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.
The other way to look at REITs is like banks create a pool of securitized assets comprising 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. Let us look at investing in REITs pros and cons and also why not to invest in REITs.
Advantages of REITs funds
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..
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 enhances the yield for investors in REIT funds.
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 to its shareholders, it will be treated as a pass-through flow and will not be taxed.
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.
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 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.
Like mutual funds REITs are expected to become fairly liquid assets over a period of time. Since the 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.
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!
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