India’s commercial realty market has been on an upswing over the past few years. Well-managed, high-quality properties with an average tenancy of three years and nearly 90% stable occupancy have good cash flow visibility. They have, therefore, seen more investments by global private equity (PE) funds. Commercial real estate continues to see positive trajectory with improved profitability and comfortable leverage. Over the next 2-3 years, too, well-managed Grade A properties are likely to see 5-10% escalations per annum.
India’s top 10 commercial real estate owners alone, which include both developers and funds, have a portfolio of around 184 million square feet (msf) translating into an annual lease rental income of over Rs 17,000 crore. The portfolio of steady cash flows has the potential to raise as much as Rs 1.5 lakh crore through the real estate investment trust (REIT) route.
While investor interest in the residential segment is declining fast because of limited property price appreciation and inability to monetise assets, REITs can be a potential investment option, providing assured and ongoing returns. REITs, which invest primarily in completed, income-yielding real estate assets, are similar to mutual funds, and can be listed and traded on stock exchanges. Through REITs, PEs can divest at the portfolio level instead of individual assets. This would sync better with their typical exit timelines of 7-10 years.
Developers stand to benefit as REITs provide higher upfront cash to asset holders, which will help partly ease the pressure on their balance sheets. They can use the divestment proceeds to reduce debt and sustain construction activity. This will also improve their credit profiles, as seen in India’s first REIT, Embassy Office Park REIT – listed in April 2019.
While regulations allow REITs to have a minimum asset valuation of Rs 500 crore, not all commercial portfolio developers/ owners will take the route. Portfolios with minimum rentals of over Rs 1,000 crore, translating into asset valuation of Rs 10,000 crore, which can absorb higher transaction costs and comply with regulations, are more likely to use this option.
REITs account for nearly 50% of the capitalisation of the real estate industry in markets such as Singapore and Japan, where they were introduced nearly two decades ago, while they account for 96% of the market capitalisation in the US which pioneered REITs in 1960s. These trends also underpin the opportunity for India considering the real estate sector’s market capitalisation (cap) of nearly Rs 1.5 lakh crore (ex-REITs). However, lack of incentives or regulatory support, like in Hong Kong, can restrict this growth. REITs were introduced in India in 2014, and over the five years a spate of regulatory changes have made it attractive to developers while also protecting the interests of investors.
However, given the high level of compliance and stringent regulatory requirements for REITs, developers with smaller commercial portfolios would continue to use lease rental discounting loans, which are accessible at rates as low as 9%. Furthermore, developers who prefer to retain the capital appreciation opportunity and not dilute their stake, will not prefer the REIT route.