Real estate investment trusts: Pros and cons

The real estate industry received a much-needed boost recently when the Securities and Exchange Board of India (Sebi) finally cleared guidelines for the real estate investment trusts (Reits).

This gives the cash-strapped industry a new route to tap capital.

Real estate is notorious for the number and size of the bubbles it creates.

The global financial crisis of 2007 and its sequel, the crisis of 2012, were both sparked off by real estate bubbles. The price of the same land can vary a lot, depending on sentiment.

This makes the Reserve Bank of India (RBI) extremely cautious about lending to the real estate industry.

Banks have to keep a high risk-weight for loans against real estate and as a result, charge higher interest and value the loans conservatively.

There are further grounds for caution since repossession of mortgaged real estate in case of default is a lengthy process due to the slow legal system.

The usual method for a real estate developer is to acquire the land (this can in itself be challenging), get clearances to build, pre-sell the property and use advances to start construction.

Advances are never enough to complete construction. So the developer has to find bridge financing, usually at very high interest. (Not to mention the financial jugglery required to manage black and white streams because the overwhelming majority of land deals involve a large undeclared component.) Enter the Reit.

This is a sort of mutual fund or pool, which finds alternative means of financing real estate.

A Reit owns real estate directly and it might also own mortgages. The assets are sub-divided into equal units, which are sold to investors.

There are income streams from interest in the case of mortgages, and from rentals in owned property. Indian Reits will be allowed to own only commercial property and there are other restrictions. To be eligible for listing, the value of the assets owned or proposed to be owned by a Reit should be worth at least Rs 500 crore (Rs 5 billion).

Assets must be valued and net asset value updated at least twice in every financial year. Reits must distribute at least 90 per cent of their net distributable cash flows to their investors every six months.

Also, at least 80 per cent of assets must be in properties that are generating revenue. A Reit can invest only 10 per cent in properties under construction.

This means Reits can also invest a small portion (about 20 per cent or less) in mortgage-backed securities and cash-equivalent assets like money market funds.

The tax treatment is pass-through, meaning the Reit need not pay tax on the income it distributes. Since Reits can be listed, they afford liquidity to investors in the same fashion as mutual funds do.

The minimum initial investment on an IPO is Rs 2 lakh, which is nominal for a foothold in real estate. Hence, Reits reduce the lumpy nature of real estate exposure.

Liquidity, relatively low entry-level investments, stable income generation, potential capital appreciation - all these are obvious benefits from Reits. What are the downsides?

Well, if there's a bubble in real estate, a Reit will tend to accentuate it.

Also, by providing a new market for trading mortgage-backed securities, Reits can encourage the sort of speculation that caused the subprime crisis.

There's plenty of unsold, semi-developed commercial property across India. Once Reits get rolling, some of that should come on the market.

This will allow developers to complete stalled projects and exit.

The infrastructure variation on the Reit, where the investment trust holds infra project assets has similar but broader applicability.

There could be a reflexive sequence of investments into realty stocks.

However, in reality, Reits will take a while getting off the ground and, as the rules stand, they will benefit only specific developers with exposures in commercial property.