ABSTRACT

Feasibility Analysis of Real Estate Investment Trust (REIT) in India

TERM PAPER
STRUCTURED FINANCE

Subhankar Barik B12056 Garima Agarwal B12081

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Table of Contents Topic Page

Different types of Real Estates Real estate Characteristics Reasons to invest in Real Estates Principal Risks Advantage of REITs over other investments Disadvantage of REITs Why India needs REITs REITs in India Real estate sector in India Comparison of REITs with other countries REITs in India vs REITs in USA REITs in Emerging Markets Areas of Considerations References

2 3 3-4 4 4-5 5 5-6 6 7 8-9 9-10 11 11 12

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Different types of Real Estate Investments

There are basic forms of real estate investments that can be easily explained using the quadrant. The real estate investments are divided into different categories based on the type of investment public or private and the type of funding used that is debt or equity. Mortgages belong to private investment where debt is used primarily for funding. Mortgage backed securities are traded in the public market. REITs and REOCs are traded in the market and it actually behave similar to shares. Direct investment & Ownership use equity as a means of funding and generally it is a private form of investing.

Figure 1 Types of Real Estate Investments

Each of the real estate investment has its own risk, returns, regulations, legal issues and market structure. There is a problem of indivisibility and illiquidity in the private real estate investments. The investments in private real estate investments are higher compared to public investments. Public real estate investments allow the property to remain undivided while allowing investors divided ownership. As a result, public real estate investments are more liquid and enable investors to diversify by participating in more properties. Real estate investments are usually actively managed. There is a need of property management for most of the real estate companies. The owner may do it himself or he can hire someone to take care of the property management. In the case of a REIT, the real estate is professionally managed; thus, investors need no property management expertise. This kind of active management is mostly used in hotels. Equity investors usually require a higher rate of return than mortgage lenders because of higher risk. As previously discussed, lenders have a superior claim in the event of default. As financial leverage (use of debt financing) increases, return requirements of both lenders and equity investors increase as a result of higher risk. Typically, lenders expect to receive returns from promised cash flows and do not participate in the appreciation of the underlying property. Equity investors expect to receive an income stream as a result of renting the property and the appreciation of value over time.

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REAL ESTATE CHARACTERISITCS

Heterogeneity - Bonds from a particular issue are alike, as are stocks of a specific company. However,
no two properties are exactly the same because of location, size, age, construction materials, tenants, and lease terms. In India there is extensive diversity in terms of location so there is high diversity in the sector.

High unit value - The unit value of real estate is significantly higher compared to other forms of
investments. For an investor who wants to diversify into different assets real estate might be a tough choice because of the higher unit value.

Active management - Investors in stocks and bonds are not necessarily involved in the day-to-day
management of the companies. There is a need of active management in case of private real estate investments. The owner may do the investments himself or he may do it hiring some external agencies. Property management involves maintenance, negotiating leases, and collection of rents. In either case, property management costs must be considered.

High transaction costs - Buying and selling real estate is costly because it involves appraisers, lawyers,
brokers, and construction personnel.

Depreciation and desirability - Buildings wear out over time. Also, buildings may become less desirable
because of location, design, or obsolescence.

Cost and availability of debt capital There is high cost involve in the development of the real estate.
Interest rates and amount of debt actually impact the property prices. Real estate values are usually lower when interest rates are high and debt capital is scarce. The real estate value increases when the interest rates are lower and the debt capital is available in abundance.

Lack of liquidity - Real estate is illiquid. It takes time to market and complete the sale of property. Difficulty in determining price The capital markets are used in order to trade Stocks and bonds.
Appraisals of the property is very important for a property like Real estate. It is very crucial to access the value of the real estate using appraisal. It is very difficult to estimate the appraisal value of the property because it is very difficult to find comparable companies. The combination of limited market participants and lack of knowledge of the local markets makes it difficult for an outsider to value property. Real estate market is less efficient compared to other types of markets. There is a significant amount of information asymmetry in the real estate environment compared to other markets.

REASONS TO INVEST IN REAL ESTATE

Current Income Investors may earn money from the rents they receive from the tenants. If there is a
lease agreement then investors can earn significant amount of money from those agreement. The actual income earned by investors after deducting operating expense, financing cost and taxes is the actual income. Capital appreciation Investor actually expect the property value to increase over time. Generally this can be a two way sword. Exceptional increase in property price may create property bubble. In the context of emerging economy like India property price may expected to increase in the long run.

