What is Real Estate Investment Trusts (REITs) and How it Works (2023)

A less commonly availed option for investing in Real Estate is commercial property such as shops, office space, etc. However, this type of Real Estate investment often features large ticket sizes of Rs. 1 crore or more especially in Metro and Tier 1 cities. Add to this the hassles of getting appropriate clearances, getting long-term leases from viable tenants, and ensuring timely receipt of rents and you stop wondering why few individuals choose this investment option.

There is of course another way to gain exposure to real estate – investment in equity stock of listed Real Estate companies. But these investments are prone to market risk and though real estate is the underlying asset, these investments can be more appropriately termed as mid or small-cap equity investments with a high degree of volatility. As a result, very few individuals are able to include Real Estate in their portfolios. However, over the past couple of years, a new way to invest in commercial Real Estate has emerged in India – Real Estate Investment Trust or REIT.

REITs are stock market-listed investments that allow investors exposure to Real Estate without having to purchase or manage properties by themselves. In this blog, we will discuss key aspects of REITs including what they are, how they work, their performance, taxation, and also whether you should invest in them.

What are REITs?

The concept of REITs originated in the United States when President Eisenhower signed the REIT Act title into law as part of the Cigar Excise Tax Extension of 1960. The US Congress had originally created the REIT to provide US investors with the opportunity to invest in and profit from diversified, large-scale professionally managed portfolios of US Real Estate.

REITs are similar toMutual Fundsas they allow multiple investors to pool their investments and in both cases, the assets are professionally managed by a designated Manager. But, while the underlying asset of Mutual Funds is usuallyEquity,Debt,Gold, or a combination of these, the underlying asset in the case of REITs is primarily Real Estate Holdings or loans secured by Real Estate.

When a Real Estate Company decides to form a Real Estate Investment Trust, it becomes the Sponsor for the REIT and appoints a Trustee. The Trustee holds the Real Estate Assets of the Trust in its Trusteeship and these assets are no longer directly controlled by the Sponsor. A REIT may control its Real Estate Holdings either directly or through the formation of a Special Purpose Vehicle (SPV). In the case of REITs, the SPV is a domestic company that holds the Real Estate Assets on behalf of the REIT, and as per regulations, the Trust holds a 50% or higher stake in the SPV.

Next, the Trustee appoints a Manager to manage the Real Estate Assets on behalf of the Trust and also make investment decisions. After the Manager is appointed, the REIT can be registered. Once registered, a REIT can raise money through the sale of units either publicly on stock markets or through private investors.

At the most basic level, a REIT unit represents part ownership of the Real Estate Assets held by the Trust and this entitles the unit holder to a share of the income generated by the REIT. Typically, a REIT is required to pay out at least 90% of its Net Taxable Income to its unitholders in the form of dividends and interest. In the next section, you will get to know the different types of REITs available globally.

Different Types of REITs

Based on the type of Real Estate holdings, the following are the different types of REITs available globally:

1. Retail REITs:These REITs are required to invest at least 24% of their assets into commercial retail such as shopping malls and freestanding retail stores.
2. Residential REITs:These are Real Estate Investment Trusts that own and operate manufactured housing as well as rental apartment buildings.
3. Healthcare REITs: As suggested by the name, these trusts primarily invest in and operate healthcare-focused Real Estate such as hospitals, nursing facilities, retirement homes, and medical centers.
4. Office REITs:These primarily invest in and operate office space. Their main source of income for this type of REIT is thus rental received from tenants with long-term leases.
5. Mortgage REITs:In the case of these REITs, an estimated 10% of investments are made into mortgages instead of physical Real Estate.

Now that we have covered some basic details of REITs, let’s how REITs in India operate.

REITs in India

In India, the concept of Real Estate Investment Trust is relatively new and the first guidelines were introduced by SEBI (Securities Exchange Board of India) in 2007. The current SEBI guidelines related to REITs in India were approved in September 2014.

There are currently only 3 REITs available for investment in India – Embassy Office Parks REIT, Mindspace Business Parks REIT, and Brookfield India Real Estate Trust. Going forward, other leading names in the Real Estate Sector like DLF and Godrej are also expected to introduce REITs.

