GuinesCorporateAdvisorsPvt.Ltd. and the

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2 Gr oupcompanyser vi c es I nves t mentbanki ngpor t f ol i omanagementi ns ur anc e Equi t y&der i vat i v escur r enc yres ear c h Depos i t or yweal t hmanagementcommodi t y Real Es t at epandi s t r i but i on I T&I T es

3 Real Estate & Infrastructure Investment Trusts ~ Opportunities and the Way Forward ~ REITs

4 Contents Real Estate Investmentt Trusts 1 "BUDGET 2014: A Game Changer for REITs?".. 11 Real Estate Investmentt Trusts A Primer.. 19 Benefits of REITS & Its Impact on Real Estate Market. 24

5 Real Estate Investment Trusts 1. What is a Real Estate Investment Trust? The concept of a Real Estate Investment Trust (REIT) was first introduced in 1960s in the United States throughh a legislation authorizing REITs passed by Congress. Realizing the benefits that a REIT provides to the population of the country, economy in general and real estate industry in particular, other countries introduced REIT legislations subsequently such as Australia in 1985, UK & Germany in 2007 and closer to home Singapore in 1999, Japan in 2000, HongKong in 2003 and Philippines in A Real Estate Investment Trust (REIT) is a trust that pools resources by offering units to investors. Such funds are used to acquire and manage income-producing properties and income generated from such properties is distributed to investors. REITs receivee special tax consideration and are characterized by low transaction costs. REITs typically offer the following benefits: For the investors - REITs as an investment class provide the common man an opportunity to invest in fixed income securities which also provide longterm capital appreciation and a natural inflation hedge. It also opens to small investors an arena (i.e. rent generating real estate assets) whichh was hitherto the monopoly of large investors; For the industry - REITs assist in streamlining the real estate sector by creating a new & transparent source for raising finance in the real estate sector. Further, REITs can provide developers with institutional capital to sell their assets and use the funds to repay banks and/ /or utilize the funds for more development. 1

6 2. REITs in India In India, REITs were first formally introducedd by the Securities & Exchange Board of India in 2007 as draft REIT Regulations. However, due to inherent limitations in the draft regulations, the final regulations were never announced and REITs weree buried for 6 long years. In September 2013, SEBI released a revised set of draft REIT Regulations for public comments. While the draft regulations issued in September 2013 were largely in line with global REIT regulations, there were some modifications required to provide REITs a more enabling framework. Significant comments weree received by SEBI in this regard. After receiving public comments, SEBI approved the SEBI (Real Estate Investment Trusts) Regulations, 2014 in its meeting on 10th August Though the final regulations are yet to be notified, SEBI in its press release mentioned the salient features of the REIT regulations as approved by the Board. 2

7 Some features of REITs are as follows: The REIT is typicallyy a trust which has a Board of Trustees; the Board of Trustees has the fiduciary duty of protecting the investors' interest & ensuring that the REIT carries out its activities based on the mandate provided in the trust deed. The REIT either directly acquires completed rent yielding properties or acquires ownership of SPVs which own completed rent yielding properties; the rental income from the properties are distributed to the REIT and then the REIT distributes such income to its investors. The sponsor (person setting up the unit holders of the REIT. the REIT) and public/institutional investors are The REIT manager (akin to an asset manager in a mutual fund format) is the manager of the REIT and takes all the day-to-day decision for the functioning of the REIT; decision relating to a'cquisition/ disposition of properties, leverage, tenants in properties etc are all taken by the REIT manager; the REIT manager gets a fee for providing such services. 3. Key features of SEBI (Real Estate 2014 Investment Trusts) Regulations, Some of the key features of the REIT regulations are: Specific eligibility criteria are to be satisfied for each of the interested party i.e. Sponsor, Manager, Trustee, Principal Valuer etc. Mandatory public float of 25% of the value of REIT assets or INR 250 crores whichever is higher, minimum unit size of INR 1 lac and subscription size of INR 2 lakhs per investor. Mandatory for all units of REITS to be listed on a recognized stock exchange. 3

