The Mutual Fund Show: Investing In Real Estate Through REITs

REITs are like a window to the world of actual real estate, said Hemant Rustagi of Wiseinvest.

<div class="paragraphs"><p>(Source: toweringgoals/Freepik)</p></div>
(Source: toweringgoals/Freepik)

SEBI defines multi-asset funds as an amalgamation of investment in three asset classes, with each having a minimum weightage of 10%.

Real estate is one of the most commonly invested assets among other options in such funds, said Hemant Rustagi, chief executive officer at Wiseinvest.

However, a 10% weightage on real estate, which is generally the case, is just done for the mere purpose of diversification, according to Mohit Gang, the founder of Moneyfront.

Therefore, it is suggested to purely invest in Real Estate Investment Trusts if one is interested in the sector, rather than investing in it through the mutual fund route which is not a full-fledged way of taking exposure into this product, Gang said.

REITs are like a window to the world of actual real estate where it allows exposure with a meagre start of Rs 10 to Rs 15,000 unlike comparatively expensive property rates. Investors should be aware that REITs can only invest in commercial properties as of now and not residential properties, Rustagi said.

The first REIT that came into being was the Embassy REIT in 2019 backed by the Blackstone Group, followed by K Raheja's Mindspace, then Brookfield Asset Management Co.'s REIT and the most recent one being the Nexus Select REIT, Gang said. These are the only four REITs listed on the exchange, he said, highlighting the small size of the space.

According to Rustagi, the return on investment in REITs usually come in two or three different forms which can be rental income, dividends, or capital gains.

Some of the pros of REITs are that it is listed, liquidity is good, the price discovery is there on the exchange and the rental yields are fairly robust where one can anticipate a regular income, Gang said.

Rustagi recommended to solely allocate only a part of the debt portfolio to REITs. "It can't replace the equity portfolio," he said.

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Edited excerpts from the interview:

Hemant, a lot of mutual funds are taking exposure to real estate through REIT. Could you take us through which mutual fund schemes do this and what according to you is the best way to take exposure?

Hemant Rustagi: When we are talking about mutual funds having exposure in REITs, you will find that the multi-asset funds will be taking exposure in REITs. As per the SEBI definition of multi-asset funds, they have to invest at least in three asset classes.

So, maybe you will see a combination of equity, debt, gold, and even real estate. And I think, again, as for the SEBI mandate, the minimum investment for each of the asset classes has to be 10%. So, usually you will find exposure to REITs in the multi-asset funds.

Mohit, what do you think?

Mohit Gang: As matter of regulation, mutual funds are allowed to invest only 10% of the overall product’s NAV into a REIT, or they can have at best 5% exposure in a single issue, which to my mind is not a very substantial investment. 10% yes, it's good for the sake of diversification and as Hemant said rightly that multi-asset funds have been incorporating a lot of REITs and invITs in their portfolio and that's just to give a flavour of this investment.

But as of now, there is one index which has come up. NSE has come out with a REITs and invITs index very recently, but there is no pure play mutual fund product, which has a complete underlying of REIT barring one, which I recall, which is a Kotak Global REIT fund of funds. That was long back, an ING product and Kotak kind of inherited the product and it's still in vogue, but it's more an international REIT product on Asian markets. But there is no proper mutual fund which gives you an exposure into Indian REIT or Indian real estate market per se.

Then to answer your question very specifically, to my mind, if someone has to really take up take a full-sized bite into real estate segment or property market in India or commercial market then one has to go pure play REIT and not to the mutual fund route. Mutual fund route can be good for startups, but it's not a full-fledged way of taking exposure into this product. 

Hemant, what are REITs? What is the primary purpose and how do they work?

Hemant Rustagi: Looking at exposure to real estate through REITs, you know, an important aspect for any investor when they are designing or working on the portfolio asset allocation, diversification obviously is very important and real estate obviously plays an important role for more than one reason.

But the problem is that when you want to invest in real estate, buy a property yourself, you need a large sum of money. There are very difficult steps that you need to take in terms of looking for a property and then going for registration, additional costs, the risk of investing in under construction properties, illiquidity. So, there are a number of issues that's why most investors overlook including real estate in the portfolio. That's why I think REITs have an important role to play.

So, REITs basically are an entity that allow investors to take exposure to real estate with as little as Rs 10 to Rs 15,000 and in a very simple manner. So, I would say structurally they are more like mutual funds. As we see in the case of mutual fund when mutual fund asset management companies will float funds, and there is a professional fund manager who is managing your money, and the underlying in the mutual funds can be equity, debt, gold, or even REITs that we mentioned.

