A Disappointing Start: REITs and InvITs require greater attention for maximum benefits

REITs and InvITs require greater attention for maximum benefits

The fledgling market for real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) has seen many regulatory changes in recent months. Despite the Securities and Exchange Board of India’s (SEBI) continuous efforts towards making the instruments attractive to investors, InvITs have had a dismal beginning. The failure of the two InvITs launched in 2017 (IRB InvIT Fund and India Grid Trust) to create much excitement on the bourses and the market still awaiting the maiden launch of a REIT is evidence of this. This has also forced other infrastructure developers to defer their plans to launch an InvIT. Pressing issues such as taxation-related anomalies and inadequate education about the product continue to keep investors at bay. In order to unlock the real potential of the investment vehicle, regulators have to bring more clarity on the product for ensuring its viability and success.

Infrastructure investment trusts

The infrastructure sector requires an investment of around Rs 50 trillion over the next five years. With the current state of the banking sector and the huge pile-up of developer debt, there was a need for a financial product which could deleverage the balance sheets of developers. In this regard, InvITs were deemed to provide a robust framework to developers to monetise their operational assets, thereby freeing up capital to be invested in new projects. An InvIT is a unique proposition, in the sense that it is a blend of both equity and debt.

The instrument is capable of breaking the vicious circle of infrastructure development. The vicious circle starts with infrastructure developers, with under-capitalised balance sheets, taking the debt-to-equity route to fund their equity investments. In addition, they borrow from various sources to finance their projects. The interest cost in the debt-equity structure, which starts accruing even while the project is under construction and has no revenue stream, starts hitting the profit and loss account and takes a toll on earnings, further worsening the balance sheet. In this context, InvITs can play an important role in creating a “virtuous cycle” of infrastructure development. The cash flow from the InvIT deleverages the balance sheet and also releases growth capital. This growth capital helps improve the project rating, which in turn, facilitates the securing of cheaper funds. This leads to higher profitability and helps the developer in undertaking new projects, which could further potentially get injected into the InvIT.

An understanding of InvITs has evolved over time, particularly among domestic investors who are gradually getting acquainted with the product. In the current scenario, investors are more cautious as they are waiting for the instrument to develop a track record, so as to assess its historical performance.

The lower-than-offer price trading of the listed InvITs is attributable mainly to three reasons. First, the product is new and is at a nascent stage. Second, the liquidity of the instrument on the exchanges is relatively low, which raises questions about its price discovery. Hence, there should be a market-making mechanism. Third, and most importantly, education and awareness about the investment vehicle are still inadequate. Also, the two listed InvITs were grossly “mis-sold” in the market, with the participation of institutional investors turning out to be lower than desired. SEBI does not allow sponsors to disclose yields from InvITs in the prospectus. Due to this, some investors, particularly retail investors, are facing problems in calculating the yields (adjusted for depreciation, etc.). Thus, the market regulator needs to proactively work on the documentation for InvITs. Further, only sophisticated investors – those that have a good understanding of the product – should be allowed to participate in InvITs.

A far more useful metric for InvITs is the net asset value (NAV), which is assessed every six months. This gives a better picture of the value at which InvITs should be trading. Laying too much emphasis on the unit price of an InvIT on the bourses will render a distorted value.

On the regulatory front, the regulations for InvITs are robust. That said, regulators have been cautious in formulating guidelines for the product given its complex structure. In order to enhance its appeal, some of the guidelines need to be tweaked. First, the high retail lot size for tapping the primary market is hampering public participation in the product. This needs to be ratcheted down for higher volume of trading and, in turn, better price discovery. Second, the leverage in such structures is capped at 49 per cent, which is too low for operational infrastructure assets. Therefore, raising the leverage to more conventional levels of 70-75 per cent will increase equity returns.

Real estate investment trusts

With the regulatory framework for REITs in place, developers were initially fairly optimistic as the structure opens up long-term capital-raising avenues for them without loss of ownership of the underlying assets. Be-

sides, developers also receive a fee income for managing the assets. However, issues such as the levy of minimum alternate tax on the eventual transfer or sale of units and the imposition of long-term capital gains tax at the time of swapping of assets with the units of REITs continue to be a dampener. Also, the experience from the two listed InvITs, which are trading below the offer price, has been a cause for concern for developers, who fear that the product will not appeal to investors. Therefore, many developers are turning to private equity players rather than listing REITs for gaining access to long-term capital at a cheaper rate.

There has been an expectation mismatch regarding returns from REITs. Developers expect to list Indian REITs at a range of 6-7 per cent, which is not realistic. Also, foreign REITs are offering higher returns, thereby rendering Indian REITs less attractive to investors.

Another issue surrounding the product is the ambiguity in contracts. A typical contract for office spaces in India is for nine years vis-à-vis a 20-year lease internationally. This raises concerns regarding the stability of contracts in the country. Moreover, rents have remained more or less flat in the past 8-10 years in most cities, on an inflation-adjusted basis. Other aspects such as dual tax incidence, stamp duties and exchange control laws (which prohibit foreign investments) could hamper the successful operation of REITs.

Conclusion

There exists significant opportunity for REITs and InvITs given the enormous infrastructure investment requirement in the country. In the US, for instance, products such as REITs, InvITs, yieldcos, etc., form around 5 per cent of the market capitalisation of the New York Stock Exchange. For argument’s sake, if a ballpark figure of 2.5-5 per cent of the market cap of the Bombay Stock Exchange is taken for India, the opportunity for REITs and InvITs would be in the range of Rs 50 billion-Rs 100 billion.

Investors and developers are fairly open to understanding the investment vehicle. The government needs to create greater public awareness about the product. Globally, institutional investors such as pension funds and sovereign wealth funds participate heavily in such structures, whereas retail participation is limited to about 20 per cent due to their limited knowledge.

Despite the advantages of REITs and InvITs, investors are currently bearish due to a lack of clarity regarding taxation, inadequate knowledge about the instrument and low liquidity. These are some of the key challenges which require immediate attention for the products to take off. Further, there needs to be a change in the mindset of the government to treat developers as a part of the ecosystem and believe that they are not minting money. With no long-term financing alternatives for the infrastructure sector, InvITs assume even greater relevance. The product has a lot of potential which can be realised if there is better investor education and a proactive role is played by the government and SEBI in making the instrument a success.

Based on remarks by Hardeep Dayal, Chief Operating Officer, Capital Markets, JLL India; Aditya Mehra, Head IR, IndiGrid; and Bharat Parekh, Executive Director, Infrastructure Research, CLSA, at a recent India Infrastructure conference