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Inflation hedge -During inflation, investors expect both rents and property values to rise. Diversification - Real estate, especially private equity investment, is less than perfectly correlated with
the returns of stocks and bonds. Thus, adding private real estate investment to a portfolio can reduce risk relative to the expected return.

Tax benefits There is favorable tax treatment in most of the countries for the investors in REIT. In the
US the depreciable life of the real estate is really short that means the depreciation is more and the amount of tax paid is lower and net income increases. In most of the countries investors investing in REITs dont pay taxes. Investors in these countries escape double taxation. (e.g., taxation at the corporate level and the individual level). Details about REITs will be discussed later.

PRINCIPAL RISKS
Business conditions - Numerous economic factors-such as gross domestic product (GDP), employment,
population growth, household income, interest rates, and inflation-affect the rental market.

New property lead time It takes lots of time in order to get approval for making a new real estate.
Market conditions can change significantly while approvals are obtained, while the property is completed, and when the property is fully leased. Future market demand prediction is very critical for this business.

Cost and availability of capital Demand for real estate reduces when the availability of debt capital
is less. Real estate demand decreases when the interest rates are high. Real estate demand is high when the interest rates are low and the availability of funding is very easy.

Unexpected inflation Real estate investments are primarily used in order to hedge inflation. But the
amount of increase in inflation might not be that high compared to the amount of increase in expenses.

Demographic factors - The demand for real estate is affected by the size and age distribution of the
local market population, the distribution of socioeconomic groups, and new household formation rates.

Lack of liquidity There are lots of due diligence involved before buying a real estate property. Most of
the real estate investments are complex. The entire process of performing due diligence takes significant amount of time. A quick sale requires significant amount of time. In India there is high probability of lack of information availability. This kind of information asymmetry may create problem related to investing in this sector.

Advantages of REIT over other forms of Real Estate Investments

REITs is preferable compared to other form of real estate investment. Liquidity - Investment in REIT allows investor with superior liquidity. The shares of REITs trade in the
stock exchange so this increases further liquidity. People who cant invest in high value real estate may still invest in these real estate by buying REITs. The minimum investment in case of REITs is significantly lower than other types of investments.

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Limited liability In the normal real estate investments entire fund is invested. In case of REITs there is
only marginal investment in terms of buying shares of the real estate. The financial liability of a REIT investor is limited to the amount invested. Because of less amount of initial money investment and limited liability people may actually invest in some prestigious properties, such as high-profile shopping malls or other prominent or landmark buildings.

No Active Management There is no need of any active professional management in case of REITs.
REITs employs professional management to control expenses, maximize rents and occupancy rates, and sometimes to acquire additional properties. Since there are significant amount of rules and regulation related to this sector. REITs will be able to sustain the information symmetry. Investors benefit from these securities regulations and from having a board overseeing the management on behalf of investors. Additionally, having public investors monitor the actions of management and the board of directors leads to financial and operating efficiency.

Greater potential for diversification - Because of the high cost of a single property, it is difficult to
achieve adequate diversification though direct investments in real estate. Through REITs, however, an investor can diversify across property type and geographical location.

Tax REITs enjoy favorable taxation. As long as certain requirements are met REITs is really good. REIT
distribution are treated as a return of capital and are this not taxable. The earnings from REITs tend to be consistent over time. There are some events which may create a difference. Rental income of the REIT is fixed by contracts.

High yield -REITs are obligated to pay out most of their taxable income as dividends. Because of this high
income payout ratio, the yields of REITs are higher than the yields on most other publicly traded equities.

Disadvantages of REITs
Lack of control The amount invested in REIT is significantly less compared to other forms of
investments. Because of this reason REIT investors has lack of control with respect to the property.

Price - Price is determined by the stock market. While the appraisal-based value of a REIT may be
relatively stable, the market-determined price of a REIT share is likely to be much more volatile. While this relationship suggests a direct real estate investment is less risky, in reality much of this effect results from the underestimation of volatility that is associated with appraised values; appraisals tend to be infrequent and backward-looking, while the stock market is continuous and reflects forward-looking values. Limited potential for income growth. REITs' high rates of income payout limit REITs' ability to generate future growth through reinvestment. This limits future income growth and may dampen the share price of REITs.

