REITs: How They Work, How They Are Valued and Are They Worth Investing in?

Real Estate Investment Trusts (REITs) are a new asset class in the Indian financial market that offers exposure to income-generating commercial real estate. Essentially, REITs give the chance to own a pie of a commercial real estate and enjoy its rents and capital appreciation, similar to buying a rental property. 
 
But unlike buying, managing and leasing out your own rental property, REITs offer you access to upscale properties in posh locations, high-profile tenants, professional management, liquidity to exit your investment, highly-regulated structure for the safety of unit-holders and a high yield on investment. Basically, buying rental properties is now as easy and convenient as buying a stock.
 
REITs are structured in the same way as mutual funds, i.e., in the form of a trust with a sponsor, trustees, investment and property managers, the real estate investment itself either indirectly through special purpose vehicles (SPVs) or directly and, lastly—the unit-holder. However, REITs have to be purchased like stocks, that is, by using a brokerage account to buy from the two major stock exchanges.
 
How REITs Make Money
Although one might assume that rent is the only source of income for REITs, it is not true. REITs own shares of SPVs—these are companies that own and manage an office park or building. For example, the Embassy Office Parks REIT has exposure to SPVs like Embassy Office Parks Pvt Ltd, Manyata Promoters Pvt Ltd, etc.
 
Each SPV collects rents, borrows money, pays costs, and the net earnings are passed on to the REIT in the form of ‘dividends’. Other than dividends, REIT also makes money by lending to SPVs and earning interest. Lastly, selling its properties for a profit is another way a REIT will make money.
 
Additionally, REITs have the flexibility to raise capital through bonds and equity for financing expansion. This is where the skills of the asset manager and the real estate climate play a key role in deciding the future income of a REIT. Therefore, a REIT investor enjoys the safety net of its trust structure and also benefits its growth-oriented corporate actions.
 
How REITs Distribute Money to Unit-holders
A REIT does not determine the distribution payable to its unit-holders from the net profits it makes from its operations. Rather, the net distributable cash–flow, after paying for management fees, is the source of income to unit-holders. REITs are mandated to distribute at least 90% of the net distributable cash-flow to unit-holders. Due to this mandate, a REIT can make huge distributions even when income from rentals and interest is not enough.
 
An example is the Embassy Office Park REIT; it made a net profit of only Rs85.65 crore in the quarter ended 30 September 2020 but made a distribution of Rs424.42 crore, mainly consisting of principal repayments of loans it made to SPVs in the same quarter.
 
How To Value a REIT
Usually, REITs are valued similar to fixed-income securities like bank fixed deposits or bonds. If a unit of REIT, trading at Rs1,000 in the market pays, say, Rs80 as distribution each year, then we say the dividend yield is 8%, i.e., (80/1,000) x 100. If a REIT is able to pay a good yield for many years, it can be said that such a REIT is worth investing in.
 
But that simple metric can be misleading, too. As said earlier, a REIT can pay more than it makes from its operations. Only a few days ago, Mindspace Business Parks REIT announced that it would distribute Rs283 crore to unit-holders for the quarter ended December 2020, even though it earned a net profit of only Rs140 crore.
 
Such excessive distributions, at the cost of a reducing net worth, may be a cause of worry. But, using the same tools used for valuing companies to evaluate REITs is not correct. One of the reasons why REITs are able to pay more than their net earnings is because non-cash charges, such as depreciation and amortisation, are not reflected in cash-flow statements. 
 
Due to such accounting methods, the net earnings will always be lower than the cash available for distributing. In other words, the REIT is not paying more than it can earn, it is paying only what it has. This is why REIT analysts tend to augment net earnings by adding back depreciation, to understand them better.
 
The same applies to the concept of the net worth. Such distortions due to non-cash charges and high distributions can make the REIT’s net worth fall every year. So, using price-to-book of the REIT will not suffice.
 
Globally, the standard metrics used to evaluate the performance of a REIT is something called as ‘funds from operations’ or FFO. FFO takes net income and adds depreciation and amortisation but reduces any gains from property sales. FFO gives the true picture about the efficiency of the REIT’s investments.
 
FFO, along with dividend yield, are the two preferred metrics used for valuing REITs. As FFO grows yearly, the price of the REIT will also grow.
 
Can REITs Beat Traditional Bank Fixed-deposits and Debt-oriented Investments?
 
Yes. REITs can beat debt-oriented investments for two reasons—rental income tends to increase over the long-term and so does the value of the properties. In debt-based investment, the only earning is from interest, and interest rates tend to fall over the long term. Due to this, a REIT can be more beneficial for long-term income planning compared to debt schemes.
 
However, REITs are a new asset class in the country and we are slowly learning more about them. One thing we have learned so far is that prices of REIT are not entirely correlated with the equity markets. This means that REITs do not necessarily rally like stocks during bull markets nor do their prices crash in bear markets. Although in the recent bear market in March 2020, Embassy REIT’s price did crash, mainly due to the fear that tenants will not be able to pay rent and work-from-home will deter growth. Barring such an exceptional event as COVID, the factors influencing REIT prices are mainly interest rates and business cycle in commercial rental properties.

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