Promising Future

Some REIT and InvIT issues still need to be resolved

The government firmed up regulations for real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) in 2014 with the aim of encouraging foreign investment, reducing the burden on the banking system, and allowing developers to monetise income generating assets. The regulatory amendments announced in Union Budget 2016-17 have addressed industry concerns, pointing to exciting times ahead for these innovative structures. Excerpts from a conference on REITs and InvITs organised by India Infrastructure…

Jayesh Desai

Managing Partner, Structured Investment Group, Piramal Enterprises

Piramal’s involvement in InvITs is at a preliminary stage and the company is still exploring the subject. The past year witnessed a number of equity transactions in operating assets in sectors like roads and renewable energy. Transactions took place across sectors where yields were in the low double digits, indicating that operating infrastructure assets is of interest to investors. Some legislative changes are also pushing investors towards InvITs. For instance, doing away with the dividend distribution tax for InvITs gives us an incentive to start working on an InvIT structure over a period of time. So, we will start seeing something developing over the next 6-12 months

Suresh

Director, Hiranandani Group

REIT is a new product, a new entity, a new topic. There is still no clarity as far as its application is concerned at the developer level, financial institutional level or regulatory market level. The composition of the real estate market is as follows: around 62 per cent is residential (5 per cent is the rental component while 95 per cent is the ownership component); 22 per cent is for commercial space; information technology (IT)/IT-enabled services (ITeS) and the financial insurance sector account for 7 per cent; recreation and entertainment space and multiplexes constitute 5 per cent; and the retail space is about 4 per cent.

From a developer’s point of view, a project needs to be developed either through its own equity funds or loans, and then put into operation. Therefore, REITs will only come in at a later stage when the rental stream is active.

REITs will be set up where there are assured, regular returns. In that sense, REITs would grow faster than InvITs due to the creation of assets with such a flow of returns. A number of financial institutions are ready to take up commercial properties where regular lease rents are coming in. There are also good models of lease rental discounting (LRD) coming up. The major real estate components given on a rental basis are commercial spaces, IT/ITeS offices, as well as financial, insurance and corporate offices. However, retail is a grey area as the returns coming in from this segment have suddenly been showing a decline. Therefore, it is not a good product for an REIT. Meanwhile, entertainment multiplexes and service apartments can be good products for this structure.

Going forward, the Securities and Exchange Board of India (SEBI) must consider including the hospitality sector under the purview of REITs. Another real estate component which could be explored is the logistics/warehousing space.

A major positive step taken with respect to REITs is the removal of the dividend distribution tax. However, the issue of stamp duties still persists. Another key concern is the ticket size for retail investors. A minimum ticket size of Rs 10 million is required for the infrastructure segment due to the huge capital investment, but whether it should be pared down for the commercial space segment and retail investors still remains a question. Lastly, the holding period of REITs could be brought down to 12 months from a period of 36 months.

A lacuna which needs to be filled in the REIT space is the absence of real estate property rating. A real estate regulator will be formed shortly in all the states, as approval for this has already been granted by the central government. Other issues which need to be addressed include the transfer of excess funds from one special purpose vehicle (SPV) to another, the varying definition of a SPV in the Income Tax Act and by SEBI, exemption of capital gains tax in exchange for REIT assets, and the absence of title insurance for REITs.

REITs have been successful in Singapore, Hong Kong, Dubai and Shanghai. In India, foreign investments can come in if the returns range from 5 to 8 per cent in the commercial space, 6 to 10 per cent in the rental segment and around 2 per cent in the residential segment. Meanwhile, foreign exchange risk is a cause for concern for which an appropriate risk hedging mechanism must be provided. So, a good REIT will take into account not only the type of yield in the market but also the type of appreciation of the property.

To conclude, REITs have the potential to attract Rs 400 billion-Rs 500 billion worth of investment in three-four years. This will be backed by the 100 smart cities planned under the Smart Cities Mission, 500 cities under the Atal Mission for Rejuvenation and Urban Transformation, and about 20 million housing projects coming up in various cities.

