By Accommodation Times News Services
The abundance of investment vehicles out there creates a challenge for the average investor trying to grasp what they’re all about. Stocks are the mainstay of investing, bonds have always been the safe place to park your money, options have increased leverage for speculators, and mutual funds are considered one of the easiest vehicles for investors. One type of investment that doesn’t quite fall into these categories and is often overlooked is the real estate investment trust, or REIT.
So what exactly is a REIT? Well, it’s a trust company that accumulates a pool of money, through an initial public offering (IPO), which is then used to buy, develop, manage and sell assets in real estate. The IPO is identical to any other security offering with many of the same rules regarding prospectuses, reporting requirements and regulations; however, instead of purchasing stock in a single company, the owner of one REIT unit is buying a portion of a managed pool of real estate. This pool of real estate then generates income through renting, leasing and selling of property and distributes it directly to the REIT holder on a regular basis
REIT – An Introduction:
REIT is a real estate company that offers common shares to the public. In this way, a REIT stock is similar to any other stock that represents ownership in an operating business. But a REIT has two unique features:
- Its primary business is managing groups of income-producing properties.
- It must distribute most of its profits as dividends.
Essentially, REITs are the same as stocks, only the business they are engaged in is different than what is commonly referred to as “stocks” by most folks. Common stocks are ownership shares generally in manufacturing or service businesses. REITs shares on the other hand are the same, just engaged in the holding of an asset for rental, rather than producing a manufactured product. In both cases, though, the shareholder is paid what is left over after business expenses, interest/principal, and preferred shareholders’ dividends are paid. Common stockholders are always last in line, and their earnings are highly variable because of this. Also, because their returns are so unpredictable, common shareholders demand a higher expected rate of return than lenders (bondholders). This is why equity financing is the highest-cost form of financing for any corporation, whether the corporation be a REIT or manufacturing firm.
Characteristics of an REIT:
To qualify as a REIT, the requirements are different for different nations.
The requirement to qualify as a REIT in USA is:
- A company must distribute at least 90 percent of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income.
- By having REIT status, a company avoids corporate income tax. A regular corporation makes a profit and pays taxes on the entire profits, and then decides how to allocate its after-tax profits between dividends and reinvestment; but a REIT simply distributes all or almost all of its profits and gets to skip the taxation.
Types of REITs :
The REIT industry has a diverse profile, which offers many alternative investment opportunities to investors. REITs often are classified in one of three categories: equity, mortgage or hybrid.
a. Equity REIT
Equity REITs own and operate income-producing real estate. Equity REITs increasingly have become primarily real estate operating companies that engage in a wide range of real estate activities, including leasing, development of real property and tenant services. One major distinction between REITs and other real estate companies is that a REIT must acquire and develop its properties primarily to operate them as part of its own portfolio rather than to resell them once they are developed.
b. Mortgage REIT
Mortgage REITs lend money directly to real estate owners and operators or extend credit indirectly through the acquisition of loans or mortgage-backed securities. Today’s mortgage REITs generally extend mortgage credit only on existing properties. Many modern mortgage REITs also manage their interest rate risk using securitized mortgage investments and dynamic hedging techniques.
c. Hybrid REIT
As the name suggests, a hybrid REIT both owns properties and makes loans to real estate owners and operators.
Structure of REITs
REITs are typically structured in one of three ways: Traditional, UPREIT and DownREIT. A traditional REIT is one that owns its assets directly rather than through an operating partnership.
In the typical UPREIT, the partners of an Existing Partnership and REIT become partners in a new partnership termed the Operating Partnership. For their respective interests in the Operating Partnership (“Units”), the partners contribute the properties from the Existing Partnership and the REIT contributes the cash. The REIT typically is the general partner and the majority owner of the Operating Partnership Units.
After a period of time (often one year), the partners may enjoy the same liquidity of the REIT shareholders by tendering their Units for either cash or REIT shares (at the option of the REIT or Operating Partnership). This conversion may result in the partners incurring the tax deferred at the UPREIT’s formation. The Unit holders may tender their Units over a period of time, thereby spreading out such tax. In addition, when a partner holds the Units until death, the estate tax rules operate in such a way as to provide that the beneficiaries may tender the Units for cash or REIT shares without paying income taxes.
A DownREIT is structured much like an UPREIT, but the REIT owns and operates properties other than its interest in a controlled partnership that owns and operates separate properties.
Advantages of REIT:
- Creates a safety net for the Investors: When you buy a share of a REIT, you are essentially buying a physical asset with a long expected life span and potential for income through rent and property appreciation. This contrasts common stocks where investors are buying the right to participate in the profitability of the company through ownership. When purchasing a REIT, one is not only taking a real stake in the ownership of property via increases and decreases in value, but one is also participating in the income generated by the property. This creates a bit of a safety net for investors as they will always have rights to the property underlying the trust while enjoying the benefits of their income.
