By Dr. Sanjay Chaturvedi , Executive Editor Accommodation Times
A real estate investment trust (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. Here we take a look at REITs, their characteristics and how they are analyzed.
The REIT Status
To qualify as a REIT, a real estate company must agree to pay out in dividends at least 90% of its taxable profit (and fulfill additional but less important requirements). 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
Fewer than 10% of REITs fall into a special class called mortgage REITs. These REITs make loans secured by real estate, but they do not generally own or operate real estate. Mortgage REITs require special analysis. They are finance companies that use several hedging instruments to manage their interest rate exposure. While a handful of hybrid REITs run both real estate operations and transact in mortgage loans, most REITs focus on the ‘hard asset’ business of real estate operations. These are called equity REITs.
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. 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. Individual investors trying to mimic a REIT would need to buy and maintain a large number of investment properties, and this generally entails a substantial amount of time and money in an investment that is not easily liquidated. 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.
The final, and probably the most important, advantage that REITs provide is their requirement to distribute nearly 90% of their yearly taxable income, created by income producing real estate, to their shareholders. This amount is deductible on a corporate level and generally taxed at the personal level. So, unlike with dividends, there is only one level of taxation for the distributions paid to investors. This high rate of distribution means that the holder of a REIT is greatly participating in the profitability of management and property within the trust, unlike in common stock ownership where the corporation and its board decide whether or not excess cash is distributed to the shareholder.
REITS – The Indian Opportunity
Information technology and information technology enabled services such as business process outsourcing have helped in powering the Indian economy to growth rates second only to China. Although information technology has been the driver, many other sectors of the Indian economy including real estate are rapidly developing.
Since independence from Great Britain in 1947, India has historically pursued a socialist style planned economy. Foreign direct investment has therefore been constrained in most sectors of the Indian economy, including in the real estate sector. However, in connection with broad-based reforms initially adopted in 1991, the Government of India recently approved measures designed to encourage greater foreign direct investment in the Indian real estate sector.
Pursuant to a recent notification by India’s Ministry of Commerce, foreign direct investment in the Indian real estate sector is now permitted through the “automatic route”, i.e., without requiring the additional approval of the Foreign Investment Promotion Board. On a practical level, the foreign investor may now by-pass some of the previously required approvals, making the investment process less cumbersome.
REMF (Real Estate Mutual Funds) and REIT (Real Estate Investment Trust) will boost these real estate investments from the small investors’ point of view. This will also allow small investors to enter the real estate market with contribution as less as INR 10,000. There is also a demand and need from different market players of the property segment to gradually relax certain norms for FDI in this sector. These foreign investments would then mean higher standards of quality infrastructure and hence would change the entire market scenario in terms of competition and professionalism of market players.
There are primarily three entry strategies which have been considered:
- Enter Greenfield – In this type of entry strategy, the foreign investor acquires land from investment funds and then develops it by hiring a developer and a property manager etc. After completion of the project, the property can be either sold or leased out.
The fallout of such a strategy is that there is lack of local expertise and several issues like relationships with regulators, developers and management of properties becomes tough.
- Participation with local developer – There are two ways to go about this strategy –
- In this type of strategy the local developer transfers some of its “Under Construction” properties in a property SPV and the foreign investor takes an equity stake in the property SPV. The property SPV uses the funds to further develop properties and sell/lease them. The advantages of this is local expertise and full participation.
- The second way to go about this strategy is a late stage investment into certain projects which foreign investor is interested in. It is usually for ‘retail mall’ projects. Investors can choose to bring in funds only after certain percentage of space secures a lease. Its major advantages are
- Less development risk
- Investor can cherry pick the projects
Its major disadvantage is lower rate of return.
- Investment in to fund and Management Company – There are two approaches to this strategy passive and active.
- Passive Strategy – In this type of strategy the foreign investor invests in International funds managed by experts in the local market. These funds will be run by professional management companies and will be co-invested by sponsors. Its advantages are pure financial investment, and no administrative hassles. Its disadvantages are Leakage to management companies and Loss & carry.
- Active Strategy – In this type of strategy the foreign investor makes investment in fund as well as in management company. There is possibility of sharing of control. Its advantages are Upside participation, Management sharing, and opportunity to value add.