Why India needs REITs?

India face supply of fresh houses. The slum population of the country is around 94.98 million in 2012. The number of houses sanctioned are really less. There is also a prediction that around 600 million people will reside in urban areas in the year 2031. These sectors are finding it difficult in order to gather funds.

6|Page REIT will provide steady supply of funds to the real estate sector. Apart from these REIT will be used as an investment vehicle for individuals. In US market REIT was able to raise around $ 66.8 billion in 2012. The fund raising has steadily increased in the subsequent year. Since India doesnt have any kinds of REIT scheme some developers have listed their REIT in the overseas. These investment vehicle in India hold both the commercial and residential properties in the development stages. With the country growing rapidly there is high demand for the Real estate investments so funding is very crucial in order to develop new projects REIT will provide the Indian investors a platform to commercialize the real estate. It will also provide a platform in order to deleverage the overleveraged sector.

REITs in India
Eligibility - The REITs will be allowed to raise funds through IPO. The REITs should be registered with SEBI.
The key party involved in the REITs are trustees manage, sponsor, valuer and the auditor. The net worth of the spons0r should be around at least Rs 20 Cr and the net worth of the manager should be around Rs 5 Cr. There should be a minimum experience of 5 years for the investors in the real estate sector. The sponsor should have a minimum commitment. They should hold at least 25% of the total units of the REIT. This shouldnt fall below 15% of the outstanding units of REITs. A real estate investment trust (REIT) is an investment mechanism contemplated by the Securities and Exchange Board of India (SEBI). REIT manages properties which are generating income and it provide common units to the public. The unit actually act as an ownership and majority shareholder might get the right to manage the property. REIT will provide a roam for commercialization of the developed property. This will also provide an opportunity to the companies which are heavily dependent on debt to move away from their strategy. REIT in India will give the investor opportunity to invest in this sector without thinking of the hassle regarding the property title and documents.

Uneven Road to REITs - The structure used by SEBI in the draft is adequate but further effort is expected
from REITs to make the structure commercially viable. One of the most important things that needs to be concentrated will be the taxation of REITs. Foreign investment in REITs and Stamping of agreements relating to transfer of REITs are also very important things. The definition of real estate should be improved to include various commercial property and infrastructure projects like Roads & airport projects. The eligibility condition of five years of experience in the real estate industry on an individual basis should be widened to enable different real estate players like hospitals, hotels and corporate houses to participate in REITs. REITs can be made to work similar to mutual fund model. SEBI regulation of mutual fund can be used as a reference to make the model viable.

Minimum Asset Value - The minimum asset value of REIT is around Rs 1000 crore. This kind of threshold
might eliminate the participation of small players. They should provide the concept of co-sponsors similar to that of mutual fund. In this case the company having smaller fund pool their resources and set up a REIT. In recent years Limited liability partnership is considered as a preferred way of investing in real estate sector. Government should permit LLP in the real estate sector. The definition of special purpose vehicle can be improved to include LLPs, thereby enabling real estate investment in LLPs Since REITs is a new product in the Indian market initially the investors will resist to invest in such sector. There should be discount in order to attract these investor. Anchor investors should be motivated to

7|Page participate in these offerings. In conclusion, while the draft REIT regulations is definitely a step in the right direction for the real estate industry, it will not be a successful effort in mobilizing real estate in India unless some of these key concerns are addressed. Foreign investors will be attracted to invest in REITs in India. This investments will be good for the real estate investment in the long run. In the short run people are curious to figure out the implication of tax in the REIT investments.

Real Estate Sector in India

Real estate is the fourth largest sector in terms of FDI inflows. The CAGR of the FDI inflow is around 20.1%. Rapid urbanization is perceived really well for the sector there is a approximate estimation that around 50% people will live in India in these sectors. The urban population will increase from 377 million in India to around 600 million. Indias share to construction in the world is estimated to be third largest in the world by 2020. Real estate contribution is around 5% of the GDP.

Growing demand
Demand for residential properties has surged due to increased urbanization and rising household income. Growing economy driving demand for commercial and retail space. Growing requirement for the hospital and the education sector. Rapid urbanization and the rise in nuclear family will actually increase growth in the sector. Rapid growth in services sectors: IT/ITES, BFSI and Telecom. There is rise in demand for MNCs. There is increase in office demand for Tier 2 cities. Population growth and easy finance will be key in these sectors.