In India, a REIT has a 3 tiered structure comprising a Sponsor, a Manager, and a Trustee each of whom performs key functions for the Trust. Their key roles and responsibilities, as specified by SEBI, are as follows:

• Sponsor –This is usually a Real Estate company that owned the assets prior to the creation of the REIT. For example, BSREP India Office Holdings V Pte. Ltd., an Indian subsidiary of US-based Brookfield Assets Management Inc., acts as the sponsor for the Brookfield REIT. The Sponsor is responsible for setting up the REIT and appointing the Trustee. The REIT Sponsor along with the sponsor group is also mandatorily required to hold 25% of units for the first 3 years after the formation of a REIT. After the completion of 3 years, the sponsor stake can be decreased to 15% of total outstanding REIT units.
• Manager –A REIT Manager is typically a company that specializes in Facilities Management. For example, in the Brookfield REIT case, Brookprop Management Services Pvt. Ltd. has been designated as the manager. Responsible for managing the assets of the REIT, making investment decisions, and ensuring timely reporting as well as disclosure by the REIT.
• Trustee –Those chosen to be a REIT Trustee are typically companies that specialize in providing Trusteeship services. For example, Axis Trustee Services Limited operates as the trustee for both Embassy Parks REIT and Brookfield REIT. The Trustee is responsible for holding the assets of the REIT in a Trusteeship for the benefit of unitholders. Additionally, they are required to oversee the activity of the manager and ensure the timely distribution of dividends.

Additional key SEBI-mandated criteria that REITs in India need to fulfill in order to qualify are as follows:

• At least 80% of investments made by a REIT need to be in commercial properties that can be rented out to generate income. The remaining assets of the trust (up to the 20% limit) can be held in the form of stocks, bonds, cash, or under-construction commercial property.
• At least 90% of the rental income earned by the REIT has to be distributed to its unitholders as dividends or interest.
• Stock market listing of REIT is mandatory

In the next section, we will discuss how Real Estate companies benefit from the creation of REITs.

Why are REITs Created?

It is clear that REITs allow investors to invest in and profit from Commercial Real Estate, which is not otherwise easily accessible to small retail investors. But, here are also a few benefits to Real Estate companies that form a REIT. In India too, REITs get a few key tax exemptions that are not available to other types of Real Estate companies:

• Interest payments and dividends received by a REIT from a Special Purpose Vehicle or SPV are exempt from tax. In this context, SPV is a domestic company in which at least a 50% stake is held by the REIT. A REIT can theoretically hold a 50% or higher stake in multiple SPVs that own individual Real Estate properties on behalf of the REIT.

• Any income obtained from renting or leasing Real Estate Assets that are owned by the REIT directly (i.e. not through an SPV) is also exempt from tax

These tax benefits can allow Real Estate companies to reduce tax liability and generate higher income. Additionally, by listing a REIT on the stock market, a Real Estate company can also get access to additional funds for future projects through the IPO. The goal of any investment is to generate returns for the investor so let us take a closer look at how REITs do this.

How Do REITs Generate Returns for Investors?

The goal of any investment is to generate wealth for investors and/or provide regular income. REITs provide both these benefits to unitholders. Investors can receive periodic dividends and/or interest payouts that provide regular income and at the same time, the sale of REIT units on stock markets can provide Capital Gains to the investor.

1. Dividend and Interest Payouts: Dividends and Interest are paid out by REITs from their Net Rental Income. This refers to income that a REIT receives by renting out and leasing Commercial Real Estate after the deduction of some key expenses related to the management and maintenance of the facilities. Some of the charges that are deducted from Gross Rental Income to arrive at the Net Income of a REIT include management fees, depreciation, maintenance charges, etc. The current SEBI mandate states that at least 90% of net rental income received by REITs must be paid out as dividends and interest to investors.
2. Capital Gains:REITs are listed and traded on stock exchanges, so the price of individual units changes depending upon their performance as well as market demand. Just like Equity Stocks and Mutual Funds, good performance by a REIT leads to an increase in the price of REIT units, that can be sold at a profit and provide Capital Gains to the investor. Next, let’s take a closer look at the key benefits and limitations of investing in the units of a Real Estate Investment Trust.

Benefits and Limitations of Investing in REITs

The following are some key benefits of investing in REITs:

1. Diversification:REITs allow you to diversify your investment portfolio through exposure to Real Estate without the hassles related to owning and managing commercial property. This diversification allows you to go beyond the usual asset classes of Equity, Debt, and Gold as part of your overallAsset AllocationStrategy.
2. Small Initial Investment:As mentioned earlier, one of the key problems associated with making Real Estate investments is the large ticket size, especially in the case of commercial properties. REITs require a much smaller initial investment of around Rs. 50,000 to provide similar portfolio diversification benefits.
3. Professional Management:Properties owned by a REIT are managed professionally. This ensures smooth operations with no effort on your part toward managing Commercial Real Estate.
4. Regular Income Generation:REITs generate income from rental collections and are required to mandatorily distribute 90% of this income to investors as dividends and interest payments. In this way, REITs provide regular income to investors.
5. Capital Gains:REITs are listed and traded on Stock Markets and their price depends on their performance. A REIT that performs well can thus potentially increase in value over time and be sold at a profit. This provides Capital Gains to the investor.

