50% of Indian Office Stock Qualifies for REITs

By,Shobhit Agarwal, MD & CEO – ANAROCK Capital

About 50% of India’s total office stock is REITable – up from 30% in 2 years Low returns, lack of sound rental policy eliminated residential’s REITs candidature Projected 5-year returns on commercial assets is 14%

The listing of India’s first REIT by Blackstone-backed Embassy Group has been in the offing for quite some time, but it now finally appears that it will be listed within the first half of 2019. As REITs await their official deployment in India, investors hoping to cash on this new avenue for generous ROI growth seek to understand what exactly is in store for them – and for the real estate market.

As with any other investment platform, REITs have their own nuances and also issues, especially in the Indian context. Obviously, the industry at large has a lot of skin in the game as REITs promise to be a major inward-facing funnel not only for foreign institutional investments but also considerable individual investments.

If the first REITs are indeed announced in H1 2019, it would certainly not happen too soon for an industry still caught in the prongs of an unrelenting liquidity crunch. There could not be a better time than this for foreign and domestic investors to pump funds into the real estate market via REITs.

FIIs Gear Up for the REIT Plunge

2018 saw large foreign institutional investors like Japan’s NikkoAm-Straits Trading Asia and US’ North Carolina Fund, among others, receive SEBI approval to invest in India under REITs. Several FIIs had already ‘conquered’ India’s equity markets in the past, and now it is the turn of the real estate market via REITs.

It is not only the timing that is right, but also the stance that FIIs have assumed for real estate plays in India. Most of them are patient investors focused on stable long-term returns which will hopefully exceed those they could expect in their own countries.

Nevertheless, whether Indian REITs will indeed be an unequivocal blessing to foreign and domestic investors still remains to be seen. As things stand now, India’s REIT environment is not really a faithful emulation of that of developed international markets like Singapore, UK, Canada and Australia.

How India REITs Compare Globally

In those countries, REITs are a market-proven model that has withstood the test of time and produced very attractive returns for their investors. Globally, REITs have responded quite favourably to the evolving market dynamics. Indian REITs hope to take a cue from their western counterparts by bringing in regulations in line with the globally recognized norms so as to maximize profits for REIT investors here.

In Canada, the average return for REIT investors was around 10% in 2017, while in the UK, it hovered between 8-10%. This average return is on all REITable assets including commercial and residential projects together.

In India, the projected five-year returns on commercial assets is an optimistic 14%, largely because Grade A commercial real estate has been on a protracted winning streak since 2017. Commercial real estate withstood the vagaries of the various reforms much better than the residential asset class.

In the US, smaller investors account for between 25-30% of REIT participation from the previous 50% about a decade ago. In India, we can reasonably start with at least 15-20% of participation by smaller individual investors. All of this certainly bodes well for both FIIs and smaller investors focused on REITable commercial real estate – a space which has also benefited from the incumbent government’s efforts to improve the ease of doing business in India.

What Disqualified Residential from India REITs

However, residential real estate, the sector that is in greatest need of institutional funding, is not included under REITs while in developed global markets, residential assets are included under REITs.

This is obviously not without good reasons. Lack of a sound and inclusive rental policy in India is one of the major hurdles for REITs in residential segment. Countries like Singapore and US have a defined rental policy which makes it easier for them to host residential REITs.

Also, the yields on residential projects in India are nowhere near those of developed countries and mostly hover between mere 2-3% in the prime locales here. In short, low returns coupled with the overall negative hype that has followed the Indian residential sector in recent years have thus clearly negated its candidature for Indian REITs – at least in the foreseeable future.

Another area of difference is the taxation structure currently being proposed for Indian REITs. Like in the more developed countries with successful REIT platforms, India too must offer a logical tax regime with a single point of taxation if they are to rise to globally comparable stature.

Commercial Spaces – Primed and Ready

From a pure industry viewpoint, India’s Grade A commercial real estate sector has certainly proven its resilience and ability to generate attractive returns. This is why NRIs and domestic HNIs have shifted their erstwhile focus from residential properties to commercial real estate.

Nor is this a passing ‘phase’ – commercial leased assets across cities such as Bengaluru, Mumbai, Pune and NCR are seeing steadily mounting interest from occupiers, and therefore also from investors. Demand for Grade A office space has been growing and vacancy levels have been sliding south in prime locales.

ANAROCK data also indicates that while commercial real estate supply across the top 7 cities in 2017 (post the disruptive reformatory changes of DeMo, RERA and GST) declined by 24% over the preceding year, 2018 saw a 21% jump in new commercial supply as against 2017. Office space absorption remained steady with top 7 cities, witnessing an increase of almost 5% in 2017 as against 2016, and a 19% increase in 2018 as compared to 2017.

Data currently suggests that approximately 50% of the total office stock in India can qualify for REITs – a definite improvement over the 30% two years ago. Clearly, the market is gearing up for the launch of REITs by developing investable commercial assets.

At the end of the day, the success of Indian REITs will be basis growth prospects of a market that is still maturing, unlike developed countries (including in the Asia Pacific region) which are already mature. India is currently seeing a lot of new construction, so the average age of office buildings is lower than in cities in Australia or even Hong Kong.

Endnote – Cause for Caution

Once REITs become an on-ground reality, the market must remain vigilant. There could be a major issue for Indian REITs if the supply of investment-grade office spaces does not keep pace with demand. If it doesn’t, we will see an asset bubble form in the short-to-mid-term.