8 Investment rules Can only invest in securities or properties in India. Cannot invest in vacant land, agricultural land or mortgages. However, REIT may invest in mortgage backed securities. A REIT cannot invest in units of another REIT. REIT may invest in properties through SPV conditions: with the following two REIT shall hold controlling interest and not less the 50% of of SPV; the equity shares SPV shall hold at least 80% of invest in any other SPVs the assets directly in properties and should not REIT shall hold at least 2 projects, directly or through SPV, with not more than 60% of the value of assets in one project. Assets rules Value of REIT assets should not be less than INR 500 crores. to be offered to public should not be less than 25% of the value INR 250 crores, whichever is higher. Further, the units of REIT assets or Minimum 80% of value of REIT assets should be invested in completed and rent generating properties. Completed property means property for which occupancy certificate has been received from the relevant authority. Further, rent generating property has been defined to mean property of which note less than 75% of the area has been rented/ leased out. Remaining 20% of value of REIT assets can be invested in other specified assets which include developmental assets, listed and unlisted debt, governmental securities etc. However, not more than 10% of the value of assets shall be invested in developmental properties for not less than 3 years. 4

9 Income rules Not less than 75% of revenues of the REIT other than gains arising from disposal of properties shall be from rental, leasing and letting real estate assets. Distribution rules Compulsory distribution of at least 90% of net distributable cash flows of the REIT to the unit holders on at least a half yearly basis. Leverage Aggregate consolidated borrowings and deferred payments of the REIT shall never exceed 49% of the value of the REIT assets. If aggregate consolidated borrowings and deferred payments of REIT exceed 25% of the value of REIT assets, for any further borrowing following requirements need to be fulfilled: Credit rating from a credit rating agency registered with SEBI Approval of unit holders to be obtained Other key features Related party transactions Stringent conditions have been imposed on related party transactions including detailed disclosures, valuation requirements, approval from majority of investors, related party abstaining from voting, restrictions on leasing of assets to related parties, requirement of fairness opinion for lease, etc. Any properties leased to related parties to the REIT shall be subject to the following conditions: Lease area not to exceed 20% of the value of underlying area of the assets; Value of assets not to exceed 20% of the value of total underlying assets; 5

10 Rental income not to exceed 20% assets. of the value of rental income from all underlying Rights of unit-holders Approval from not less than 75% of the unit holders (by value and by number) is required to be obtained in a number of cases, such as, specified related party transactions, borrowing in excesss of prescribed limit, transaction value exceeding 15% of the REIT assets etc. Investment in REITs is open to all types of investors subject to RBI guidelines for foreign investment; whether resident or foreign REITs can have multiple sponsors (up to 3). Sponsor of the REIT would continue to hold a percentage of the units (5%) of the REIT during its lifetime; 3.1 Industry suggestions Globally corporates doing a sale and lease back of their properties to a REIT and then listing such a REIT is a common practice. The SEBI regulations are not clear on whether such sale and lease back transactions are permitted. Further where a corporate desires to be a sponsor / manager and undertake a REIT for a sale and lease back transaction, the 20% restriction in related party transactionss would make it impermissible for a corporate being designatedd a sponsor/ manager. One of the eligibility criterions for the sponsor is that the sponsor should have not less than a 5 year experience in the real estate sector. This condition narrows down the community of sponsors and excludes corporate houses, banks, financial services players etc. The definition of sponsor has to be more inclusive to have a wider community of sponsors comprising real estate developers, banks, financial servicess players, corporate houses, real estate owners etc Currently, the definition of 'securities' under Securities Contract (Regulations) Act, 1956 does not cover units of REIT. Amendmen nt should be brought in the definition of Securities so as to include REIT units under the same. 6

11 To facilitate & enablee availability of long term funds to REITs, appropriate changes as may be required should be made to relevant laws such that domestic pension funds, provident funds, insurance companies and mutual funds are allowed to invest in REITs. It is also imperative that the Government brings clarity on foreign direct investment and foreign portfolio investment in REITs. 4. Tax regimee for REITs The Hon'ble Finance Minister Mr Arun Jaitely in Finance Act 2014 introduced a tax regime for REITs and announced that REITs will be granted' a pass through status. Tax implications in the hands of REITs and its stakeholders are given in the ensuing paragraphs. 4A Taxability in the hands of Sponsor a) In respect of units of REIT received against exchange of shares of SPV The current tax regime provides for a deferral on capital gains arising on exchange of shares in SPV with units of business trust to be deferred. Such capital gains shall be taxable only at the time of disposal of units by sponsor. In respect of such units, the period of holding and cost of acquisition shall be as follows: - Period of holding of included such units - period of holding of shares of SPV to be - Cost of acquisition of such units - cost of shares in specified SPV Further, benefits otherwise available to other not be available on such units. unit-holders on disposal of units shall b) In respect of other units acquired by Sponsor Tax implications would be same as that in the case of other unit-holders. Please referr para 4D for the same. 7