There are also a few limitations of REITs that you should be aware of:

1. Limited Options:Currently there are only 3 REITs and 1 International REIT Fund of Fund in India. This significantly limits the choices for investors.
2. Low Liquidity:While REITs are listed and traded on Stock Markets, the number of market participants is currently low especially with respect to retail investors. As a result, selling REIT investments profitably might be a challenge, especially in an emergency. This results in low liquidity of the investment.
3. Taxable Dividend:Any dividend or interest earned from REITs is completely taxable in the hands of the investor according to the applicable slab rate. Thus those in the 30% tax slab will lose a substantial portion of their dividend income as taxes. Another important aspect to consider before investing in REITs is the taxation rules and that is discussed next.

Taxation Rules for REITs

As investors obtain different types of income from REITs, two different taxation rules are applicable – one for dividend income and one for Capital Gains. Moreover, the tax treatment is also different in the case of redemption of investments made through an International REITs Fund of Fund. The applicable taxation rules are as follows:

1. Taxation of Dividends:As per current rules, dividends obtained from REITs are completely taxable in the hands of the investor. Dividend payouts from REITs are included in the annual income of the investor and taxed according to the investor’s slab rate for the applicable Financial Year.
2. Taxation of Capital Gains:Capital Gains from the sale of REITs units are covered by Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) applicable to equity investments. STCG is applicable if the holding period of units is 1 year or less from the date of unit allocation. The STCG tax rate is 15% of capital gains obtained from the sale of units. If the holding period exceeds 1 year from the date of unit allocation, LTCG taxation rules are applicable. The LTCG tax rate is 10% of gains in excess of Rs. 1 lakh (across all equity investments for the applicable FY) with no indexation benefit.
3. Taxation of Capital Gains for International REIT Fund of Funds:If Capital Gains are obtained from the sale of units of International REITs Fund of Funds, non-equity Capital Gains taxation rules are applicable. In this case, Short Term Capital Gains are applicable if the holding period is 3 years or shorter (calculated from the date of unit allocation). STCG in this case is as per the applicable slab rate of the investor for the FY. LTCG tax is applicable on units held for over 3 years calculated from the date of unit allocation and is 20% of indexed Capital Gains. Next, let us see how you can invest in REITs.

How to Invest in REITs

REITs are listed and traded on stock markets just like Exchange Traded Funds (ETFs), as a result, purchasing units on the stock market is the best way to invest. Thus, a Demat Account is mandatory for investing in REITs in India. Just like Exchange Traded Funds, the price of REITs units on stock markets changes depending on both the demand for units as well as the performance of the REIT. At present, you have 3 options – Embassy Office Parks REIT, Mindspace Business Park REIT, and Brookfield India Real Estate Trust.

Apart from stock market purchases, you can also invest in REITs through mutual funds. Currently, Kotak International REIT Fund of Fund is the onlyInternational Mutual Fundin India that invests exclusively in International REITs. A few domestic Mutual Funds have also started investing in REITs in the past few years, however, the actual exposure of these schemes to this Real Estate Investment is quite limited. Thus, the only way to gain meaningful exposure to Real Estate is currently through the purchase of REITs Units on the stock market. Now that you have an idea regarding the key features, benefits, and limitations and how you can invest in REITs, let’s answer the key question – “Should you invest in REITs”?

Should You Invest in REITs?

The primary reason to invest in REITs is to diversify your investment portfolio through exposure to commercial Real Estate without the hassles related to purchasing and maintaining one or more immovable properties. Additional benefits of investing in REITs include professional management of assets and relatively small ticket size for making the investment.

While these are undoubtedly significant positives, key limitations such as very few investment options and limited liquidity of REITs can impact your ability to monetize the investment even in an emergency. As a result, it is recommended that REITs should only form a minor part of your portfolio (ideally no more than 10%). Your decision to invest in REITs should ideally depend on whether or not you have already optimized asset allocation across Equity, Debt, and Gold and are now looking to invest in Real Estate.