Before getting into the pros and cons of investing in real estate investment trusts (REIT), let us first look at the whole concept of REIT benefits and risks. A REIT is a pool of real estate assets that can generate regular income and is held like a mutual fund. Like a mutual fund collects monies from investors and then invests the same in the stock market, the REIT will collect money from retail and institutional investors and deploy these funds in real estate assets. Typically, these will be commercial real estate assets like offices and shopping malls that can generate regular rental income. REITs in India are popular because the generation of income through real-estate assets is almost assured, or at least, this is what investors believe. With real-estate only on the rise, and appreciation better than that relative to other asset classes, REITs are gaining steam.
The other way to look at REITs is like banks create a pool of securitized assets consisting of different categories of loans which are then issued as securities to investors. REITs are, in a way, a method of securitizing real estate receivables. If you wish to invest in a REIT, it's worth knowing about some aspects of it, so you can make informed decisions on your investment. Let us look at investing in REITs pros and cons and also why not to invest in REITs.
REITs offer a variety of advantages to different parties including the sponsor of the fund, the investor and the property developer. Here are some of the key advantages of investing in REIT stocks through a REIT fund…
Since REITs are required to distribute nearly 90% of their earnings in the form of dividends to the REIT investors, they can be assured of a higher income ratio. This percentage has to be distributed to all investors on a yearly basis. This enhances the yield for investors in REIT funds. In terms of REIT investment, investors do not just invest in stock that is publicly traded, but also in the real-estate markets themselves. The popularity of REITs has been witnessed historically as their competitive market performance has yielded high returns for investors through the years. Therefore, investors get a stable and steady (and seamless) flow of investment, significantly higher than other assets like equity and bonds. Moreover, the stream of returns is rarely influenced by volatile market events and conditions.
REITs are designed to be tax efficient. The government has given them pass-through status. That means; when the REIT receives the rentals and distributes them to its shareholders, it will be treated as a pass-through flow and will not be taxed. This is a crucial impetus for investors as tax-saving on REITs is more than that of other investments like gains on stocks and commodities.
The REIT assets are normally secured by long term leases and therefore there is no risk to the REIT investor. The long term lease also ensures that the income flow to the REIT will continue in a more predictable manner. Hence, REITs prove very useful to certain investor classes, those who have a low risk appetite, novice investors and senior citizens alike. Besides this, how to invest in REITs is simple to grasp for many investors who want a hassle-free investing experience.
What the REIT will bring in is professional management to the pool of real estate assets. Like mutual funds bring in professional management into equities and debt, REITs will bring in professional management into the real estate pool. This will permit them to bargain for better lease rentals, get a good price on trading real estate etc.
From an investor’s point of view, the REIT offers two distinct merits. Firstly, it offers an opportunity to buy real estate as a financial security. It is much cheaper and less cumbersome to transact in REITs than to transact in property. For investment purposes REITs make a lot more sense. Secondly, it offers a new asset class to investors outside of traditional equity, debt, cash and gold and thus helps diversify the risk. Portfolio diversification, which is the single most vital factor to leverage your position against inflation and other fluctuations in the financial world, is achieved through REITs.
Like mutual funds REITs are expected to become fairly liquid assets over a period of time. Since real estate is traded in the form of securities, the creation of demand and supply will be much easier in this case. Thus, investors in REITs will not have to worry much about entry and exit costs.
For real estate developers, REITs offer the benefit of monetizing their assets. This allows the realty companies to focus more on executing realty projects rather than owning the realty assets. This makes them asset-light and improves their ROI.
Finally, REITs will be regulated by SEBI since they will be a traded financial security and will be transacted through the secondary market. The SEBI regulation will come with stringent reporting and disclosure practices, which the REIT will have to adhere to. This will ensure greater transparency, which is good for the investor.
But REITs also have some challenges; here are few of them…
There are also some key challenges that REITs face in India. While some are regulatory, others are driven by the business environment..
The key determinant of the success of REITs is the rental yield. In India, rental yields are not too attractive. Rental yields are the rents that one can receive compared to the price of the property. More attractive rental yields are only possible if property prices come down further from current levels.
REITs have a major growth challenge. They are required to distribute a chunk of their earnings as dividends to REIT holders. This stifles their ability to plough back money into the REIT business and enable it to grow.
Globally, REITs have had situations when they have relied extensively on debt and this created a major financial risk for them. In many cases, the REIT holders have ended up taking a loss due to this. That is something REIT investors need to be cautious about.
There is still a degree of uncertainty on the tax front. While the pass through status has been given to REITs, there is no clarity on other aspects of income tax and capital gains on these instruments.
If a company wishes to qualify as a REIT, it has to meet the following requirements:
The majority of REITs function in a fairly simple manner. The business model of a REIT is easy to grasp and this is what makes the concept of investment appealing. By the means of leasing space, and the collection of rent thereof, any company can generate an income paid out to shareholders (dividends). While financial results are reported, like any other public companies do, REITs have to report earnings for every share according to net income which is defined by GAAP, or generally acceptable accounting principles.
Finally, regulation is a major challenge. Real estate in India is still subject to state level regulation. Therefore, there is no national policy as far as real estate is concerned. Till the time that happens, the spread of REITs in India may be a challenge!