- Another advantage that this product provides to the average investor is the ability to invest in real estate without the normally associated large capital and labor requirements. When buying a REIT, the capital investment is limited to the price of the unit, the amount of labor invested is constrained to the amount of research needed to make the right investment, and the shares are liquid on regular stock exchanges.
- Furthermore, as the funds of this trust are pooled together, a greater amount of diversification is generated as the trust companies are able to buy numerous properties and reduce the negative effects of problems with a single asset.
Status of REITs in India:
REITs are not presently operating in India but are expected to come into force soon. SEBI had invited suggestions and objection and one can have on their website. Implementing REITs would require a number of substantial measures on the industry side as well as on the fiscal side. Some of the decisions pending on REITs in India are:
- Ownership: The persons who can form REIT’s
- The type of scheme: Open ended or close ended
- Legal Issues: Issues relating uniform stamp duty, clear titles etc.
- Valuations of Property
With the government over the years having shown a keen desire to propel growth in the real estate sector by offering several tax and other fiscal benefits to developers and end users, we believe that such easing of restrictions and, moreover, increasing regulatory acceptance can be taken as an indication of REITS seeing the light of day in India.
Expectations from Government’s Side:
To begin, with an exclusive stock exchange could be set up under Securities and Exchange Board of India (SEBI) guidelines for trading real estate stocks. The Government should permit the setting up of a Real Estate Investment Trust (REIT) which should be regulated by SEBI in order to open the investment floodgate for the real estate sector. The REIT would operate like a mutual fund, where investments of individual investors are consolidated to invest in real estate, rather than stocks of companies. It would provide a higher level of liquidity as well as professional advice for price discovery, as the investor would be investing through an asset management company. It also provides assured returns in the form of dividends to its investors from rental income earned on real estate assets. The essential difference between a REIT and a mutual fund is that investments made in REIT are traded in real estate stocks and not invested in stock of companies. Further the swings in this market are in the range of 5-10 per cent, which an average investor is in a better position to absorb than the 60-90 per cent swings on the stock market.
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- There is no restrictions on the manner in which the fund is used
Reverse Mortgage In India
The concept of Reverse Mortgage is new to India. Recently National Housing Bank has come up with a plan to introduce reverse mortgage in India. The facility will be made available by banks to people aged 62 years and above. National Housing Bank will do the re-financing. The loan will be for up to 15 years. The value unlocked will be a function of borrower’s age and value of the house. The interest will be based on the prevailing rate.
National Housing Bank is currently sorting out issues with CBDT that the finance received by senior citizens is treated as a loan and not income. The bank is also trying to build in a mechanism where the loan amount could flow beyond 15 years.
To qualify for a reverse mortgage the borrower will have to approach a housing finance company (HFC) or a bank and express his interest in pledging his home for the reverse mortgage scheme. The HFC will asses the value of the house and, depending on the age of borrower and the prevailing interest rate, the amount of loan payable to him will be decided upon.
The value of the house will be determined by independent valuation through the generally accepted property valuation methodology in the industry. The loan amount will be fixed on the basis of current value and not on possible future appreciation.
However, the most critical factor in deciding the amount will be age. The older the borrower, the more are the chances of getting a higher value. This is because the lender will have to typically provide the loan for a lesser number of years. The interest rate at which the loan will be given will typically be marginally higher than the prevailing interest rates as the lending company will receive its money when the borrower dies. However, currently on the basis of present actuarial analysis, the loan to value ratio is fixed at 45-60 per cent of the value of the property based on the age.
NHB on Reverse Mortgage
Under the present recommendations of the NHB, a borrower need to be 62 years of age and the tenure of the loan is fixed at 15 years. However there have been recommendations to lower the age to 60 as people usually retire at that age. The primary lenders shall however have the discretion to consider shorter/longer tenure. Incase the borrower outlives the tenure of the loan, he will not be asked to move out of the house. In such a case payments made to the borrower will stop after 15 years, but the interest will keep accumulating till the accounts are finally settled. There are also suggestions of adding insurance to reverse mortgage. The premium for that will be deducted from the payment made to the borrower. The corpus accumulated at the end of 15 years will be used to fund the years that the borrowers outlive the loan tenure. NHB has also recommended that a certain portion from the payments be parked in bank fixed deposits to fund the years that borrower outlive the loan. The accounts will be settled by the HFC only after borrower’s death or if he chooses to vacate the property. The settlement of the outstanding loan amount, along with the accumulated interest, will be met by the proceeds of the sale. In the event of borrower’s death, the spouse can continue to occupy the property until his/her demise, and he/she usually made a co-borrower.
NHB is working towards speedy introduction of this concept. As the apex financial institution for housing in the country, NHB has designed the product on ready-to-deliver mode based on specific needs of the asset-rich but cash-poor senior citizens. It will endeavor to popularize reverse mortgage as one of an array of post-retirement financing options. NHB will not provide retail loans but it can refinance reverse mortgage to banks and HFCs. And in the event of a borrower seeking additional assurance that the bank/HFC will continue to provide payments under reverse mortgage for the contracted period, NHB can guarantee such obligations.