Similarly, even in the REITs there is a designated fund manager who takes decisions on your behalf. The underlying of course, are the various real estate projects, but it is important to understand that when we talk about REITs they are allowed to invest only in commercial properties as of now they can't invest in residential properties.

So, there are three tiers of structure, there is a sponsor, there is a trustee, and there is a manager and I think a couple of important regulations. It is important to understand what REITs can do and what they can't do. SEBI has mandated that 80% of the investment has to be made in commercial properties that can be rented out, which means they have to be ready for possession and then 20% can be invested in under construction, or even can be held as stocks or bonds.

The second is that REITs have to distribute 90% of their net rental income to the investor and third is that REITs have to be compulsorily listed on the exchanges, which means that they have much better liquidity than buying property yourself. So, like I said, it's an entity that allows investors to invest as small as Rs 10 to Rs 15,000 and take exposure to real estate.

Mohit, what are the options available right now and how does the landscape look?

Mohit Gang: The discussions around REITs started happening in the Indian ecosystem as way back as 2008 but it took almost a decade for the first REIT to come in play and it was only in 2019 the first REIT came into being which was the Embassy REIT. The promoters or the sponsors as we call them, the Blackstone Group and that is, in fact, the largest REIT in terms of the area under development.

So, I think most of almost 40 million square feet kind of an area, a little more than that, which is under development. They are specifically into commercial spaces, that's the first and the oldest. The second one to enter this market was Raheja’s REIT which was Mindspace. Mindspace is owned by K. Raheja, the sponsors are the K. Raheja Group entities, basically and again, mostly to commercial spaces and more into I.T. parks. The third one which came which is from Brookfield Asset Management Company, and again, the core domain out there is commercial spaces.

And the recent one Nexus Select REIT which came last month into consumption centres. So, the portfolio is completely different from the previous three REITs. They own retail malls; they own some hotels, and they own hospitals also. So, which is a very different kind of portfolio which they bring on table.

So, these are the only four options available. All put together is not more than around $12 billion of market cap. So, the Indian REIT market is fairly small, and these are the only four players right now, which are available on the exchange. 

Hemant, could you explain how the gains from this would work and how they would be taxed?

Hemant Rustagi: As I mentioned, 90% of the net rental income has to be distributed. So obviously, the distribution is very important when you are investing in REITs, but REITs usually will give you return in two or three different forms.

So, they can be rental income, which we talked about interest, it could be dividends, or also the capital gains. So, the rental income or the interest that you get is basically taxed in the hands of investors at your marginal tax rate. Second is the dividend taxation, obviously, will depend upon whether it has opted for the lower tax regime under Section 115 BA. If that is the case, then the dividend is taxable in the hands of investor. If they have not, then the dividend is tax free.

The capital gains tax, long-term capital gains after three years which is taxed at 10% and any short-term gain within three years is taxed at 15%. But there is a significant change that was announced in Finance Act 2023. What happened was there is a law that comes back to you as an investor. In the Budget 2023, the finance minister announced that it will be taxed at your marginal tax rate. Obviously, the industry wasn't happy about it. They made a representation and when the Finance Act was passed, it was amended.

So, what it says is that the loan repayment which is paid to the investor will be reduced from your cost of acquisition. Let me just explain that I think that is a very significant thing from the taxation point of view. So for example, if your cost of acquisition is Rs 400 and if you sell let's say, after three years at Rs 500 and during this period, if there is a loan repayment of let's say Rs 50, Rs 50 rupees will be reduced from Rs 400 which means your cost of acquisition will become Rs 350 and Rs 150 is the difference between what you are selling at and the cost of operation with your capital gain, which is taxed at concessional rate.

This is very significant, which means that as long as the money that has been reimbursed to you as no repayment is less than the cost of acquisition. You know, you get the benefit of that it's not taxed to you. So, I think that's a significant thing. So, these are the ways you get your income or return from REITs, and this is how they are taxed.

Mohit, is that dividend taxable in the hands of the investor?

Mohit Gang: As Hemant rightly said, look, it's slightly more complex than what it comes out on the face of it. To be very honest, I think as an entity, it's a pass-through taxation which the REITs enjoy, but dividend, prima facie at a very broad level, if you kind of see the receipts which have been coming from these REITs, mostly it is tax free to my mind.

But as there is one particular clause which Hemant rightly put out which is a very specific thing, but I think it's more nuanced at a very broad level, I think dividends are tax free, I think for the normal investor I think that's what one has to take.

What according to you Mohit, are the pros and cons?

Mohit Gang: I think it’s a very nice, professionally managed setup for investors who really want to take flavour of commercial real estate and I distinguish here between commercial and residential, all of us individually, would have perhaps tried investing into residential real estate or wouldn't own our own houses.

