Commercial Real Estate (CRE) has been a popular asset class for HNIs and institutional investors around the world. CRE provides monthly cash yields linked to an underlying lease along with a capital appreciation kicker that can together lead to returns in the high teens for investors.
HNIs and institutional investors (like pension funds, sovereign wealth funds, endowments) have traditionally accessed CRE via blind-pool close-ended real estate funds that run for 7-10 years. Retail investors participate to a smaller degree through pooled vehicles like Real Estate Investment Trusts (REITs) that invest in a portfolio of real estate assets.
REITs were allowed in India only in the last few years and since then there have been three major REIT portfolios that have been listed on the stock exchanges – Embassy Office Parks, Raheja Mindspace Business Parks and Brookfield India REIT.
Apart from real estate funds and REITs, investors today can also participate in CRE opportunities directly through tech-enabled platforms that list, manage and sell income-generating assets completely online.
Let’s understand the pros and cons of each of these investment avenues:
Yield
The first and most important parameter to consider is the yield on the instrument. Yields are the highest when an investor invests directly into the asset, which is the case with tech platforms. Yields on platforms like Property Share are 9-10% annually which go up by 5% every year due to rents that are linked to inflation. Compared to this, the yield on REITs are 5-6%. This is because REITs have a part of their portfolio in land and under construction assets which do not provide any returns to the investor. Further REITs use leverage in buying the asset (49% allowed) which requires the REIT to pay EMIs that eat into the yield. Real estate funds do not return any yield to investors as they use up to 60% leverage to buy assets.
Frequency of distributions
Here again, direct real estate investment scores highly as the distributions are monthly as and when rents are paid by the tenant vs quarterly for REITs and no distribution for RE funds. Real estate funds are close-ended funds that return money to investors only at the end of the fund term (7-10 years). REITs, on the other hand, typically distribute rents on a quarterly basis to unitholders.
Diversification
REITs have the best diversification as they invest in a variety of assets across locations. Real estate funds are mandated by law to invest in at least 4 assets. In the case of direct tech-based investing, the investment is into one asset. However, the investor can diversify on his/her own by investing across various properties listed on the platform, which is highly recommended. However, in direct investing, the individual investor decides on each property whereas in REITs and RE funds, the investor is dependent on the manager to make decisions on his/her behalf which exposes them to corporate governance issues.
Liquidity
REITs are the most liquid instruments as they are listed on the stock exchanges. Real estate funds are the most illiquid as funds are only returned at the end of the tenure, which is usually 8-10 years. Tech platforms facilitate resale of assets on a quarterly basis which provide added liquidity
Property Management
All three modes of investment help investors manage the property including vacancy, leasing, building upkeep, and maintenance through separate Asset Management teams.
Volatility
REITs are the most volatile as the units are traded daily on the stock market. The Embassy REIT which listed at around Rs. 300 went up to Rs. 448 and is currently trading back at Rs. 300. Investors who bought at the higher prices have lost capital of up to 33%. Any external news – positive or negative impacts the value of the investor’s holdings and the yields. Real estate funds and tech platforms have little or no volatility as they are either not traded or traded in much smaller lots privately.
Fees
Real estate funds charge the highest fees (2/20, meaning 2 per cent management fees and 20 per cent performance fees) owing to high operating costs and distributor fees.
REITs charge slightly lower fees but have high operating costs on account of being a listed entity. Tech platforms have the lowest fee structure of up to 1% property management fee.
Investment decision
Both real estate funds and REITs are pooled vehicles and all investment decisions are made by their corresponding Investment Committees exposing the investor to well-known corporate governance issues. Tech platforms allow direct investment into individual assets according to the investor’s requirements. For example, an investor from Bangalore may be comfortable in investing only in Bangalore properties. In such a case, the Investor IS the Investment Committee.
Leverage
Real estate funds use leverage (debt) in almost all investments, which eliminates monthly cash distributions to investors (due to interest and EMI payments) but could lead to higher overall returns with higher risks of capital loss.
REITs, by law, are allowed to take only a certain amount of leverage. Tech platforms are entirely unleveraged transferring the entire yield on the asset to the investor.
Taxation on distributions
The taxation on REITs' distribution is dependent on the prevalent tax laws as well as their corporate structure. The 2023 Budget removed some of the tax exemptions which the REITs enjoyed previously. This has made almost the entire income of Brookfield REIT taxable as opposed to Mindspace REIT, where less than 10% of the income is taxable. Moreover, since it is a nascent asset class, their nature of taxation has also been changing quite frequently. Distributions from tech platforms, on the other hand, are taxed at marginal tax rate which can be optimised by investing through entities or individuals with no taxable income.
Pros and cons of CRE investment avenues |
|||
Tech Platforms like Property Share |
REITs |
Real estate funds |
|
Rental Yield (%) |
9-10% |
5-6% |
Nil |
Rent Distribution |
Monthly |
Quarterly |
NA |
Diversification |
Medium |
High |
Medium |
Liquidity |
Medium |
High |
Low |
Property Management |
|
|
|
Volatility |
Low |
High |
Low |
Fees |
Low |
Medium |
High |
Asset Selection |
Individual Investor |
Investment Committee |
Investment Committee |
Leverage |
None |
Low |
High |
The article has been published on Moneycontrol.com on 20th March, 2023.