12 4B Taxability in the hands of SPV SPVs shall be subject to taxes at normal rates of tax. Any distribution of dividend by SPV to effective rate of % %. trust shall be subject to DDT at an Interest paid by SPV to trust shall not be subject to any tax withholding. Further, such interest shall be allowed as a deduction to the SPV. 4C Taxability in the hands of REIT Taxability of various streams of income received by REIT Dividend and interest received by REIT from SPV would be exempt in the hands of the REIT. Capital gains on disposal of REIT assets (i.e. shares/ rental assets) Capital gains shall be taxable in the hands of REITs. Effective tax rate of 20% (plus surcharge and education cess) on long term capital gains with indexation benefit and maximum marginal rate for short term capital gains) Any other income taxable at maximum marginal rate Distributions by REIT to its unit-holders Distribution of interest component of income by REIT to its unit holders would attract withholding 5%/ 10% for non-resident at higher rate of 20% in absence of PAN. and resident unit holders respectively. Tax may be deductedd Dividend & capital gains component of income distributed by REITs to the unit holders will be exempt in the hands of the unit holders REITs to file return of income 4D Taxability in the hands of unit-holders by non-resident unit holders shall be taxable at 5% Interest income received concessional rate & at applicable rates for resident holders 8

13 Capital gains on sale of listed units of REITs on the exchange to attract levy of security transactionn tax at par with that of listed equity shares. Long term capital gains (where units held for more than 36 months) would be exempt and short term capital gains would be 15%. Where sale of units is off the exchange LTCG taxable at 20% and applicable rates MAT applicable on interest income and capital gains on sale of REIT units 4.1 Industry suggestions on tax treatment for REITs Deferral of capital gains should also be available on exchange of assets by sponsor Under the current legislation for REITs, deferral of taxes has been provided only in case of transfer of shares of SPV by sponsor. The deferral is not provided in case the sponsor transfers immovable property or infrastructure assets or interest in firm to the business trust. Such deferral should be extendedd to the sponsor on transfer of assets or interest in firm to the REITs. Further, even though a deferral has been provided for transfer of shares of the REIT, MAT may continue to apply making the deferral redundant. SPV to Deferral of capital gains to sponsor on contributio on of saless and calculation of capital gains tax. Sponsor of REITs should be subject to capital gains tax only in respect of capital gains uptill the the time of transfer of shares in exchange of REITs unit. Any subsequent gain to sponsors of REITs (i.e. from the time of exchange of unit to final sale of units of REITs) should be subject same treatment as provided to other unit holders. For example cost of share - INR 100 FMV on date of exchange - INR 1,000 Sale price in future - INR 1,200 Capital gain - INR 900 (1, ) Same treatment as provide to other unit holders - INR 200 (1200-1,000) Dividend distributed by SPV to REIT should not be subject to dividend distribution tax Dividend distribution tax is applicable on the SPV distributing dividendd which makes the structure tax in-efficient and un-attractive; an exemption from DDT is 9

14 necessary to make the structure workable and returns attractive to investors. Period of holding of units of REIT REITs should be accorded same treatment provided for listed equity shares. Accordingly, period of holding for the purpose of capital gains should be 12 months and not 36 months. In absence of the same, intention of the legislature to grant same tax benefits is not achieved. Allocation of expenses of REIT The current tax provisions are silent on treatment and allocation of expenses at the trust level such as manager fee, trustee fee, administrative expenses, interest cost. Such treatment should be clarified for REITs. 10

15 "BUDGET 2014: A Game Changer for REITs?" Budget ("Budget") has introduced tax incentives for the real estate investment trusts ("REITs") regime, and also providedd for relaxations in foreign direct investment ("FDI") regime. With the tax incentives in place, the Securities and Exchange Board of India ("SEBI") is likely to formally announce the REIT regulations that are currently in draft form. In this hotline, we discuss some of the key changes and its Budget 2014 impact on the real estate sector. For a detailed analysis of the impact of Budget on other aspects as well, please referr to our hotline "India Budget 2014: New Beginnings and New Direction". Changes In relation to REITs 1. Background As a background, the Securities and Exchange Board of India ("SEBI") had released the draft regulations on REITs ("Draft Regulations") for comments on October 10, The Draft Regulations as released are available here. Though the Draft Regulations were received positively, it was imperative that attendant tax and regulatory incentives weree also announced. Now, with the tax incentives announced and effective from October 1, 2014, it seems almost certain that the SEBI will put in place an operating framework for REITs by October Please refer to our article titled "REIT Regime In India: Draft REIT Regulations Introduced" for a detailed analysis of, and our suggestions on, the Draft Regulations. 2. Structure of REIT Before we move on the tax incentives proposed in the Budget, we set out below a quick snapshot of the REIT structure as contemplated under the Draft Regulations. REITs in India are required to be set up as private trusts under the purview of the 11

