The real estate sector in India has conventionally been a highly preferred asset class for investors on account of the capital appreciation and inflation hedge it offers. However, owing to the inherent limitations in owning a property viz. huge investment outlay, lack of scope for geographic diversification, tight liquidity, among other reasons, a more diversified and secured investment opportunity in the form of real estate investment trusts or REITs, is being considered for investment.

REITs enable an investor to invest in a portfolio of income-generating real estate assets, by purchasing units of the REIT, similar to units of a mutual fund. Any income generated by the underlying real estate assets is then distributed by the REIT to its unitholders. Here’s what you need to know before investing in REITs.

You need to compare and analyze the performance of REITs across various parameters before investingMumbai Stock Exchange. These parameters include:

Occupancy: This is the ratio of rented or used space to the total amount of available space.

Asset portfolio: As an investor, you must also look at the clientele of the REIT and the clientele of the special purpose vehicle (SPV), which is the company or the limited liability partnership in which either a REIT holds or proposes to hold an equity stake or interest of at least 50%.

Businesses from various sectors occupy space in REIT properties. Tenants compromising on rental payments due to poor performance of their own business or sectoral downturn can affect the returns of unitholders.

There are no regulations from market regulator Securities and Exchange Board of India (SEBI) on the regularity of cash flows from rented or leased properties, which in turn, form the main income-generating portfolio of REITs. Therefore, investors are not shielded from poor collectability of rentals.

Geographical and sectoral diversification: The IT sector has traditionally been the major occupier of premium, high-quality grade A spaces. However, over-dependence on a single sector, especially the IT sector, where work from home has become a new normal, may pose risks in the long run.

A unitholder should thus ensure that their REIT has a well-diversified portfolio, spanning sectors from IT, FMCG, banking financial services and insurance, pharmaceuticals, hospitality, among others, to protect its interests.

Geographical diversification, across various cities or towns, is also required as supplying spaces predominantly in one single city may also be disadvantageous, especially because real estate is governed by state-specific laws that may vary from one state to another.

Re-leasing spread and rolling renewals: Re-leasing spread refers to the change in the rent per square feet (psf), between new and expiring leases, expressed as a percentageAgra Stock. It signifies the ability of the REIT to execute new leases with increased rentals for the same property.

Rolling renewals, on the other hand, signify the number of occupiers who have exercised their renewal options after the end of the initial commitment period, which is generally five years.

Other factors such as consistency of income flow, experience of the sponsor and manager, brand name, increasing interest rates, economic downturn, among others, can have a bearing on the performance of REITs.

REITs are listed and traded on the stock market, just like equity shares are. Therefore, a demat account is mandatory for investing in REITs in India.

Earlier, there was a minimum requirement of INR 50,000 for an investor to invest in units of REITS; however, recently, vide notification issued by SEBI on July 30, 2021, the same has been dispensed away with, for investment directly via stock exchanges. The minimum investment criteria of INR 10,000-15,000, which is reduced from INR 50,000, is now applicable for investment through initial public offerings (IPOs) and follow-on offers (FPOs).

Another shift in policy is the lot size of REITs traded, which was a lot size of 100 units. By virtue of the same SEBI notification, the minimum lot size has been reduced from 100 units to 1 unit.

At present, there are 3 REITs that allow investors to invest in India. These include:

Embassy Business Park REIT

Mindspace Business Parks REIT

Brookfield India REIT

Typically, commercial real estate provides returns between 8% and 10% per annum. However, grade A office spaces and commercial spaces in prime locations have the potential to provide better returns. The projected return on investment in REITs is anywhere between 8% and 14% in the short to medium-term (after adjusting for fund management fee, which is deductible before paying out to the unitholders), with minimum risks.

But one may need to stay invested for longer periods—three to five years—as in any asset class, one needs to keep a long-term horizon, and be patient in riding out the real estate cycles that tend to last long.

Despite the ongoing global pandemic, Embassy Office Parks REIT offered a yield of 6.8%, followed by 5.9% by Mindspace REIT, whereas Brookfield India REIT offered a higher yield of 8.5%.

Income received by the REITs in the nature of dividend, rent, and interest and distributed to its unit holders is in the same nature i.e., deemed as dividend, rental and interest income, respectively, in the hands of the unit holder.Jaipur Wealth Management

Note: Applicable surcharge and cess is levied additionally.

Opportunity to buy real estate as a financial security: The shortcomings of investing in physical real estate assets can be mitigated by investing in real estate assets through a REIT structure, as tabulated below:-

Operational Assets: Indian REITs have a regulatory guideline to have 80% operational and income-generating assetsBangalore Stock Exchange. Operational assets have a lower risk associated with them, by virtue of having a proven track record of revenue generation, which makes REITs a safe investment option.

Stability of Earnings: Typically, commercial leases are of long periods like six or nine years or even more, with rent escalation clauses. This makes REITs less volatile than other investment avenues.

Mandatory Distribution: Grade A commercial office spaces in India tend to have an operating expenditure of 10-15% of the total lease rentals. After deducting the operating cash outflows like maintenance activities and interest payouts to REIT unit holders, the net distributable cash flows lie in the range of 75% to 85% of the total revenue of the underlying commercial portfolio. Out of this, the retail investor is mandated to receive 90% of such distributable cash flows, which makes REITs a safe alternative against volatility of broader equity markets.

Transparency: REITs have the benefit of being under the purview of professional management. There are stringent regulations under SEBI, governing REITs and the parties to REITs (which refers to the sponsors and managers who must have at least five years’ experience in development of real estate or fund management in real estate industry) including regular reporting mechanism and valuation of REIT assets by experienced valuer, so as to maintain transparency and professionalism in its operations.

Investment Security: Approval of the unitholders is required to be obtained in the following cases, which guarantees investment security:

Any sale of property by the REIT or the SPV, or sale of shares or interest in the SPV by the REIT, either of it exceeding 10% of the value of REIT assets in a financial year.

If the total value of all the related party transactions, in a financial year, pertaining to acquisition or sale of properties or investments into securities, exceeds 10% of the value of REIT.

If the value of the funds borrowed from related parties, in a financial year, exceeds 10% of the total consolidated borrowings of the REIT or SPV.

If the aggregate consolidated borrowings and deferred payments of the REIT or the SPV, net of cash and cash equivalents, exceed 25% of the value of the REIT assets.

In case of a purchase transaction, if the property is proposed to be purchased at a value greater than 110% of the value of the property as assessed by the valuer.

In case of a sale transaction, if the property is proposed to be sold at a value less than 90% of the value of the property as assessed by the valuer.

Limited Options: Currently there are only three listed REITs in India. This significantly limits the choice for investors and might make REIT a relatively less liquid alternative on the stock exchanges.

Property Vacancy: One of the biggest risks that REITs face is vacancy. This issue has been further aggravated by the pandemic and the wide-spread adoption of work-from-home. With several IT companies seeking to embrace work-from-home as a more permanent solution, an investor should look at the occupancy of the properties with a REIT and the average tenure of the lease, before making an investment decision.

Low-growth Prospects: REITs are mandated to distribute 90% of their income to the unitholders. This stifles their ability to plough back money into the REIT business and might hinder its growth.

While India has restrictions on overseas investment in real estate and the concept of REIT is at a nascent stage, the Indian real estate market has the potential to align Indian REITs in line with their foreign counterparts. Robust regulatory guidelines issued by SEBI also bring about much-needed investor confidence for the newly-introduced REITs in the Indian financial markets.