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What Is A REIT And How Does It Work?

What Is A REIT And How Does It Work?

A real estate investment trust (REIT) is a form of collective investment scheme that would enable an investor to invest in a portfolio of income-generating real estate assets, by purchasing units of it. Investment is made in assets such as shopping malls, office spaces, hotels, apartments and these assets are rented or leased with the aim of generating income for the unitholders, from the pool of funds contributed by them.

To better understand, REITs are similar to mutual funds; however, instead of securities, REITs have real estate assets, directly or indirectly, as their underlying investments.

Let’s take a hypothetical scenario where you and two of your friends, optimistic of a favourable real estate environment, pool in a corpus of INR 3 crore (INR 1 crore, each) to buy an office space and rent it. The rental income, so received, after deducting the costs of maintenance, staff salary, etc., is distributed equally amongst all of you. This is the basic framework on which the model of REITs is based.

How Does a REIT Work?

A REIT is set up in the form of a trust registered with the stock market regulator Securities and Exchange Board of India (SEBI).

Stakeholders involved in a REIT

  • Sponsor: The sponsor is a person who forms the REIT. They set up the REIT and transfer the property owned by them i.e., the real estate assets to the trust. Therefore, a builder or developer desirous of raising funds through REIT generally plays the role of a sponsor.
  • Trustee: The trustee is a person appointed by the sponsor, who holds the assets on behalf of the unitholders.
  • Manager: The trustee appoints a manager who manages the REIT assets and is responsible for making investment decisions. The manager is typically a private company closely held by the sponsor.
  • Unitholders: They are the beneficiaries of the trust, who become indirect holders of REIT assets by subscribing to the units of the REIT. Unitholders can be Indian residents or foreign investors.
  • Independent valuer: Apart from the sponsor, manager and trustee, a REIT appoints a credible independent valuer who values the REIT’s assets at periodic intervals.

Additionally, auditors, registrar and transfer agents, merchant bankers and custodians may be appointed by the manager, to carry out activities incidental to the operation of REITs and additionally, meet the requirements of law.

After registration with SEBI, REITs make an initial public offer or an IPO of its units within three years and get its units listed on the stock exchange. Thus, as an alternative to borrowings, real estate developers can effectively use a REIT structure to raise capital from the market and bring the much-needed liquidity in their operations.

A subsequent issue in the stock markets can be through a follow-on offer, a preferential issue, a qualified institutional placement, rights issue, bonus issue or offer for sale.

Structure of a REIT

The REIT’s assets can be directly owned by the REIT or through a “special purpose vehicle” (SPV) or through a holding company (holdco) that, in turn, holds such SPVs.

SPV: A SPV is a company in which either a REIT or holdco, holds or proposes to hold, an equity stake or interest of at least 50%. The SPV holds at least 80% of its assets, directly in properties, and is not allowed to invest in any other SPVs nor engage in any activity, other than holding and developing a property and any incidental activity relating to such holding or development.

Holdco: A holdco is a company or or an limited liability partnership in which the REIT holds or proposes to hold an equity stake or interest of at least 50% and which, in turn, has made investments in other SPV(s), which ultimately hold the real estate property or properties.

The holdco does not engage in any other activity other than holding of the underlying SPV(s), holding of real estate or properties and any other activities pertaining to and incidental to such holdings.

Investment by a REIT

  • REITs are permitted to invest only in real estate assets situated in India.
  • A REIT is obligated by law to invest a minimum of 80% of the value of its assets (as assessed by a valuer) in completed and rent or income-generating properties.
  • The balance 20% of the value of REIT assets can be invested in the following assets:
    • Any under-construction properties held by the REIT, subject to the condition that post completion of construction, they continue to be held for not less than three years.
    • Completed and non-rent generating properties, provided they are held by the REIT for not less than three years from the date of acquisition.
    • Mortgage-backed securities (MBS): A bank lends a borrower the funds required to buy a house and collects monthly payments on the loan extended (mortgage). Banks bundle hundreds or thousands of these individual mortgages into a group and sell these in tranches to another bank (investment bank). This is known as a mortgage-backed security, for which the underlying asset is “home or residential property”.

      In return, the investor gets the rights to the value of the mortgage, including interest and principal payments made by the borrower.
    • Listed or unlisted debt of companies or body corporates that are engaged in real estate, other than debt of holdco or SPV of the REIT.
    • Equity shares of companies, whether listed or unlisted, deriving 75% or more of their operating income from real estate activity.
    • Government securities.
    • Unutilized floor space index (FSI) or the maximum buildable area that can be constructed on a plot of land, of a project in which investment has already been made by the REIT.
    • Transferable development rights (TDR) acquired for utilization in relation to a project where REIT has already made investment.
    • Money-market instruments or cash equivalents, such as Treasury Bills (T-bills), Commercial Papers, Certificate of Deposits, etc.
  • A REIT cannot invest in units of other REITs.
  • REITs are not allowed to invest in vacant land, agricultural land or mortgages, other than mortgage-backed securities.

How to Invest in REITs

REITs entered the Indian market only in April, 2019 when Embassy Business Park REIT became the first REIT to be listed in India. Unlike in other countries such as the U.S. wherein, private REITs and public non-listed REITs are also regulated; in India, only public REITs registered with SEBI are in place as of now.

At present, investors can invest in three REITs, which include:

  • Embassy Business Park REIT
  • Mindspace Business Parks REIT
  • Brookfield India REIT

To invest, a demat account is required as investing in REITs is similar to investing in equity shares. To encourage investors, SEBI has made two significant amendments to rules of investing in REITs in India.

First, there was a minimum requirement of INR 50,000 for an investor to invest in units of REITS. This has been done away with. Now, the minimum investment criteria of INR 10,000-15,000, lower from the previous INR 50,000, is applicable for investment through initial public offerings (IPOs) and follow-on offers (FPOs).

Second, the minimum lot size of REITs traded has been reduced from 100 units to 1 unit.

Returns To Expect From REITS

  1. Rental income, dividends and interest: Rental income is earned by a REIT from direct investments in properties whereas dividend income is earned if such investments are made through a SPV. Interest income is generated by a REIT if investments are made in MBS or debt instruments.

    By law, a REIT is required to distribute at least 90% of the net distributable cash flow (NDCF), i.e., the income generated after deducting expenses, to its unit holders at least twice a year.
  1. Capital appreciation: Just like how the price of stocks rise or fall over time, the units of the REIT also appreciate or depreciate in value. Since unit holders indirectly own a portion of the property that REITs buy, the investments grow in tandem with the value of the properties that the REIT holds.

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