16 Indian Trusts Act, (i) Parties: The parties in the REIT include the sponsor, the manager, the trustee, the principal valuer and the investors / unit holders. Sponsor sets up the REIT, which is managed by the manager. The trustee holds the property in its name on behalf of the investors. The roles, responsibilities, minimum eligibility criteria and qualification requirements for each of the abovementioned parties are detailed in the Draft Regulations. Sponsors are required to hold a minimum of 15% (25% for the first 3 years) of the total outstanding units of the REIT at all times to demonstrate skin-in-the-game. (ii) Use of SPV: REITs may hold assets directly or through an SPV. All entities in which REITs control majority interest qualify Regulations. as an SPV for the purpose of the Draft (iii) Investment and Listing: Units on a recognized stock exchange. of a REIT are compulsorily required to be listed (iv) Potential income streams: REITs are principally expected to invest in completed assets. Income would consist of rental income, interest income or capital gains arising from sale of real assets / shares of SPV. (v) Distribution: 90% of net distributable income after tax of the REIT is required to be distributed to unit holders within 15 days of declaration. The illustration below gives the typical REIT structure: 12

17 3. Proposed tax regime under the Budget The Finance Bill, 2014 ("Bill") proposes to amend the Income Tax Act ("ITA") to provide for the income tax treatment of REITs. These provisions have been incorporated depending on the stream of income that the REIT is earning and distributing: (i) Units of REIT akin to listed shares - The Bill proposes that when a unit holder disposes off units of a REIT, long term capital gains ("LTCG") (units held for more than 36 months) would be exempt from tax and short term capital gains ("STCG") would be taxed at 15% since units would be treated as listed securities under the ITA. In addition to the above, the Bill has also proposed that securitiess transaction tax is to be payable on transfer of units of a REIT. Analysis Treatment of listed REITs unit akin to listed shares with respect to rates for LTCG and STCG is a major relaxation for the unit holders, and will give a major impetus to the REIT regime. Though the requirement of holding the units for at least 36 months for characterization as long term capital gains, unlike 12 months in case of listed shares, is understandable since REITs are meant to be akin to holding real estate directly which is any ways subject to 36 months holding period, this may be a disincentive to invest in REITs. (ii) Tax treatment of the sponsor - The Bill proposes to make the transfer of shares of the SPV into a REIT in exchange for issue of units of the REIT to the transferor (or the sponsor) exempt from capital gains tax under the ITA. However, although the units of a REIT would be listed on a recognized stock exchange, specific amendments are proposed to exclude units of REITs from the exemption of tax on LTCG / STCG if sold by the sponsor; and the cost of acquisition of the shares of the SPV by the sponsor shalll be deemed to be the cost of acquisition of the units of the REIT in his hands. Analysis Although the Draft Regulations allow REITs to hold real estate assets either directly 13

18 or through an SPV, the tax benefit for a sponsor to set up a REIT has been extended only to cases where real estate assets are held by the REIT through an SPV. This can be a substantial dampener for sponsors looking to set up REITs holding direct assets since transfer of real estate assets instead of an SPV to a REIT may involve a tax leakage. An additional issue that is outstanding is in cases where assets are held in a partnership or a limited liability partnership and on the tax treatment in order to transfer the partnership interest to the REIT. (iii) Income in the nature of interest - The Bill provides for a pass through treatment in respect of any interest income thatt is received by the REIT from an SPV. This will result in the REIT not being subject to any tax in respect of such interest income, whereas the investors will be subject to tax on the same. However, there would be a levy of withholding tax that would be imposed on distribution by the REIT to its unit holder. This withholding tax would be at the rate of 10% if paid to resident unit holders and 5% if paid to non-resident unit holders.1 In case of non-resident unit holders, the 5% tax would be the final tax payable by the non-resident, while in case of residents, they will be subject to tax as per the tax rate applicable to them. Analysis To avail the tax pass through on interest income, the sponsor would have to tradeoff by paying tax on transfer of the SPV / assets. This is so because, (a) the REIT cannot acquire any debt securities without a tax incidence for the sponsor (the exemption is only for shares); and (b) if the monies are raised by REIT from the public, and infused into a newly created SPV by way of debt, which acquires the asset from the sponsor; there is no tax exemption for the sponsor in such case. To that extent, the benefit of this relaxation is highly questionable. iv) Income in the nature of dividend - Where dividends are distributedd by the SPV to the REIT, the existing provision dealing with Dividend Distribution Tax ("DDT") under Section of the ITA would apply and the SPV would face a 15% tax on distribution with no further liability on the REIT as a shareholder. Further, the Bill proposess that any income distributed by the REIT to its unit holder that is not in the nature of interest or capital gains is exempt from income tax. 14