There is significant amount of Private equity investments in the sector. Of the 43 private equity (PE) investments witnessed in the sector during 2012, 35 had an announced value of USD1.14 billion. Foreign funds actually constituted around 50% of this sector. Mumbai remains a place where there is significant amount of PE investments followed by Bangalore and NCR. Maximum amount of investments in the PE firms are executed by SPVs. There is high growth expected in the regions of SEZs where there will be significant amount of investments expected in the future. Ease in housing finance and the increase in number of banks will help the sector to grow significantly.

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Comparison of REITs across different countries

India REIT Conversion Costs USA REIT
None. However, any unrealized gain at time of conversion is bought into tax within the REIT over a 10 year period. There is also a charge on exit from the REIT regime if, by the end of the first year as a REIT, any earnings and profits from any pre-REIT years remain undistributed Not required

France SIIC
Upon election, a 16.5% exit tax is due on latent real estate capital gains, paid over four years in four equal installments

UK REIT
Entry charge of 2% of the gross market value of properties within the property rental business. Can be paid by installments.

Germany REIT
Possible 20% exit taxation

Listed

Required to be listed on a stock exchange as specified in the offer document

Form Restrictions on activities

Corporate 90% of the value of the assets of the REIT is invested in 'completed' and 'rent generating properties'. The remaining 10% may be invested in developmental properties, listed /unlisted debt of companies, mortgage backed securities government

Corporate Ability to develop property if developing for the production of rental income and for itself. Use of taxable subsidiary to carry out addons

Yes. Must be a listed company on the French regulated market. Minimum share capital of c15 million Corporate Main corporate purpose must be the acquisition or construction of buildings for rental purposes and/or the direct or indirect holding of shares in companies having the same corporate purpose SIIC may perform non qualifying activities within certain limits. These activities

Required to be listed on a recognized stock exchange (not AIM)

Required

Corporate At least 75% of the total income profits must arise from its property rental business. The value of the assets in the property rental business must be at least 75% of the total value of all its assets

Corporate At least 75% of the total income profits must arise from letting real estate assets. At least 75% of assets must meet certain qualifying criteria. Exclusions apply in the case of residential property

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securities and money market instruments / cash equivalents amongst others Income of REMF is exempt remain taxable under the Standard corporation tax rules Not subject to tax on capital gains it distributes To extent retained Not subject to tax on income it distributes To extent retained Exempt if relates to eligible activities Exempt if relates to eligible activities Exempt from corporation income tax, the solidarity surcharge and trade tax if meet qualifying criteria Exempt from corporation income tax, the solidarity surcharge and trade tax if meet qualifying criteria At least 90% of net income must be distributed annually Yes, reduced rate for certain taxexempt resident taxpayers. Restrictions may apply to holdings of 10% or more

Tax on capital gains

Tax on income

Income of REMF is exempt

Exempt if relates to eligible activities

Exempt if relates to eligible activities

Income distribution requirement Withholding tax

No withholding tax on income paid to REMF

At least 90% of taxable income must be distributed annually 30% withholding on foreign distributions unless lowered by treaty 35% withholding tax on distributions of REIT capital gain dividends to foreign shareholders attributable to the sale of real estate assets by the REIT

At least 85% of rental income must be distributed annually Non-French investors subject to 25% withholding tax. This can be reduced under applicable tax treaties

At least 90% of taxable income must be distributed annually 22% withholding tax but exceptions apply for some investors. Restrictions may apply to holdings of 10% or more

REIT in India Vs REIT in the USA

In India the exposure to REITs will be on completed and revenue generating property and the exposure to the mortgage backed security will be really less. Rental revenue is expected to be around 75%. Minimum size of subscription is expected to be around Rs 2 lakh. The rental income received from these investments will be distributed as dividends. REITs can invest through a special purpose entity having around 51%

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controlled share. The entire asset of REIT can be invested in a single project. There is no provision regarding Tax provided in the Income Tax Act, 1961. There is expectation of tax concession.

