Looking to invest in REITs? Here are 3 factors to consider before investing

But, while the underlying assets in mutual funds are usually equity, debt, gold or a combination of these, the underlying assets in the case of REITs are primarily Commercial Real Estate Holdings.

REITs historically have delivered competitive returns, based on steady distribution income and long-term capital appreciation. Their comparatively low correlation with other assets also makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns.

The Government of India launched REITs to bring in long-term yield capital into the country and to increase private participation in infrastructure and real estate. India saw its first REIT in 2019.

Three years later there are now three (Mindspace REIT, Brookfield REIT and Embassy REIT). REITs as an investment option have gained significant popularity among institutions & retail investors.

Embassy Office Parks REIT, for instance, has witnessed an absolute appreciation of around 22.67% (as on 18th Jul 22) since listing (3rd Apr 19) while BSE Sensex and BSE Realty Index registered absolute returns of 10.37% & 15.11% respectively in the same period. Thus, the early trends of performance of REITs are encouraging.

The commercial reality market in India has been expanding over the past few years. A long tenancy period, stable occupancy ratios, well-managed, high-quality properties provide good cash flow visibility attracting more investments by global investors.

Further, favorable government policies (e.g., enabling investment by foreign portfolio investors) and long-term investment outlook has attracted many marquee investors including sovereign and pension funds to raise their stakes in such assets.

While REITs have raised capital of over US$4 billion in India, a funding requirement of over US$1.4 trillion by 2025 is estimated by the National Infrastructure Pipeline announced by the Government of India.

The three listed REITs mentioned earlier cover 87 million sq.ft. of commercial real estate assets– Mindspace 31 million sq.ft, Embassy 42 million sq.ft. and Brookfield 14 million sq.ft.

Despite the near to medium-term headwinds from COVID-19, there is potential for more stock getting added to the existing REITs or the listing of new REITs as the commercial office market bounces back.

Lastly, to close the gap between big and small investors, SEBI recently made a series of announcements such as reducing the minimum application value and reduction in the minimum number of trading units.

With these announcements, SEBI has encouraged more retail investors to participate in this asset class.

With GDP growth estimated to be ~8% – 9%, REITs are likely to have an accelerated entry into the market offering a new investment opportunity to retail investors who currently find it difficult to invest in commercial real estate assets on account of high capital costs and in the residential segment owing to low/negligible returns.

Investors should consider these factors before investing in the REITs:

Distribution yield

Distributions by REITs are based on the Net Distributable Cash Flows (NDCF) unlike companies where the dividends are paid based on profits. SEBI guidelines state that REITs in India must distribute at least 90% of the cash available to unitholders in the form of a dividend, interest and/or loan repayment.

If a REIT does not opt for the new tax regime, then distributions in the form of dividend are tax exempt in the hands of unitholders.

This is an additional advantage for an investor in REITs as compared to dividend payouts in the case of direct equities and mutual funds which are now taxed at the marginal rate of taxation. REITs in India currently offer yields in the range of 5.1-5.5%.

These yields may further escalate depending upon the rental renewal rates of tenants (Re-leasing).

Investors should consider critical clauses such as weighted average lease expiry, escalation clause, guidance by the company management and cost of unit purchased to understand the current and likely future distribution payouts.

Underlying portfolio quality of the REITs

REITs should have a well-diversified asset base with income accruing from multiple properties often spread across multiple cities and tenants from diverse sectors.

Diversification of asset base reduces the volatility of rental income and the investor is less exposed to a single asset risk.

Also, the assets of REITs are generally Grade A office buildings which witness higher rentals and occupancy levels within a micro-market. An occupancy rate of 85-90% is a good number.

Net Operating Income (NOI)

NOI determines the revenue and profitability of an invested real estate property after subtracting necessary operating expenses.

A higher NOI indicates good performance of the underlying portfolio and REIT. The increase in NOI would be driven by the following factors:

• Increase in occupancies.

• Completion of an under-construction portfolio

• Contractual lease escalation for leased properties

• Re-leasing of expired leases at higher lease rentals: As lease periods expire, the re-leasing would typically happen at market lease rentals which in most cases are higher than existing lease rentals

[The author is Managing Partner- Products & COO at TrustPlutus Wealth (India).]