The new Bharatiya Janata Party government’s July budget announcement, and August’s final Real Estate Investment Trust (“REIT”) regulations from the Securities and Exchange Board of India (“SEBI”) constitute a major step towards promoting a systematic, transparent and liquid real property market in India. The real property sector accounts for about 5 percent of GDP, is among the largest sectors by employment, and continues to grow at a rapid double-digit rate despite overall slowdown in the last few years. However, it is still regarded as unorganized, opaque and associated with the most unsavory of groups.
Now, Indian real estate is being presented with a mechanism to transform itself. The promise represented by REITs is that small and large investors may finally be able to invest in real property without having to suffer through the due diligence, property management, opacity or illiquidity associated with it, while being able to diversify and receive regular income. Similarly, developers can look forward to a new stream of funds that doesn’t add to debt, with tax benefits to boot.
A staple in major industrialized nations, REITs have long been desired in India. This summer, the government laid the groundwork with tax incentives for REITs, and SEBI permitted them to be listed on exchanges. Below are key features and some areas for consideration.
Pursuant to the regulations, REITs will be set up under the Indian Trusts Act, 1882, and registered with SEBI. They will be permitted to invest only in commercial real estate, and will be required to have assets of at least $83[1] million (as well as minimum initial offerings of at least $41.5 million). Of a REIT’s total assets, 80 percent will need to be revenue generating and 90 percent of its distributable cash flow distributed every six months. Consolidated borrowings and deferred payments will need to stay at or below 49 percent of asset value.
The 2014 budget proposes amendments in the tax structure, including exemption from long-term capital gains (defined as gains on units held more than 36 months) and a 15 percent tax rate on short-term capital gains arising from sale of REIT units. Contrast this with the 12-month holding period for ordinary listed shares, making REITs a slightly less attractive investment. Additionally, tax incentives for sponsors start to shrink if REITs directly hold real property assets, versus holding them through special purpose vehicles (“SPVs”). Interest income from the SPV to the REIT is accorded pass-through treatment, but the impact of pass-through status is weakened because acquisition of debt (as against equity) securities by REITs precludes the sponsor’s applicable tax exemption. A 15 percent distribution tax applies to dividends from the SPV to the REIT, with neither the REIT nor the recipient REIT-unit holder being subject to income tax on such dividends – but given the requirement to distribute 90 percent of cash flow, the pass-through effect is weakened.
Other considerations remain. Residential properties are excluded from eligible investments, and a recent slowdown in growth and completion of previous projects have led to oversupply in key commercial real property markets. An influx of money could create a bubble for real estate prices and increase rent for commercial and residential property alike. Also, for the moment, only institutional and high-net-worth individuals are permitted to invest in REITs.
What’s clear is that given the low barriers to entry – minimum initial unit subscriptions of at least $3,350 and secondary trading units of at least half that – assuming progressive relaxation in investor qualifications, the Indian middle class will have a real opportunity to invest in real estate. It won’t hurt investors to have a flow of income moving in tandem with inflation. Developers struggling under high leverage and high interest rates will have new sources of finance. Mandatory disclosure requirements may even start to usher in the end of the murky developer-politician-criminal nexus.
[1] US dollar (“USD” or “$”) values represent rounded conversions of Indian rupee (“INR”) values at an exchange rate of INR 60 for each USD.
Published October 22, 2014.
