Looking for regular income? Invest in REITs, but watch out for these risks

However, they should be aware of risks such as the building staying vacant or getting re-leased at lower rates

Embassy Office Parks, the joint venture between Bengaluru-based Embassy group and US-based private equity fund Blackstone, plans to file the offer document for its real estate investment trust (REIT) soon. With REITs set to become a reality in India in the near future, investors need to understand the pros and cons of this new asset class.  

REITs offer several advantages to retail investors. First, the underlying asset in REIT is a commercial real estate. If the retail investor were to invest in commercial real estate directly, the ticket size required would be very large. "With REITs, investors will be able to invest in quality commercial real estate with even small amounts," says Rajeev Bairathi, executive director and head–capital markets, Knight Frank India.  

Second, REITs will allow investors to diversify their portfolios. They will be able to go beyond stocks, mutual funds, bonds, fixed income instruments and residential real estate. While the underlying asset here will be commercial real estate, investors will get the liquidity of a financial instrument. A REIT, which will trade on an exchange, will be more liquid than a direct investment in a commercial building.

Three, REIT is expected to be a transparent product. Since it will be listed on a stock exchange, it will have to comply with a large number of regulations of the Securities and Exchange Board of India (Sebi). It will also have to make several disclosures regarding the quality of the building, the liabilities (on and off balance sheet), quality of tenant, length of leases, forecast on revenues and costs, among others. All this information is not easily available to an investor investing directly in commercial real estate.

Initially, institutional investors may deploy their money in REITs, but as the product matures more retail investors can be expected to come in. "This will be a suitable product for investors looking for a regular income. It will not be suitable for those looking for capital gains over the short term. Capital gains will happen, but only over the longer run," says Bairathi.

Globally, REITs give an average return that is 125-175 basis points higher than the benchmark government bond. In India, Bairathi expects gross yields to be in the range of 14-15 per cent. To arrive at the net yield, one will have to deduct the expense ratio from this figure, which is not known at present.

REITs will also be subject to a variety of risks. One is that the building, or parts of it, may remain vacant. The other is pricing risk, which means that the building could get re-leased at a lower rate. In an economic downturn, companies optimise costs by relocating to inferior areas, reducing the area occupied, or by re-negotiating their rentals. The coming up of newer buildings with better specifications can also have an impact on the demand for older buildings. All these factors will have a bearing on the returns earned by REITs.

Finally, let us look at how earnings from REITs will be taxed. Capital gains will be taxed at the same rates as listed securities. If you hold them for the long term, the tax rate will be 10 per cent and 15 per cent for the short term. The Rs 100,000 exemption on long-term capital gains will also apply to REITs. The only difference is in the holding period.   

For listed shares, the holding period for capital gains to become long-term is 12 months, while in the case of REITs it is 36 months.

As for interest and dividend payments, the rates will depend on the kind of payment the special-purpose vehicle (SPV) makes to the REIT. If the REIT receives interest payment from the SPV and distributes it, it will be taxed as interest income, while dividend received from SPV will be taxed as dividend. Dividend will be tax free in the hands of the investor. Interest income will be taxed at five per cent for non-resident Indians and resident Indians will be taxed at the maximum marginal tax rate.