Real estate refers to land or fixed assets like; residences, buildings, and factories built upon it. Real estate is considered an alternative investment even though it has been an essential investment for investors for thousands of years. The real estate market is segmented into the commercial, industrial and residential sectors.
Real estate becomes a liquid investment when it is securitized – when shares in a pool of real estate assets are resold to investors, as in the case of REITs (Real Estate Investment Trusts).
Physical real estate and securitized real estate are two critical aspects of real estate as an investment. Many investors hold physical real estate as primary or secondary residences or investment properties. Physical real estate has several distinguishing features.
Real Estate Investment Trusts (REITs) consolidate the capital of a large number of investors to
invest in and manage a diversified real estate portfolio. Investors participate by buying “units” in
the trust. As a result, investors receive net returns from the pool, pro rata, to their unit proportion.
As a result, REITs allow investors to invest in commercial and industrial real estate previously available only to corporate or more affluent and sophisticated investors.
To qualify as a REIT, a company must have most of its assets and income tied to real estate investments. REITs are typically structured as mutual fund trusts and may be either open-ended or closed-ended.
REITs can be either privately offered to prospectus-exempt investors through an offering memorandum or publically offered to any investor on an exchange issued through a prospectus offering. The terms of privately offered REIT redemptions vary by company and may be limited.
REITs have been successful in the recent past. Following are some main features of REITs and REIT investing:
- REITs tend to be more correlated to equities than bonds, as their sensitivity to macroeconomic factors and overall economic health is similar to stocks.
- From an asset allocation point of view, REITs tend to be construed as high-yield bonds or equity substitutes. Their liquidity makes them less stable than physical real estate investing and makes their market value significantly more volatile.
- Investors contemplating the addition of REITs to retail portfolios should be mindful of the real estate already present in net worth and consider the market cycle typical of this asset category.
Benefits of REITs
REITs allow the investor to have her properties managed by a professional real estate team that knows the industry, understands the business, and can take advantage of opportunities by taking advantage of their ability to raise funds from the capital markets.
Publically traded REITs provide exposure to real estate through highly liquid, marketable securities with daily price quotations. Real estate is a financial asset with tangible value and reliable income streams. However, investors should determine the liquidity of any particular REIT before investing, as some specialized REITs have thin trading volumes, despite being exchange-traded.
Limitation of Personal Risk
Direct real estate investors may be exposed to liability beyond their initial investment because of leverage, i.e., loans on real estate. At the same time, REIT investors’ liability is limited to the cost of the REIT units.
REITs offer investors an opportunity to gain exposure to a diversified portfolio of real estate properties with a relatively small investment. REITs also offer portfolio diversification as they tend to have relatively low correlations with the overall stock market and other financial assets like bonds and mutual funds.
REIT managers minimize risk by avoiding real estate development and investing primarily in established income-producing properties. In addition, to reduce the danger of incurring too much debt, most REITs limit the extent of leverage to 50% to 60%. As a result, real estate leverage ratios tend to be significantly higher.
REITs offer tax efficiency because they flow profits back to investors to be taxed in their hands.
Risks in REITs
The volatility of the Real Estate Market
REITs face many risks typical of real estate investments related to interest rate cycles, the quality of properties, rental markets, tenant leases, debt financing, natural disasters, and liquidity.
Poor Quality of Management
Although professional management is cited as a benefit of REITs, investors still need to check the qualifications and experience of the REIT management team. Unfortunately, investors are just as susceptible to management ineptitude as any other pooled investment.
Types of REITs
There are different types of REITs. The most common three types include –
Equity REITs own property and lease it to various companies or people. The income is mainly generated from rent and capital gains from the sale proceeds of properties. The revenue from the property is shared among the investors in the form of dividends and capital gains. These REITs are the most sought after amongst all other REITs.
These REITs mainly finance real estate owners and property owners. These mortgaged properties do not belong to the REITs. The earnings of Mortgage REITs are through interest on the mortgage loan and are shared among the REIT investors. REITs get EMIs against the property from owners and builders.
These REITs can either invest in mortgage or equity REITs per the investor’s choice, or they can invest in both to diversify their portfolios. The income is generated both from rent and interest earned on the mortgage.
Another classification of REITs
Private REITs are trusts which work as private placements that serve only a select number of investors. It’s important to note that private REIT units are not traded on stock exchanges. This type of REIT is not registered with the SEBI.
Publicly Traded REITs
Publicly Traded REITs offer units or shares traded on stock exchanges. The SEBI regulates publicly Traded REITs. These REITs offer liquidity and are subject to market volatility.
Non-listed public REITs
These are real estate investment trusts which are registered with the SEBI, but they are not traded on the stock exchange. As a result, they are less liquid than publicly traded REITs but are not affected by market volatility.
Subscription in Initial Public Offer of REIT
An eligible investor may apply for an initial offer of units through the application form available on the websites of designated Stock Exchange(s) during the period for which the public issue is kept open. Such application and bidding (except for Anchor Investors) must only be made through the ASBA process. The allotted units must be listed within six working days from the issue closing date.
The allocation in the public issue of units is made in the following manner:
- Not more than 75% of institutional investors
- Not less than 25% to other investors. In case of an under-subscription in any category, the unsubscribed portion can be allotted to applicants in the other category.
Preferential Issue of REIT Units
Preferential issue” means an issue of units by a listed REIT to any select person or group of persons on a private placement basis and does not include an offer of units made through a public issue, rights issue, bonus issue, or qualified institutions placement.
REIT is registered as a business trust in India. Section 2(13A) of the Income Tax Act defines Business Trust as below:
Business trust” means a trust registered as a Real Estate Investment Trust under the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations, 2014, made under the Securities and Exchange Board of India Act, 1992 (15 of 1992).
These trusts are like mutual funds that raise resources from many investors to be directly invested in real estate or infrastructure projects. The income-investment model of REITs (referred to as business trusts) has the following distinctive elements:
- The trust would raise capital by way of issue of units (to be listed on a recognized stock exchange) and can also raise debts directly both from resident as well as non-resident investors;
- The trust would hold the income-bearing assets by acquiring controlling or other specific interest in an Indian company (SPV) from the sponsor.
REITs: Pass-Through Status
REITs have been conferred a hybrid pass-through status for income tax purposes, meaning that the onward distribution of income by a REIT to its unit holders retains the same character as the underlying income stream received by the REIT.
Income Not Taxable
- Interest income
- Rental income from property
- Dividend income
- Capital gains on the sale of assets or shares of an SPV are taxable in the hands of the trust, depending on the period of holding,
- Any other income earned by a REIT shall be subject to tax at the maximum marginal rate.
Bottomline: REITs offer Dual Benefits of Real Estate and Pooled Investments
Investors can diversify their investment portfolio by investing in REITs. Investors can get real estate exposure without owning and managing any commercial or prime property. Therefore, REITs could be considered for diversification beyond usual asset classes – mutual funds, FDs, equity, debt, gold, etc.