REITs: Meaning, Types, Benefits and How To Invest

Real Estate Investment Trusts (REITs) have recently developed to become an attractive investment avenue for retail and institutional investors looking to invest or increase exposure in the real estate sector. By pooling capital from multiple investors, REITs invest in income-generating real estate assets and provide regular dividends and potential capital appreciation to investors. This comprehensive chapter will explore all key aspects of REITs, including - what they are, different types, working, benefits, limitations, performance, taxation and more.

What are REITs? 

A Real Estate Investment Trust is an alternate investment instrument that owns, operates or finances income-generating real estate. REITs allow both large and small investors to participate in sizeable real estate investments that would otherwise be inaccessible.

REITs own commercial real estate properties like offices, residential apartments, hotels, hospitals, shopping malls, warehouses, etc. The rental income from these properties is shared among REIT investors as dividends.

So, in essence, REITs provide an opportunity to invest in real estate without directly buying, managing or financing properties. The real estate assets are owned and managed by professional REIT management teams.

REITs Globally

The first REIT was established in the USA in 1960. Since then, REITs have become popular in countries like the USA, UK, Japan, Singapore, Malaysia, France, and Germany. As per estimates, the global REITs market had a valuation of approximately US$1.7 trillion in 2020. The USA has the biggest REITs market, around US$1 trillion.

In India, REITs in India were introduced by SEBI in 2008, but the first REIT was listed only in 2019. Embassy Office Parks REIT became India's first listed REIT in April 2019 after raising ₹4,750 crore through its Initial Public Offering (IPO). This was followed by the Mindspace Business Parks REIT listing in August 2020, which mopped up ₹4,500 crore.

As of 2022, only 3 REITs are listed in India - Embassy Office Parks REIT, Mindspace Business Parks REIT and Brookfield India Real Estate Trust. However, the Indian REITs market is expected to grow with more players tapping the opportunity. Market estimates suggest India has REITable assets worth $50-60 billion across commercial and rent-yielding real estate assets.

How REITs Work?

REITs work on a simple business model. They raise funds from investors and invest that capital into income-generating real estate properties. The rental income earned from the properties is distributed to investors as dividends.

Here is a brief overview of how REITs work:

• A sponsor or a group of sponsors form a trust and transfer ownership of their real estate assets to this trust. A sponsor is typically a real estate company or developer.
• The trust raises capital by issuing units to investors through an IPO. Investors can buy these units to gain ownership of the REIT's assets. 
• The trust utilises this pooled capital to purchase and manage commercial properties like offices, malls, hotels, etc. This helps diversify the REIT's portfolio across asset classes and geographies.
• The real estate assets generate rental income from tenants. This rental income earned by the REIT is distributed back to unit holders as dividends.
• REIT units are listed and traded on stock exchanges. This provides liquidity to investors as the units can be easily bought and sold. The trading price of the units is influenced by the REIT's net asset value (NAV) and performance.

So, in short, REITs earn through rental income from properties and pay out most of this as dividends to unit holders. Capital appreciation of the underlying assets provides potential upside. The units also provide liquidity through listing on exchanges.

Types of REITs

REITs can be classified into different types based on the real estate assets they invest in. The most common types of REITs globally are:

Equity REITs

They own and operate income-producing real estate properties. The properties are usually leased out to earn rental income. Equity REITs form the largest category, accounting for around 90% of global REITs.

Mortgage REITs

Instead of directly owning properties, these provide financing to real estate owners and operators directly or through the purchase of mortgage-backed securities. Their income comprises the interest payments on financing provided.

Hybrid REITs

As the name suggests, these invest both directly in properties and by providing financing. Hybrid REITs allow investors to gain exposure across equity and debt real estate assets.

Retail REITs 

These REITs invest primarily in retail properties like shopping malls, retail stores, restaurants, etc. Their income comes from rent paid by retailers who lease space in these properties.

Residential REITs

These own and manage residential rental properties like apartments, housing societies, etc. The rental income comes from individual tenants who live in these residential spaces.

In India, the REITs market is still in its infancy. The listed REITs so far mainly fall under the equity REIT category as they own Grade-A office buildings across metros. However, the market is expected to evolve with new REITs specialising in other segments.

