Reits work better than direct investment in realty

Transparency and higher liquidity give Reits the edge in the long run

For most people, owning a property is their biggest investment. One always thinks of investing in real estate as it fetches reasonable returns in the long run. However, directly investing in real estate sometimes is not feasible due to huge costs involved.

Real Estate Investment Trusts ('Reits') can be a reasonable choice for those who don't have the capital for direct investment.

The Sebi-authorised Reit is structured as a trust and aims to invest in commercial real estate, either directly or through Special Purpose Vehicles (SPVs). The SPV can either be a company or a limited liability partnership (LLP). Reits raise funds from investors through issue of units, listed on a stock exchange, and can raise debts directly both from resident and non-resident investors.

Reits investments may include residential, commercial, industrial, agriculture, real estate, etc. Reits can be classified as equity, mortgage, or hybrid. Reits investors receive income from rent obtained from underlying properties as well as capital gains when properties are sold. Reits ensure transparency as investors know what is being bought, including the property's current value. They also have a realistic income expectation from their investment.

Please consider the following before investing in Reits.

Differentiating factors

• While real estate investment involves owning a property directly, investment in Reits gives an opportunity to indirectly invest in real estate by way of purchase of listed units.
   
• Large capital is required for real estate investment whereas Reits do not require such big capital.
   
• Long-term gain on sale of assets gets taxed in the hands of the Reits whereas the same gets taxed in the hands of real estate owner when direct investment is made in real estate property.
   
• Regular rent received by owner of real estate property is taxable whereas regular dividend received by Reits unitholder is tax exempt.
   
• Real estate owners have to physically maintain their properties or must pay someone else to do it. They often have to deal with tenants and collect rents unlike Reits investors. Further, real estate is rather illiquid and takes time to sell, whereas Reits investors can sell their units at any time.

Pros and Cons
Reits are a good option because of:

• Low entry cost: It doesn't take much money to get started in Reits investment.
   
• Highly liquid: Investors can sell Reits units any time unlike direct real estate which can be difficult to sell. Dividends distributed by Reits can be a stream of stable income.
   
• No maintenance: Apart from occasionally checking on the investment, no substantial maintenance or effort is required to hold a Reits as against a property that requires continuous maintenance.
   
• Diversification: With Reits one can easily invest in skyscrapers, nursing homes, industrial properties, shopping malls, etc.

However, one has to also keep in mind the following:

• High fees: A private Reit can charge huge fees upfront before your investment even touches the real estate. This could include sales commissions, dealer manager fee, organization and offering expenses, acquisition fees and acquisition expenses. Additionally, a Reit may not distribute all of the income generated by its properties back to investors, significantly lowering overall returns.
   
• Lower average returns: Average Reits dividend may be significantly lower than average returns from direct commercial realty ownership.
   
• Volatility: Reits shares are traded on the stock exchange and are subject to the high volatility and market shifts of the stock market as a whole.
   
• Lack of control: Although there is a diversity of assets, there is also a lack of control over which assets are being purchased.
   
• Less transparency: Although Reits may have strict reporting guidelines, most investors know little about properties in a Reits portfolio.

Tax implications
Dividends distributed by Reits or long-term capital gains on sale of the units of Reits are exempt from tax. Gains on sale of property are taxable for real estate owners. Corporate unitholders of Reits have to pay minimum alternate tax on the book profits. Since income from Reits is exempt, this could have an adverse effect for corporates in the form of a higher disallowance of expenses under section 14A of the IT Act.

Analysis of tax implications

• Rental income from real estate property is taxed as income from house property, after claiming deduction for municipal taxes paid and standard deduction of 30% of net rent (after deduction of municipal taxes). Rent income is taxable at the slab rate to the investor.

For Reits, rental income is taxed in the hands of entity owning the property, either the SPV or the Reits itself. Such rental income is taxed at a flat rate of 33.99%, irrespective of the slab rates or income level.

• The interest income earned by the Reits from SPV is not taxable. However Reits is required to withhold taxes on interest income of unitholders (5% for non residents and 10% for resident unitholders). The dividend received by the Reits shall be subject to dividend distribution tax at the level of SPV but is exempt in the hands of the trust. Further, the dividend component of the income distributed by the Reits to unit holders is also exempt from tax.

To sum up, Reits work well in the long run and shouldn't be used as a substitute for direct investment.

The writer is managing partner, Nangia & Co, assisted by Neha Malhotra of Nangia & Co.