There Is Not Much To Celebrate About REITs Just Yet – Livemint – 09-Dec-2014
December 16, 2014 - Uncategorized
I recently happened to answer a few investor queries regarding real estate investment trusts (REITs) and it got me thinking whether these are right for retail investors in India. At least for a while, REITs may not make too much sense for retail investors.
The sudden interest in REITs has been triggered by the market regulator, Securities and Exchange Board of India (Sebi), issuing regulations governing these products. To analyze their viability as an investment option, it is imperative to understand what these really are and what would be the implications of investing in this product category.
REITs are like mutual funds that invest in real estate. These are, therefore, a way for investors to participate in an asset class that has traditionally required large investment sizes. In addition, REITs also provide the benefit of easy liquidity. You can buy and sell your units at a day’s notice—something not possible with physical real estate.
This, therefore, seems like a product made for the real estate passionate Indian market and one can understand the excitement about these products. But are REITs really as good an option?
For a better assessment of REITs, we must understand the distinction between two different types of returns—income and capital appreciation.
Income returns are those that come by way of a periodic cash flow, for instance, interest on fixed deposit or rental from a house. Capital appreciation comes by way of increase in value, such as price appreciation of a company’s stock or in the value of a house you own. REITs invest in income generating assets, typically commercial properties, which provide rental income. Internationally, REITs own office buildings and shopping malls. They are assured of long-term, committed revenues, using which they provide a stream of income to shareholders in REITs. Sebi has also mandated that more than 80% of funds raised by a REIT be invested in ‘completed’ commercial property that generates income. Also, REITs must distribute 90% of their income.
This makes REITs an income investment. This is fundamentally different from the return model for a typical real estate investor in India. Most profits from real estate are currently being generated due to rise in residential property prices, i.e. capital appreciation.
This also leads to recognition that returns on REITs are not likely to be very different from fixed income returns; in fact, it could even be worse. Typical commercial real estate rental yields in India are about 9%. After accounting for management fees, what the investor can expect would be at most 7.25%. This is just about comparable to fixed deposits and debt funds with a much longer track record.
In addition, a lot has been written about how the fantastic profits that retail investors envision from real estate investments do not take into account all the costs, such as interest, property taxes and transaction costs. In a REIT, all of these will need to be accounted for and the real returns may be significantly below the expected returns from real estate.
So, are REITs all bad? The answer is, no; as long as you evaluate the product with the right return expectation and with the right objective in mind. And this is a caveat that holds true for any investment option. Globally, REITs are seen as a hedge against inflation—rental contracts typically have inflation adjustment built in (in the form of escalation clause when you rent a home). This means that income to investors continues to increase. To that extent, these are different from bonds or fixed income investments. In other words, REITs are a more liquid and convenient alternative if you are considering paying for your retirement through inflation adjusted rentals from a house or commercial property. It is not, however, an alternative to investing in real estate for capital appreciation.
Wait for adequate track record
Since REITs are new, retail investors should wait till these establish a track record before investing in them. It will also take time for the market to adjust to the business practices brought in by institutions—no cash payments and transparent contracts, among others.
For mutual funds, a track record of at least 4-5 years is recommended, and there is no reason why it should be any lesser for REITs. This means that even if REITs are launched by, say, 2016 or 2017, a suitably long performance history may not be available for retail investors until about 2022.
Given these factors, retail investors should, for now, choose established asset classes with a proven history. Over time, REITs could have a transformative effect on real estate in India, but for retail investors, the benefits could be uncertain for some time.