Benefits of Investing in REITs

REITs offer several unique benefits that make them an attractive investment opportunity for investors:

1. Accessible Investment Option: REITs allow even small investors with capital as low as ₹50,000-1,00,000 to gain exposure to income-generating commercial real estate. The unaffordability of physical real estate is a key hindrance that REITs help overcome.
2. Liquidity: REIT units are listed on stock exchanges and can be easily bought and sold at any time. This makes them more liquid than directly owning a property.
3. Diversification: Investing in REIT units can diversify the portfolio geographically and asset class.
4. Professional Management: experienced real estate companies professionally manage REIT properties. This ensures smooth functioning and maintenance.
5. Regular Income: REITs provide steady dividend payouts from rental property rental income. Dividend yields from Indian REITs currently range from 6-8%. 
6. Transparency: REITs are regulated investment vehicles with high compliance and transparency requirements, like regular financial reporting.
7. Potential Upside: Capital appreciation in the value of the underlying real estate assets provides a possible upside to the unit price.

Limitations of REITs

While REITs have multiple advantages, investors should also be aware of the following limitations:

1. Limited Options: There are very few listed REITs currently, thus limiting investor choice. The market, though, is expanding.
2. Interest Rate Risks: Any increase in interest rates can negatively impact REIT valuations as it increases their cost of capital.
3. Lack of Control: Investors have no direct control over REIT properties' selection, valuation or management. They depend on the management team.  
4. Tax Inefficiency: Dividends received from REIT units do not enjoy any tax relief. They are added to the investor's total taxable income.
5. Tenant Risks: Performance depends on the occupancy levels and the rent payment track record of tenants across its properties. Any major tenant vacating can impact income.

Despite some limitations, REITs offer a unique opportunity for investors to gain exposure to commercial real estate in an accessible and liquid form.

Taxation of REITs

Like any investment, taxation plays an important role in REITs. Here is how REIT investments are taxed in India:

• Dividends received from REIT units are fully taxable as per the investor's applicable Income Tax slab rates. No tax exemption is available on REIT dividends.
• Capital gains taxation on the sale of units depends on the holding period. Short-term capital gains tax of 15% is applicable if units are sold within 12 months. Long-term capital gains tax of 10% without indexation is applicable if units are held for over 12 months.
• Unlike dividends from stocks taxed at 10% (plus surcharge and cess) in the hands of investors, REIT dividends do not enjoy this beneficial tax rate. They are fully taxable as per slab rates.
• While REITs enjoy certain direct tax relaxations, dividends and capital gains in the hands of unit holders are fully taxable. Hence, investors should factor in taxation before making any investment decision.

How to Invest in REITs?

• Purchase REIT Units on Stock Exchanges: REIT units are mandatorily listed on exchanges. Investors can buy units through their Demat account, just like stocks. This allows participating in REITS with an amount as low as the value of one unit.
• Apply to REIT IPOs: Investors can directly apply to REIT Initial Public Offers (IPO) when launched to get unit allotment. This allows investing at the IPO price before the units get listed. But IPOs require application amounts running into a few lakhs.
• Invest in REIT ETFs: Few Asset Management Companies have launched REIT Exchange Traded Funds (ETFs) that invest in REIT units. These ETFs provide diversified exposure to multiple REITs through a single fund purchase.
• Invest in REIT Fund of Funds: Another option is to invest in a Fund of Funds like Kotak International REIT FoF, which invests in international REITs across countries. This provides geographic diversification.

For retail investors, directly purchasing Indian REIT units through the exchanges or investing through REIT ETFs offers a convenient option to add these to their portfolio.

Things to Consider Before Investing in REITs

Here are some factors an investor must review before deciding to invest in REITs:

• Review Portfolio: Evaluate whether the REIT has commercial properties in multiple locations and asset classes. 
• Quality of Assets: Its location, building specification and maintenance are crucial. REITs that own grade-A buildings are priced at a premium.
• Tenant’s Profile: The tenant’s quality, lease expiry cycles and occupancy rates affect rental collections and valuations.
• Financial Health: Consider crucial financial indicators that include Debt/EBITDA, EBITDA margins, debt ratings and dividend payout ratios.
• Management Track-Record: The management team’s experience and record in running REITs adds credibility.
• Valuations: Compare valuation multiples such as the P/BV ratio with other REITs for relative expenses.

By evaluating such data, retail investors can comprehend how the REITs function before investing in them.

Conclusion

REITs have allowed Indian investors to invest in the commercial real estate market in a transparent and liquid form. Though an emerging investment opportunity, REITs provide rental income stability and a possible capital upside. Investors may allocate a small portion to REITs for diversification once they have looked at parameters such as the quality of assets, financial health, and valuations. There are only 3 REITs currently listed, and options are restricted, but more prominent developers expected to launch new REITs will broaden choices. However, with the development and expansion of the REITs market, investors will have more opportunities to access India's growing real estate sector.