Budget 2021 had introduced a tax-friendly measure for REIT investors. It withdrew Tax Deducted at Source (TDS) for the dividends declared by the REITs.
How does REIT stack up vis-à-vis other investments after this move? Does it make sense now to invest in REITs?
Let’s understand its pros and cons.
What is a REIT?
REIT is an acronym for Real Estate Investment Trusts. They typically invest in a pool of income-generating real estate assets including office spaces, hospitals, shopping centres, hotels and warehouses. As per Sebi norms, at least 80 per cent of a REIT’s assets should be from such income-generating properties, while the rest could be invested in under-construction properties, mortgage-based securities and so on.
Globally, there are two types of REIT – Equity REIT and Mortgage REIT. Equity REITs are essentially owners of real estate properties and they lease properties to companies or individuals and earn lease rentals. The latter in turn is shared with its investors in the form of dividends.
In contrast, mortgage REITs are not real owners but only receive EMIs against the property from its builders and owners. Here, the earning made from the difference between the interest earned on the mortgage and the cost of funding the loan is distributed as a dividend.
Indian REITs are essentially equity REITs that generate rental income from commercial properties. A REIT might own properties across cities and locations thereby giving the advantage of diversification. And since the REITs distributes at least 90% of their income in the form of dividends, their investors earn the bulk of their income in that manner.
Additionally, since the Indian REITs are listed on the stock exchanges, they are also impacted by price movements. Any appreciation can improve their overall yield and vice versa. You could own units of a REIT by buying its shares from the stock market in India.
Sebi regulates REITs. It has listed down specific criteria for the qualification of REITs. In addition to those on income distribution and investment (mentioned above), REIT must also have an asset base of at least Rs 500 crore, while disclosing NAV at least twice in a financial year.
Moreover, since REITs function more like a mutual fund, it gives the advantage of investing in real estate at a fraction of a cost, while also getting an exit option by selling shares in the market.
Typically, commercial leases are of long-term nature – nine years or more with built-in annual escalation costs (say 5-10%) which gives stability to income flows.
Tax treatment for REITs over the years has been favourable. In the previous Budget, the central Government abolished the Dividend Distribution Tax (DDT) in order to incentivize investment while making dividends taxable in the hands of shareholders.
And in Budget 2021, TDS on dividends were removed as the amount of dividend income couldn’t be estimated correctly by the shareholders while paying their advance tax.
If you are investing in REITs, dividend income while not subject to TDS, would get taxed at the marginal rate. And for those in the highest tax bracket, the post-tax returns will be as low as that of interest earned from a bank fixed deposit.
Insufficient track record
While the draft REIT regulations were introduced in 2007, the first REIT to hit the market was Embassy Office parks in 2019. It was later followed by Mindspace Business Parks and Brookfield. While the REITs market is well developed in the US, there is an insufficient track record for Indian REITs (and there are only a few). Moreover, REIT share prices have seen a bit of volatility in India with prices of a REIT even quoting below the offer price.
Challenging economic condition
Historically, in developed countries, REITs have generated returns somewhere between that of bonds and stocks. In India, bonds have historically given 6-8% annually while it has been 10-12% for stocks. While REITs propose to give an annualised yield of 7-9% along with share price appreciation (if any), investors need to review it in the current context. Work from home is increasingly becoming the norm which in turn is expected to reduce demand for office space over the medium term. Moreover, with the new supply of office properties increasing in certain cities like Mumbai, rental yields are expected to come down or reduce occupancy rates. This could impact the overall yields of REITs, going forward.
Without a long track record of performance, REITs remain a dark horse. While TDS removal is a welcome change, its post-tax returns are only expected to be similar to that of Bank FDs.