Can REITs replace physical real estate in your investment portfolio?

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© Vandana Ramnani Can REITs replace physical real estate in your investment portfolio?

Real estate has always remained the most preferred and sought after asset class for Indians. Plots, houses, apartments or commercial spaces are favourite investment avenues. According to a 2017 report—Indian Household Finance— of the household finance committee of RBI, “The average Indian household holds 84 percent of its wealth in real estate and other physical goods, 11 percent in gold and the residual 5 percent in financial assets.”

Interestingly, over the last decade investor interest in real estate, especially the residential segment has declined significantly because of negligible capital appreciation. For instance, according to the housing price index—RESIDEX— of National Housing Bank (NHB), composite housing prices in 50 cities of India increased by only about 4 percent annually between June 2013 and September 2020. Adjusting for inflation, the returns are negative. Investing in residential property for low rental yields of 1.5 percent to 2.5 percent doesn’t seem attractive. Commercial properties fetch better rental yields, but one needs to have deep pockets to invest.

However, in the last two years, Indian investors have taken to Real Estate Investment Trusts (REITs). Here’s more about REITs, the alternatives to investing in physical real estate.

What are REITs?

A REIT is an investment trust that owns income generating real estate. As of now, in India, a REIT is allowed to invest only in commercial properties. Just as mutual funds do, REITs pool together money from investors and invest it in real estate. The best part of a REIT is that it allows the retail investor to invest in commercial real estate, especially Grade ‘A’ office space properties that would otherwise be inaccessible to them. There are three REITs listed on Indian exchanges so far— Embassy Office Parks REIT , Mindspace Business Parks REIT and Brookfield India Real Estate Trust. DLF and Godrej Properties are expected to come up with REITs soon.

While REITs are new in Indian market, globally they have been available to investors for a long time. For instance, in the US, Singapore and Japan, REITs are well-established investment options and also attract good participation from investors. According to a 2019 report—India’s REIT opportunity—from CRISIL, “REITs account for nearly 50 percent of the capitalization of the real estate industry in market such as Singapore and Japan, where they were introduced nearly two decades ago, while they account for 96 percent of the market capitalization in the US, which pioneered REITs in 1960s.”

Why REIT over physical real estate?

Investing in physical real estate requires a large fund, besides a tedious job of finding the right property. Maintenance, liquidity, taxes and transaction cost are also a deterrent. “To own one’s home is a desire for most. Beyond that, any investment in real estate has to be viewed from the point of returns (growth) and return (income or rental). Rental yields are not very high in the residential category and we know that appreciation/ growth needs patience. Disruptions such as demonetisation, RERA, pandemic can throw your plans awry; hence if liquidity is a must for your portfolio, avoid real estate,” says Lovaii Navlakhi, Managing Director & CEO, International Money Matters.

On the other hand, investing in REITs, “is a great way to diversify in the real estate space; it’s like buying a mutual fund instead of one stock,” added Navlakhi. REITs can also help you earn better returns compared to investment in physical real estate. “REIT allows one to participate in high quality rent yielding real estate which is generally not available to a retail investor. One needs to evaluate whether this makes sense over and above the real estate investments they already have, which is true with most people,” says Suresh Sadagopan, founder, Ladder7 Financial Advisories.

Capital application or regular income

Whether you should invest in REITs with the objective of capital appreciation or regular income is a question. “The choices in India are limited – we know that internationally REITs cater to both objectives,” says Navlakhi.

“It is more suitable for someone looking for regular income, more than capital appreciation but the income post expenses and taxes are going to be comparable to debt products. If that is OK, REIT should be good as a diversifier,” says Sadagopan.

However, experts believe that REIT is not suitable for senior citizens looking for stable regular income. “We would not suggest REITs to Senior citizens who want a steady income, low volatility & capital protections. As REITs would give similar returns like a debt product, it makes sense for a Senior Citizen to invest in debt products instead,” says Sadagopan

Tax on income from REITs

When you invest in REIT, during your holding period you earn in the form of dividends and you make capital gains/loss when you sell the units. Dividends are fully taxable in hand of investors, as per the applicable slab rate. Capital Gains from the sale of REITs units are considered as Short Term Capital Gains (STCG) if the holding period was less than one year and Long Term Capital Gains (LTCG) if held for more than 1 year. While, the STCG tax rate is 15 percent of capital gains obtained from the sale of units, whereas LTCG tax rate is 10 percent of gains in excess of Rs 1 lakh (across all equity investments for the applicable FY) with no indexation benefit.

Risk of investing in REITs

Navalakhi believes that REITs are new to India and it is very early to evaluate the risk involved. However, Sadagopan says that, “investment in REIT is concentrated investment, underlying properties can have periods of no occupancy, legal tangles, problems in rental yields/ non-occupancy or lower offtake for commercial properties emanating out of COVID situations etc.  No real benchmark to compare REIT against is another downer.”

Can REIT give better returns than other assets?

“Each of these investment options have different objectives. Debt instruments include those for liquidity and for income. Equity asset class is for long term growth. Once the REIT market matures, one can consider 10 percent of the net worth in REITs,” says Navlakhi.

Given that fixed income instruments are currently offering all time low interest rates and the equity market is trading at exceptionally high price-equity ratio, a REIT can give a retail investor diversification to an alternative asset class. “REIT cannot provide better yields post expenses and taxes as compared to any equity-oriented product. Their performance can be compared to a debt-oriented product only,” says Sadagopan.

Impact of the pandemic on REIT

As mentioned above, in India, REITs are allowed to invest only in commercial real estate, especially office spaces that can generate regular income. But, because of the pandemic, companies allowed their employees to work from home, there is a big question mark on demand for office space and, eventually, on REIT’s future. Experts believe that investors need to be cautious about investing in REITs. “As we know, the pandemic has impacted commercial real estate more severely and it could be a while before these get their head above water,” says Navlakhi.

However, most real estate stakeholders are of the view that once the situation get normalized, demand for better office space will pick up. So, this could be a good time to invest in REITs, as valuations are low. However, make sure you invest in a REIT only if it is in line with your asset allocation and risk profile.