Aug 31, 2016: Incentives and initiatives for REIT listings are underway but what does it take for markets to absorb these initiatives, and regulator to create an ecosystem conducive to REITs?

After SEBI issued recent guidelines for Real Estate Investment Trusts to see the light of day, REITs have been the talk of the town. While REITs were allowed to generate capital from overseas and help realtors reduce leverage since 2014, the trusts have failed to take off so far as cumbersome regulations and high levies garnered limited investor interest. In an effort to resolve this puzzle around REITs uptake, the regulator has been ideating at three critical fronts – spectrum of projects coverage, organizational structure, and above-par realizable returns – to make REITs a reality.

Encouraging the listing of portfolios by realtors, SEBI recently proposed REITs to invest up to 20 per cent in under-construction projects, raising the earlier cap of 10 per cent. On one hand, the investment relaxation improves the potential for capital gains, particularly for investors who have a medium- to long-term investment horizon and are not necessarily chasing pre-leased assets. On the other hand, the relaxation brings a favorable exposure to under-construction assets since any part of under-developed asset with title will continue to form part of a ‘completed’ investment. Interestingly, surveys on REIT risk-return appetite suggest that Fund Managers globally prefer an equity holding of less than 30 per cent in under-developed assets, which falls in the correct order as per the new SEBI proposal.

Bringing an organizational structure to the ‘uptake puzzle’, SEBI also proposed a change in the number of REIT sponsors to five from current level of three. Moreover, a special purpose vehicle (SPV) is currently required to hold at least 80 per cent of its assets directly and cannot invest in other SPVs. The proposed removal of the restriction on SPVs to be able invest in other SPVs definitely enables portfolio diversification and is a good step towards market making. Alongside, the limit on at least 50 per cent equity in a holding company by a REIT and so on between the holding company and SPVs is also likely to improve the quality of assets held, thereby reducing the overall portfolio risk and bringing organizational discipline needed for the newer asset-class in the making.

There is impetus from the government to ensure above-average realizable returns through removal of Dividend Distribution Tax (DDT) from returns realized and distributed by SPVs held under a REIT. Typically, REITs worldwide have a potential to generate returns between 8-11% annually. With near-term volatility in the market and the falling rupee, there’s likelihood that early listers will be able to realize above-average yields.

The way ahead..
While the government push has been strong off-late to kick-start REIT listings, there are crucial areas that still need to be addressed to further the momentum and take REITs proposal across the last mile. While some may feel that relaxation in Capital Gains Tax and stamp duty applied on portfolio assets will trigger the inflection for REITs uptake, there are other cautions that are to be addressed at strategic levels before listings could be actually seen.

The key to a fair value proposition is going to be quality due-diligence and risk-return profiling of the asset holding. To ensure this, most mature markets have a minimum threshold for stake held in a REIT by fund managers. The lock-in and dilution criteria for fund managers could be reviewed over a structured time-line but an equity stake of 20- to 30 per cent held by a fund manager will help maintain institutional quality of assets, and attract retail investors to the forefront.

Another important aspect is related-party transactions that needs more detailing, especially if the related parties hold investments in non-property assets. One open-ended area for discussion is how the management fee will be built in the entire gamut of REIT holdings: pegged to share price, EPS or DPU growth. Assuming it’s a performance inducing management fee, the role of rating agencies and independent performance evaluators is going to be quite critical. This requires a paradigm shift for Realtors who are used to financing projects, primarily through lending institutions, which are not subject to a regular review of project performance.

Essentially, the ‘checks and balances’ revolving around standardized metrics (i.e. information reported, reporting time-lines and cut-off dates) for performance assessment of REITs will need to come into play to kick start their listings.

By Shubhankar Dongre (Co-Founder, Propstack) and Ashish Sikka (Consulting Head, Propstack)