreciate, so it’s somewhere between an equity and a debt-oriented product.
So dividend distribution tax will come into play in most other cases. in the case of uh real estate investment trusts, one of the most significant advantages is that the dividend declared by the real estate investment trusts is not taxable in the investor’s hands. So the only exception to that is if that particular SPV or special purpose vehicle is coming under some special tax dispensation, then, of course, it will be taxable. But REAL ESTATE INVESTMENT trusts will ensure that they are not under special dispensation. I am not very sure about embassy Real estate investment trusts, but in the case of mind space Office Parks, they are not coming under that, and dividends definitely will not be taxable.
But in general, this particular advantage is there where rental income, if it comes or as far as dividends are concerned, is not taxable, and in the case of interest income, that will be taxed, of course.
Let us understand a little more in terms of how Real Estate Investment Trust will work in somebody’s portfolio?
Thinking of buying real estate as an investment is incidentally a conversation that we had recently. We talked that a real estate asset is possibly one of the most considerable assets you will ever acquire. It’s a very substantial chunky asset, so that you would look at it. REAL ESTATE INVESTMENT TRUST as an alternative to an investment in real estate is how you would look at it.
Many people want to invest in real estate, and it is a different asset class, so I am also inclined to think that if you’re going to invest in real estate, this is probably the best possible way to invest in real estate. Because, number one, you don’t have to invest a considerable amount of money here; you can invest whatever amount of money required to buy the minimum number of units ( multiplied with current market price).
If you feel you want to invest in real estate, let us say you have 10 lakh rupees or 5 lakh rupees or even less than that you can invest only that amount of money into real estate. You can get the same advantage as another person who is investing one crore into that exact property. You are a fractional owner. To the extent of your part of ownership, you will get a return precisely like a prominent property owner is going to get.
And look at this beautiful thing. It is also there are also no liquidity problems here. So, in this case, at any given point in time, you can sell that on the stock exchange. The liquidity is there through the stock exchange, and you can sell that on the stock action. So you have all the advantages of participating in a property. You don’t have to have the hassles of managing the property; collecting the rent, and you don’t have any of the hassles. With Real estate investment trusts, you get all the advantages of owning a property without actually getting into the hassles of managing a property. So this is, I think, the best of both worlds.
Let us understand the liquidity aspect of it. Since The ReITs are listed on the stock exchange, one would assume there has to be a counterparty, so is there a risk involved if the real estate investment trusts are not well established. For example that if the traded volume in exchange is much lower, then there is counterparty risk. That’s one thing and also if you have a capital appreciation as you said. That is one more way to earn money; therefore, in that sense, does it still follow the taxation in terms of capital gains.
So the first thing is, of course, the counterparty there has to be somebody who will buy over those units, so that is of course there, these are very early days as far as real estate investment trusts are concerned in India. So the ReIT market will develop, it will take some time. But I will go back one step before. Real estate investment trusts are not vehicles where you see great appreciation like anything of stock. You will see some appreciation for sure, and you will also see liquidity.
People who want a diversified source away from, say, the debt products, and they want a source which can give consistent income, and it’s a form a different asset class. So from that point of view, this real estate investment trust is a great proposition.
As far as capital gains are concerned, if you are holding on to the ReIT units for some time, the capital gain will be there. Because of the property appreciation and the rent appreciation, which happens over some time. The asset management company will also renegotiate the rents periodically to keep pace with escalating inflation. For the same property, you will get a higher and higher rate—one of the advantages in the case of real estate investment trusts.
In debt instruments, the coupon payment is constant forever, which means it simply ignores the underlying inflation risk. So this rental yield in ReITs always gets adjusted for inflation, and that’s positive now as far as capital gains are concerned. It is something on the same lines as equity, only that instead of a one-year short term is treated as three years, and you pay a fifteen percent tax. The long-term investment is treated as beyond 36 months, and you pay 10 percent, just like in the case of equity-oriented taxation. Only the duration is different in this case.
In terms of real estate investment trusts, you can have an allocation like for example, if you say gold should be about ten and not more of your overall portfolio, and if you have a 60 – 30 sort of a ratio for the rest of it, towards equity and then debt. Where would you say that real estate investment trusts can fit into it?
So let me talk about what generally, we see as far as the Indian public is concerned with that real estate as a proportion of their overall investment is pretty high, so it may not be necessarily commercial real estate. Still, it may be land, and it may be residential real estate. So that’s what we see in most of the people’s portfolios. We’ll have to look at the overall real estate allocation that people have in their portfolio, which in many cases is quite significant.
So in the context of that, if you want to give a portion in commercial real estate for all the right reasons, probably something like maybe five to ten percent only and in some cases if you already have too much exposure to real estate, because a lot of people are loaded on real estate, and you should not increase further real estate unless you are willing to sell off some existing real estate in favor of ReIts.
Why ReITs Are Better Than plots or Actual Real Estate?
I own land and physical real estate, one house, one two-bedroom flat, one shop, one garage. Hence I can tell you the maintenance costs associated with real estate are often ignored. Plots have some other expenses too. If you want to keep the land for a long time as an investment property, you would like to fence it. And fencing costs money, which does not get added to the price of the land. Your home, apartment have maintainece charges. Say you rent out your real estate in India, and the rental yield is around 2 – 3%. That means you make 2 – 3 % on your investment. On top of that, you will have to deal with tenants and all the mess they will make. Moreover, the tenant will not be around the year.
With ReITs, you will not have any of these hassles. Although all these will still be applicable since it is a real estate business, but for us small investors, the management company will serve a great purpose, shielding us from all the hassle. And since most listed ReIts are commercial properties, the leases are usually long-term, the rental yield is better, and it comes with a price escalation clause, which will help keep up with inflation.