So, we have some flavour or some touch and feel of it, but commercial is not everyone's game. So, you need a professional manager if you really want a good rental income. If someone wants to plan for retirement, someone wants to get a good, fixed income basically at a very regular interval and without any interruptions then I think REIT is a very nice instrument worldwide, it is highly acclaimed.

In fact, the U.S. market has over a trillion dollars of listed REITs. So, it's a good setup to take smaller bite-sized positions into commercial real estate or as the market grows, you will find more consumption centres, you will find more retail malls and everything coming into the ambit of this. So, if today I want to buy a part of a hotel or a hospitality chain or a hospital, it's all possible through buying units of a REIT.

It is listed, liquidity is good, the price discovery is there on the exchange, the rental yields are fairly robust right now currently in the range of around it varies, so I will put a slightly broader range from a 5.5 to 7.5 is the broad range where you can anticipate your regular income to flow from and these are all the pros.

In terms of cons, the net asset value, which actually determines the underlying property is the real work, is declared twice a year, even on the exchange when you go and sell, the liquidity can become sometimes kind of an issue. The underlying property portfolio, we are not experts in commercial properties, we will never know what the legal encumbrances are, what the real status of those properties are plus, you have to track a lot of different matrices, when you track a REIT.

You have to track what is the ongoing rental yield of the projects and what is the average value or expectancy of the leases to finish. So, basically roughly from five years to seven years is the average lease tenor of all the four REITs which I kind of mentioned before. So, you have to track this average lease expiry years as to which REIT is following what kind of model, how long is the expiry there, what are the renewables out there, what are the new lease contracts which they are signing, and what is the area under development.

So, it's really complex. If one really wants to understand the nuances of it, easy to do, but complex if you really want to get into it and understand the fine print.

Hemant, the strategy one should employ.

Hemant Rustagi: As strategy is concerned, it all begins with whether there is a space in your portfolio for real estate. I mean, in what form you want to do, it comes later. If you believe that you want to build a multi-asset portfolio that we talked about earlier, then obviously, this is the best route for you, and we did talk about whether the route should be through the multi-asset fund or directly to the REITs.

One point I would like to add is, when you are doing it through the REITs, through the multi-asset fund, I think the exposure to real estate becomes incident because only 10% and if let's say, portfolio is of Rs 50 lakh, and you have invested like Rs 2 lakh or Rs 3 lakh in a multi-asset fund. I mean, there's hardly any exposure that you are getting.

The multi-asset fund does not replace the need for asset allocation so you can only invest in a multi-asset fund.

Hemant Rustagi: Oh, absolutely. I think unless and until you only have multi-asset funds in your portfolio, then you can talk about asset allocation, but otherwise, you are just adding one more fund, it doesn't really help you in any way in your asset allocation.

So, my point is that if you want to have exposure, then obviously it has to be directly investing into the REITs. Secondly, I believe that only a part of your debt portfolio should come out of it. It could be maybe you want to generate some regular income, which also you will not be able to get through a multi-asset fund.

So, when you are investing in REITs, you can get a regular income. So, my belief always is that you are looking at REITs, first find out whether there is a space. Second, only the part of debt portfolio should go into that, it can't replace your equity portfolio. I think usually if you are investing in REITs, time horizon should be at least three to five years, not less than that.

Mohit, residential real estate versus commercial real estate through REITs, would you have a view on that?

Mohit Gang: There's one peculiar thing which people would have observed who track REITs, for last two years REITs haven't done well at all. There has been a lot of price correction and that's particularly in the rising interest rate scenario.

Typically, the REITs take a kind of beating because people find a lot of fixed income avenues which can replace that kind of rental yield which REITs give. Today the rental yield which these REITs are offering or the yield in the hands of the investor is replaceable with debt instruments.

It's only in a low interest rate scenario that people would find these attractive, so I kind of endorse what Hemant said that it has to be long-term product. It has to be specifically debt replacement or a fixed income replacement. It can never replace equity and can never create wealth for you.

To answer your question, specifically on the residential versus commercial thing, look, as I told you at the start of my thing, that residential is something which we all can opine on. Even though I might not know a few things about property, I will still have one opinion on a property here and there, but commercial is something which is out of context, and which is out syllabus for most of us.

If you really want to take a chunk of it then REIT is the right way, it's a great allocation in any fixed income portfolio for a fairly long term. You want stability, certainty, I think Indian commercial market is yet to see the big boom. The I.T. sector is just about exploding, and you have lot of SEZs coming in, lots of business parks coming in, huge hospitality chains and everything.

I think a lot of global players will enter this market considering what has happened in the U.S. I think there is a huge market available for REITs in India, and people should consider REITs and invITs, obviously, as part of their asset allocation portfolio.