A new investment option

Long before the cut-off (January 10) for comment on the Securities and Exchange Board of India's draft guidelines on the regulation of Real Estate Investment Trusts (REIT) rolls around, it is evident that the 64-page document is fairly comprehensive, and clearly indicative of Sebi's mindset. The outlines suggest that the regulator is exercising abundant caution while allowing the introduction of what has proved to be a popular investment vehicle in other markets. An REIT can be described as a specialised mutual fund that only invests in real estate. Like all AMCs, it constructs schemes with different parameters, raises money by selling units to retail investors, invests proceeds from new fund offerings in real estate, declares net asset values, pays dividends, etc. The advantages are manifold. REITs lower the entry barrier for investors who might wish to allocate moderate amounts to real estate. It simultaneously offers diversification inside the sector, giving a chance to spread risks across various real estate plays. Wherever they exist, REITs give the real estate industry transparent access to clean funding and offer private equity investors and developers the option to exit a completed or semi-completed project. Crucially in the Indian context, REITs might help lower the velocity of black money flowing in and out of real estate.

The danger lies in the fact that REITS are based on financial "slicing and dicing" of real estate projects. In theory, if an REIT has a small percentage of its corpus in each of many projects, it is less affected by one project's failure or delay. In practice, as parcelled holdings are passed around, financial structuring spirals and it can become difficult to judge the quality of a given portfolio. A lack of due diligence and unrestrained financial structuring can lead to crises like the US sub-prime situation. Sebi is clearly determined to ensure that this does not occur. REITs may be started only by banks, financial institutions or companies. They will be vetted for financial solvency with compulsory credit ratings and minimum net worth requirements (Rs 3 crore initially, rising to Rs 5 crore), there must be independent directors, etc.

Just as importantly, the parameters under which REITs can invest and disburse gains are delineated. All schemes will be listed and closed-ended, which makes them long-term investments. Not more than 15 per cent of the corpus can be allocated to a given project and not more than 25 per cent to projects from the same group, and preference must be given to income-generating projects. This invites a focus on commercial projects with rental income. Interestingly, 90 per cent of the annual net income must be disbursed to investors; this, by the way, could be tax-inefficient. Clearly, Sebi views the REIT as a vehicle for diversified investment in income-generating real estate plays, rather than as a platform for logging speculative gains on land price appreciation. This is a radically new approach for Indian real estate players and investors.

The devil, of course, will lie in the details. How much upside will there be in REITs for investors and how much risk? No one knows the contours as yet. The first launches will probably be a year down the line. Still, the draft prepares the ground for the creation of a new class of financial instruments. These could be a focus for wealth creation as well as be instrumental in helping to clean up a sector that is notorious for its opaque financial practices.