 Jayen Shah

Senior Director and Head, Debt Capital Markets, Commercial and Wholesale Bank, IDFC Bank

In the past 16 years, IDFC Bank has lent to various infrastructure sectors including roads, power, ports and airports. It has been predominantly participating as a lender to infrastructure assets during all the project phases – pre-construction, under construction and post-construction. The bank has forayed into the real estate segment with lending to hotels and hospitals, and for commercial office spaces in IT special economic zones and IT parks.

With respect to REITs, sponsors try to optimise the return on equity. It is for them to decide whether to continue to remain in a loan-financed operating asset or transfer to an REIT structure. Sometimes, post-commissioning, the debt amount exceeds the original project cost. As a lender, one does not consider recovering the value of the outstanding principle by selling the underlying asset. Debt servicing is expected to be financed through the running cash flow, which could be assured or uncertain depending on the nature of infrastructure assets.

Recently, IDFC Bank undertook a transaction pertaining to an office space in Hyderabad for K. Raheja Corporate Services which was a successful experience. Investors in the insurance and mutual fund sectors also participated. However, pricing remains an issue and is still debatable. The transaction structure is available for replication in other operating assets but the LRD levels are tight in a relative sense. The ability of a sponsor to refinance the asset by getting incremental cash flows or by taking advantage of a lower interest rate is not feasible in a bond structure, while in a loan framework the sponsor has the flexibility to refinance on a rolling basis.

The experience was similar in infrastructure project bonds. Logistics projects for the Paradip refinery and Indian Oiltanking Utkal, renewable projects and a transmission project for Sterlite Technologies were executed by converting the existing financing through a loan framework to a bond framework. There was participation from insurance companies, pension funds, provident funds and mutual funds. Meanwhile, IRB Infrastructure Developers is expected to form the country’s first InvIT consisting of operational road projects. The company’s plan is to launch an initial public offering for the InvIT, the size of which will be in the range of Rs 60 billion-Rs 70 billion.

Further, equity inflow from foreign direct investment has been increasing over the past two years. However, the participation of offshore investors in debt-oriented assets like InvITs or REITs has not demonstrated any significant increase. Positioning plays an important role – whether the trust has a debt plus or equity minus structure. Offshore investors take investment decisions based on returns in their home markets vis-à-vis other countries, in addition to the cost of hedging. Meanwhile, the key challenge for InvITs is primarily related to the risks associated with different infrastructure sectors.

Bharat Parekh

Executive Director, CLSA Limited

The InvIT product is transformational; however, it is five years late. The government has been slow with regard to these products. For instance, SEBI’s initial guidelines for InvITs came out in 2014 but the operating guidelines came out only in 2016.

The first key issue from the developer’s perspective is related to access to debt. This will stop about 80 per cent of the deals from actually happening. The second issue pertains to valuation. The majority of the assets currently available are linked to the book. If a blend of infrastructure debt funds and bank lending is used then debt can be obtained at a rate of 9.8-9.85 per cent. But without any equity release, the private developer will not be incentivised to undertake a project. So the 25 per cent norm could give InvITs a dubious start.

There are significant challenges on the ground, especially in the road sector. Many road projects are on the brink of bankruptcy. In the power sector, under the new norm of competitive bidding, the central transmission utility is just a transmission mechanism to collect cash from the state to be given to the developer. But the question is, who will pay in case the state fails to pay, a question that still remains unanswered. Hence, such issues do not render these assets saleable.

For investors, these products are still new, and they are concerned with the immediate or short-term yield. Revenues from a typical road asset follow a J-curve – no immediate yield but higher yield at a later stage of operation. It would be difficult to strike a deal for such an asset under an InvIT. Therefore, investors should look for developers with mature assets or a mix of new and mature assets.

Lastly, from the regulatory point of view, the product is still not classified as a security. Therefore, a lot needs to be done on the regulatory front.

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