Remember as kids when you used to play hide and seek? The best strategy would have been for everyone to hide in different parts of the house. This way, even if one or two people were sighted, the remaining hiders had a chance to win the game. This is, in essence, what diversification is all about.
Portfolio diversification is the process of investing your money in different asset classes and securities in order to minimize the overall risk of the portfolio. There are two broad asset classes; physical assets and financial assets. Under physical assets you have real estate, commodities and other tangible assets, where as in financial assets you have equities, fixed income instruments and other intangible assets. REITs (Real Estate Investment Trusts) are financial instruments that facilitate investing in real estate assets. Let’s understand more about REITs
History of REITs
The real estate investment trusts (REITs) where first introduced in the United States when President Eisenhower signed the REIT Act in 1960. The REIT was originally created by the US Congress to allow US Citizens to invest in and profit from diversified, large-scale professionally managed portfolios of US real estate.
What are REITs
REITs are a pool of real estate assets that can generate regular income and is managed similar to a mutual fund. Like a mutual fund, a REIT collects money from investors and then invests into income producing real estate assets like office spaces, retail/commercial areas or residential units. It provides a source of dividend income to individuals without having to buy and manage the properties themselves.
REITs in India
In India, the concept of Real Estate Investment Trust is relatively new and the first guidelines were introduced by SEBI (Securities Exchange Board of India) in 2007. The current SEBI guidelines related to REITs in India were approved in September 2014 and updated in 2019. REITs in India are governed by SEBI and have to follow the below mandated guidelines;
- A REIT’s investments must consist of at least 80% completed commercial developments that can be rented out to produce regular income. As a result, REITs’ primary source of revenue is rental income.
- REIT’s are also required to pay-out 90% of their income as dividends or interests to its investors regularly.
- REIT’s are required to mandatorily list on stock exchanges in India to facilitate adequate liquidity to its investors.
Different Types of REITs
- Equity REITs – This is one of the most common types of REIT. Typically, it is associated with the operation and management of commercial properties that generate money. Equity REITs own and operate properties and generate revenue primarily through rental income.
- Mortgage REITs – It is largely associated with lending money to proprietors and giving mortgage facilities, and it is also known as mREITs. REITs also have a preference towards acquiring mortgage-backed securities. Mortgage REITs also make money by charging interest on the money they lend to business owners.
- Hybrid REITs – When companies invest in both, mortgage and equity-based REITs, they are categorized as Hybrid REITs. Here, the investors generate income from rents as well as interests.
In India, there are only equity REITs that invest in commercial office spaces and are able to generate rental income.
Advantages of REITs
- Mandatory Income Payout : REITs are required to distribute nearly 90% of their earnings in the form of dividends to the REIT investors, they can be assured of a higher income payout ratio.
- REITs are designed to be tax efficient : The government has given them pass-through status. That means; when the REIT receives the rentals and distributes to its shareholders, it will be treated as a pass-through flow and there is no double taxation.
- Diversification opportunity: REITs are a relatively stable asset class compared to equity and provide an opportunity to diversify your investment portfolio
- Liquidity: Since REITs are mandated to trade on public stock exchanges, they are easy to buy and sell, which adds to their liquidity aspect.
- Generates risk-adjusted returns: Investing in REITs provides individuals with risk-adjusted returns while also participating in the generation of consistent cash flow. It allows people to have a consistent stream of income to rely on, even when inflation is strong.
Disadvantages of REITs
- Rental Yield is Low: The key determinant of the success of REITs is the rental yield. In India, rental yields are comparatively very low to other developed markets. Rental yields are the rents that one can receive compared to the price of the property.
- REITs have a major growth challenge : The prospect of capital appreciation is quite low in the case of REITs. It is mainly because they return as much as 90% of their earnings to the investors and reinvest just the remainder 10% into their venture.
- Market-linked risks : Globally, REITs have had situations when they have relied extensively on debt and this created a major financial risk for them. Their valuation is also dependent on their demand and supply on the stock exchange.
- No tax-benefits: When it comes to tax-savings, REITs are not of much help. For instance, the dividends earned from REITs are subjected to taxation. While individual investors are not required to pay local stamp duties and registration taxes, the REITs are still liable to pay applicate state taxes if they wish to add or exit rental properties.
- State level regulation: Finally, regulation is a major challenge. Real estate in India is still subject to state level regulation. Therefore, there is no national policy as far as real estate is concerned. Till the time that happens, the spread of REITs in India may be a challenge!
- Minority Shareholders : The decision making at REITs are controlled by their sponsors and management who could have a conflict of interest while managing the assets.
How are REITs Taxed
- Taxation of Dividends: As per current rules, dividends obtained from REITs are completely taxable in the hands of the investor. Dividend pay-outs from REITs are included in the annual income of the investor and taxed according to the investor’s slab rate for the applicable Financial Year.
- Taxation of Capital Gains: Capital Gains from the sale of REITs units are covered by Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) applicable to equity investments.
- STCG is applicable if the holding period of units is 1 year or less from the date of unit allocation. The STCG tax rate is 15% of capital gains obtained from the sale of units.
- If the holding period exceeds 1 year from the date of unit allocation, LTCG taxation rules are applicable. The LTCG tax rate is 10% of gains in excess of ₹ 1 lakh (across all equity investments for the applicable FY) with no indexation benefit.
- Taxation of Capital Gains for International REIT Fund of Funds: If Capital Gains are obtained from the sale of units of International REITs Fund of Funds, non-equity Capital Gains taxation rules are applicable.
- In this case, Short Term Capital Gains are applicable if the holding period is 3 years or shorter (calculated from the date of unit allocation). STCG in this case is as per the applicable slab rate of the investor for the FY.
- LTCG tax is applicable on units held for over 3 years calculated from the date of unit allocation and is 20% of indexed Capital Gains.
How to invest in REITs
REITs are required to mandatory list on stock exchanges which makes it easier to invest in them through your DEMAT account. The prices of these instruments change on a daily basis depending on their demand and supply, just like other stocks on the stock exchange. Currently, there are three REITs in India, which are;
- Embassy Office Parks REIT
- Mindspace Business Park REIT
- Brookfield India Real Estate Trust
All of them specialize in office space and have their primary income by rental out office space to corporate entities. In addition, there is an international fund of fund by Kotak AMC that invests in international funds having exposure to REITs. It is important to evaluate them on their merit before allocating your funds in them.
Should you invest in REITs
REITs are relatively an efficient way to add real estate exposure to your asset allocation mix and should be looked only after you have sufficient exposure to asset classes like equity and fixed income instruments. The major reason to invest in REITs is to diversify your investment portfolio by gaining exposure to commercial real estate without having to deal with the headaches of owning and managing a single or multiple immovable property. Professional asset management and a relatively small investment ticket size are two more advantages of investing in REITs.