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In anticipation of SEBI REIT Regulations 2008

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Looking at investment needs of developers who are instrumental to infrastructural development in India, primarily on the real estate front, M Damodaran, chief, Securities and Exchange Board of India (SEBI), in December last year, issued some draft guidelines for real estate investment trust (REIT).

REIT acts as an affordable, broad and balanced way of investing in the property market. They operate in just the same way that ordinary investments do – by pooling in investors’ money and investing the fund generated in commercial and residential property. An investor, therefore, becomes a ‘shareholder’ in the REIT. In contrast to directly investing by purchasing property that, otherwise, is expensive to buy, an owner of one REIT unit buys a ‘one-unit portion’ of a managed pool of property. This pool of property then generates income through renting, leasing and sales, and distributes the said income directly to the REIT-holder on a regular basis, like listed companies pay dividends to their shareholders. Individuals can invest in REITs either by purchasing their shares directly on an open exchange, or by investing in a mutual fund that specialises in public real estate. Among other things, REITs invest in shopping malls, office buildings, apartments, warehouses and hotels.

In a 64-page draft proposal, SEBI said that a scheme would be launched by a real estate investment trust, which will be managed by a real estate investment management company. It also mentioned that this would help meet the capital needs of the real estate sector and allow investors to participate in the real estate growth opportunity. The proposed guidelines are expected to be effective from the date of their publication in the official gazette. If and when finally approved, it will be known as SEBI (REIT) Regulations, 2008.

Though the move aroused some speculations and curiosity, in general, it was welcomed by the industry. Professionals in the real estate business expressed their concern, while some prominent associations and interest groups started discussing the good and the flip sides of REITs.

Some prominent organisations, based on their experience and requirements, submitted their comments/suggestions that they believed would help in the strong establishment and efficient functioning of REITs in India. Among them was the K Raheja Group, a diversified business group with interests in the real estate, hospitality and retail sectors. In an email to Indiaretailing, the group expressed appreciation of the SEBI move saying that it has opened up another avenue for growth in the maturing real estate market. The group consulted a few important functionaries in the real estate business and proposed the following points that SEBI must refer to while sketching the SEBI (REIT) Regulations, 2008.

1. To provide REITs the flexibility of investing either in real estate assets directly or invest in shares of special purpose vehicles (SPV) that own the assets, primarily to address the following:

(i) Transaction costs on acquisitions
Transaction costs relating to real estate assets in India mainly consist of stamp duties enforced at the state level, ranging from five to fifteen per cent. This would adversely impact the return to investors as internationally, REITs are required to distribute 90 per cent of their income; thus, this additional cost would erode the corpus of the REIT investors. Such high transaction costs may act as a deterrent to REITs in firming up its presence in India.

(ii) Transaction costs on leases
There should also be an exemption to REITs from stamp duty on long-term leases. The marketability of REITs is primarily driven by the quality of assets and the tenure of the lease. Internationally, lease tenures are generally between 20 and 30 years. In India, stamp duties on leases with such long tenures are as high as stamp duty on conveyance of property. This could impair the return to investors and also impair the ability of REITs to leverage costs.

(iii) Protection from future disputes
At the time of acquisition of any immovable property, there is title diligence carried out to avoid future disputes. However, this does not guarantee that no litigation will arise, and, hence, additional safeguards should be built.

2. Foreign investments in REIT
Globally, it has been observed that a significant portion of the investments in REITs have been from financial institutions. Following international trends, REITs in India may also garner a majority of its investments from financial/foreign institutions, taking into consideration a small base of investment-savvy retail investors to raise substantial contributions for investments.

Under the Foreign Exchange Management Act, 1999 (FEMA), foreign institutional investors and non-resident Indians are permitted to invest in units of a mutual fund. It is suggested that the units issued by REITs be brought at par with mutual funds, by amending the relevant regulations under FEMA.

3. Removal of investment limitations
The draft regulations have imposed certain investment limitations on REITs, whereby collectively all its schemes are not permitted to invest more than 15 per cent of its corpus in a single real estate project. A REIT, under all its schemes, is also not permitted to invest more than 25 per cent of its corpus in all real estate projects developed, marketed, owned, or financed by a group of companies. All these are restrictive conditions.

4. The draft REIT regulations should provide for extension or early termination of scheme

Regulation 35 of the draft REIT Regulations states that a scheme shall be terminated on expiry of duration specified in the scheme. In case of mutual funds, a close-ended scheme can be rolled over if the purpose, period and other terms of the rollover and all other material details of the scheme are filed with SEBI.

The draft REIT Regulations do not allow rollover of a scheme on expiry of the duration specified in the scheme. If rollover is not provided, a scheme will not have the flexibility to extend in a scenario of good performance, thereby depriving unit-holders to the scheme of better returns.

5. Other regulations should be amended to support REIT framework
In order for the draft REIT Regulations to be implemented successfully, a number of allied laws and regulations supporting the same need to be amended. Laws that may need to be re-looked at to launch a successful platform for REITs include taxability of REITs and the unit-holders (income tax), and taxability of distributed income in the hands of unit-holders.

It is also recommended that capital gains on transfer of units of REITs should be taxed in the same manner as capital gains on transfer of units of equity-oriented mutual funds are taxed.

6. It should be clarified how the deposits received from tenants should be treated in determination of net worth
Real-estate assets producing lease/rental income are generally accompanied by a security deposit received from the tenants at the beginning of the lease period. The draft REIT Regulations should clearly bring out the treatment of such deposits in computing the net worth of the REIT.

Other than the United States, REIT is a largely new concept in most parts of the world. There are nearly 200 publicly traded REITs operating in the United States. Their combined assets are worth approximately $500 billion, and about two-thirds of them are trading on national stock exchanges. Australia is emerging as the world’s largest REITs market outside the United States. More than 12 per cent of global listed property trusts can be found on the Australian Stock Exchange (ASX). In the United Kingdom, the legislation laying out the rules for REITs was enacted in the Finance Act 2006 and came into effect in January 2007, when nine UK property companies converted to REIT status.

Japan is one of a handful of countries in Asia with REIT legislation (other countries include Hong Kong, Singapore, Malaysia, Taiwan and Korea), having permitted their establishment in December 2001. REIT securities in Japan are traded on the Tokyo Stock Exchange (TSE), and most participants are Japanese conglomerates and foreign investment banks. Some see REITs as a way to increase investment in the real estate market, although notable increases in asset values have not yet been realised in the country.

Indian developers, amid the country’s unpredictable market situation, are undoubtedly harbouring high hopes from REITs. How SEBI looks at the industry’s recommendations and how they are incorporated in the proposed SEBI (REIT) Regulation 2008 is a matter of wait-and-watch.

– By Ranjan Kaplish

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