REIT investment
India: At least 90% of the value of the REIT assets shall be in completed revenue generating properties. It is allowed to invest 10% in other assets. Different properties like hotels, malls, offices, residential complex should derive at least 75% of their revenue from the real estate investments. Different properties like debt of companies, MBS and the equity shares of companies should be there and they should also derive at least 75% of the revenue from real estate activities. US: In US it is compulsory to invest at least 75% of the assets in real estate and cash. There cant be more than 25% of its asset consist of non-qualifying securities or stock in taxable REIT subsidiaries.

Shareholder pattern
India: Size of the asset under REIT shouldnt be less than Rs 1000 Cr. The initial offer size can be minimum Rs 250 Cr and minimum public float is around 25% in order to make sure adequate public participation. The REIT may raise funds from any investors, resident or foreign. Only for HNI - Minimum subscription size shall be Rs2 lakh and the unit size shall be Rs1 lakh. US: There will be minimum 100 shareholders after first year as a REIT. There cant be more than 50% of shares held by 5 or fewer individuals during the last of taxable year.

Type of REITs
India: There will be at least 90% of the total investment in completed revenue generating properties. There wont be any investment in vacant, agricultural, mortgages securities. There can invest the entire money in one project if the size of the asset is at least Rs 1000 Crore. US: The REITs are divided into three categories. The three groupings are equity REITs, mortgage REITs and Hybrid REITs. Equity REITs are the maxim. Most REITs belong to equity REITs. The equity REITs own and operate income producing real estates. Real estate owners and operators receive money from mortgage REITs. There is more leverage involved in mortgage REITs. Hybrid REITs are generally the average of the two REITs.

REIT Income
India: In India not less than 75% of the revenues of the REIT from rental and leasing. Gains arising out of property disposals will not be taken into account. US: At least 75% of the income will be derived from rents and mortgage interests.

Distribution of REIT Income

India: In India it is mandatory to distribute at least 90% of the net distributable income after tax of the REIT to the investors. US: There should be a distribution of at least 90% of its taxable income to shareholders in terms of dividends.

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REITs in Emerging Markets Mexico

FIBRA was introduced in 2004. From this time onwards REITs started in Mexico. The problem of tax component was evident after introduction or REITs in Mexico. In 2011 there was a first IPO by FIBRA Uno in the Mexican stock exchange. There are more offerings coming in the future with more expectation in the future. These IPOs are well received by the people of Mexico. Investment made by FIBRAs should be held for at least 4 years with 95% of the income will be distributed to the holders. There should be around minimum of 75% of the portfolio in the real estate. The portfolio of the REITs is performing really well so the investors are attracted towards these investment classes.

Ireland
In the December Irish budget it was announced that Ireland will establish REITs by the finance act of 2013. The prime objective of such establishment is to attract investors from around the world. Ireland is following the regime developed by the United Kingdom. The REITs of the Ireland will be an incorporated company with the shares listed in the Ireland stock exchange and the European Union stock exchange. This company will hold both Irish and overseas real estate investment and this will provide investors a great alternative to invest in these kinds of security.

China
In china there will be REITs within next 2-3 years. China real estate is booming with an exceptional growth rate so there is high chance that china will need REITs in the recent years. China has also conducted a research by china securities regulatory commission (CSRC). UBS created a local fund sponsors in order to invest in public rental housing based on future REITs. While not technically a REIT, this vehicle may eventually issue as a REIT product. Draft REIT legislation is under review.

Areas of Consideration which needs to be improved in the future

(a) sponsors minimum holding of at least 15% of the outstanding units of a REIT, can prove restrictive for Real Estate Funds acting as a sponsor to a REIT, since they have a defined fund life; (b) Minimum asset size of Rs 1000 crore is too high and this may actually prevent the participation of lots of quality sponsors and rent generating assets from (c) There is not clarity regarding the funding of shortfall in an IPO an there is no solution regarding how this will be funded (d) The clarity of the asset transfer to the REIT prior or post listing of the REITs (e) There is no clarity on the pricing after the offer (f) There should be physical inspection of the property and full valuation should be updated at least once a year and it should be updated every six months

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References
Why India needs Real Estate Investment Trust? Economic Times SEBI proposal on real estate investment trust set to get RBI nod The Hindu Money Life Investing Alternative Investment REITs in India: How does it compare with REITs in US? Getting REIT right - Money Life Alternative Investment - CFA institute Readings REIT Regime in India Draft REIT Regulation Assets compare and contrast real estate trust regimes Kdx REITs Global perspective of REITs Ernst & Young