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In India, one of the favourite investment avenues for high-net worth investors is buying up commercial buildings and letting them out for rent. With rental yields of 7-8 per cent, commercial real estate investments have proved far more lucrative for rental income seekers than residential homes, where you are lucky if you get a rental yield of 3 per cent.
In the last few years, a bunch of fractional ownership platforms had sprung up to rope retail investors into such deals. This prompted Securities and Exchange Board of India (SEBI) to step in, to propose a new regulated asset class called Small and Medium Real Estate Investment Trusts (SM REITs).
The first SM REIT — Property Share Investment Trust — is set to launch its maiden scheme next week. Many more players are waiting in the wings. So, what are SM REITs and how are they different from the already-listed REITs?
How REITs work
If you are already familiar with REITs, you should know that they are a kind of mutual funds for real estate. They pool investments from hundreds of investors, both retail and institutional, and invest these funds in a portfolio of properties. This portfolio is periodically valued by an independent valuer to generate a Net Asset Value (NAV) for the REIT. This forms the basis for the units to list and trade on the stock exchanges.
Regulations require that Indian REITs only invest in completed, cash-generating properties. A REIT owns its properties through a set of Special Purpose Vehicles (SPVs), in which it makes equity and debt investments. The rental income that these SPVs earn is passed on to the REIT and it may also generate income from sale of property. The bulk of this is distributed to investors.
Globally, REITs are bought for their distribution yield more than their capital appreciation. India already has five listed REITs which invest in a diversified portfolio of properties across cities. Now, SM REITs are set to make a debut.
How SM REITs differ
SM REITs will differ from the already listed diversified REITs in many ways. Six key differences are relevant for investors.
₹10-lakh ticket size: The minimum application size in the initial public offer for SM REITs is mandated at ₹10 lakh. However, investors can apply to offers from diversified REITs with a minimum application size of just ₹10,000-15,000. In the secondary markets, investors can buy diversified REITs for as little as ₹500 or ₹1,000, but the secondary market trading lots for SM REITs are set at ₹10 lakh. This can lead to much lower liquidity for SM REITs than is the case with existing listed REITs. While a higher ticket size for SM REITs may seem contrary, SEBI has kept the entry bar for SM REITs high because they expose the investor to concentration risks.
Two-tier structure: While diversified REITs operate on a three-tier structure with a sponsor, trustee and investment manager, SM REITs will have only a two-tier structure with an investment manager and trustee. SEBI permits only professional real estate management firms to launch SM REITs, unlike diversified REITs where developers or real estate investment firms can be sponsors. The investment manager acquires and manages the property and can charge a fee for both acquiring and managing the property. SM REITs are barred from acquiring assets from any related party, which avoids conflicts of interest.
Concentrated exposure: While diversified REITs own a portfolio of properties across cities, SM REITs follow a scheme-based structure where a single scheme may own only one or a few properties. Propshare SM-REIT, which is making its debut next week, for instance, proposes to own only one asset — Prestige Tech Platina, which is an office building at Prestige Tech Park in Outer Ring Road, Bengaluru. It will own only this asset, earn rental income from it and distribute this to its investors. Investors in SM REITs are, therefore, acquiring an interest in one or two properties in specific locations and not a portfolio of assets, as is the case with diversified REITs. SM-REITs can launch multiple schemes with different assets.
Asset size capped: SM REITs are meant for acquiring properties valued at between ₹50 crore and ₹500 crore, while diversified REITs must start with a minimum asset size of ₹500 crore. The ₹500-crore cap effectively means that SM REITs will end up owning concentrated exposures to just one or a few properties. SM REITs are, however, required to distribute 100 per cent of their net cash flows after expenses to unitholders, while diversified REITs need to distribute only 90 per cent.
Relaxed regulations: The regulatory and disclosure requirements for SM REITs are more relaxed than for diversified REITs. While diversified REITs are required to get their assets valued and NAV declared on a half-yearly basis, SM REITs are required to do this only once a year. SM REIT managers are also subject to lower net worth and experience requirements than diversified REITs. SEBI requires SM REIT managers to demonstrate a ₹20-crore net worth and have a team with just two years’ experience in the real estate industry. Diversified REIT sponsors need ₹100-crore net worth and tend to have far more seasoned management teams.
Less skin-in-the-game: Skin-in-the-game requirements are much lower for managers of SM REITs than diversified REITs. In diversified REITs, SEBI mandates that sponsors own 25 per cent of the REIT’s units for the first three years after the IPO and 15 per cent after that. For SM REITs, the investment manager needs to own 5 per cent of units in the scheme for the first five years, 3 per cent for the sixth-tenth year, 2 per cent in the 11th-20th year. If the scheme takes on leverage, the manager needs to own 15 per cent of the units in the first three years with all remaining requirements being the same.
Pros and cons
Overall, owning just one or a few properties simplifies management for SM REITs, as they need not juggle properties across locations. Finding a tenant for a single property in a good location may also be much easier than finding tenants for many properties and keeping vacancies low, at a portfolio level. SM REITs have simple financials due to their concentrated investments.
But on the flip side, investing in a SM REIT may be very similar to taking a stake in a commercial building on your own, because any external event or natural disaster that affects the specific property, or any financial troubles impacting the tenant, will directly dent your returns from the SM REIT, as there is no diversification to cushion you against risks.
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