19 Therefore, distributions of dividends received from the SPV by the REIT to the unit holders would be exempt from tax in India. Analysis Though distribution of monies received by the REIT as dividend to the until holders is exempt from tax in the hands of the unit holders, still the applicability of both, the corporate tax and dividend distribution tax, in the hands of SPV makes this route of distribution tax inefficient. Since, unlike listed developers, REITs are mandatorily required to distribute 90% of net distributable income after tax to investors, the applicability of dividend distribution tax is a major dampner. To ensuree real pass through, it would have been better if the government had dispensed with the dividend distribution tax in case of REITs. (v) Income in the nature of business profits/lease rentals/management fee - Chapter XII-FA is proposed to be added to the ITA by which Section 115UA is to be included for dealing with the taxation of income earned by a REIT that is not in the nature of capital gains, interest income or dividend. All such income is proposed to be taxed in the hands of the REIT at the maximum marginal rate i.e. 30% %. Such income, while distributedd by the REIT to the unit holders would be exempt in the hands of the unit holders. Analysis This would apply in a situation where the REIT is holding the assets directly or in situations where.they are charging fees to the SPV. There is no relaxation in such case, as even under the existing tax regime, tax once paid by a trustt would have been exempt in the hands of the unit holders. To ensure true pass through to REIT, the gains should have been tax exempt in the hands of REIT and should have rather been taxed in the hands of the unit holders. (vi) Income in the nature of capital gains - Where the REIT earns income by way of capital gains by sale of shares of the SPV, the REIT would be taxed as per regular rates for capital gains i.e. 20% for LTCG and slab rates for STCG. However, further distribution of such gains by the REIT to the unit holder is proposed to be exempt from tax liability. Analysis Please refer to our analysis in point (v) above. 15

20 Relaxation in the FDI Regime In line with the commitment of the government to have housing for all by 2022, and also to promote the Prime Minister's vision of 'one hundred Smart Cities', the Finance Minister in the Budget has proposed key reforms for foreign investment in the real estate and development sector. 1. Relaxation in minimum area and minimumm capitalization The Finance Minister has proposed to reducee the requirement of minimum project size from 50,000 square metres to 20,000 square metres, and the capitalization requirement (for a wholly owned subsidiary) from USD 10 million to USD 5 million respectively. Analysis Previously, in order to qualify for FDI, the project size had to be a minimum of 50,000 square metres and at least USD 10 million had to be infused for a wholly owned subsidiary. This was a major challenge since in Tier I cities whichh formed a bulk of the demand demography, finding such a large project was difficult, whereas in Tier II and III cities where such projects were available, the demand was not sufficient enough to warrant investor interest. This relaxation has partially addressed the long standing demand of the industry, whichh was expecting a reduction to 10,000 square metres, since even 20,000 square metres could be difficult for some Tier I cities (ex Mumbai). The relaxation is a positive step towards providing impetus to development of smart cities providing habitation for the neo-middle class, as contemplated in the Budget. 2. Promoting affordable housing The Budget has proposed introduction of schemes to incentivizee the development of low cost housing and has also allocated this year a sum of INR 40 billion for National Housing Bank for this purpose. In addition to the above relaxation, to 16

21 further encourage this segment, projects which commit at least 30% of the total project cost for low cost affordable housing have been proposed to be exempted from minimum built-up area and capitalisation requirements under FDI. The Finance Minister has also proposed to include slum development in the statutory list of corporate social responsibility ("CSR") activities. Analysis The INR 40 billion allocated for NHB will increase the flow of cheaper credit for affordable housing to the urban poor and lower income segment. Further, the relaxation of 20,000 square metres requirements in case of projects committing at least 30% project cost to low cost affordable housing, would provide a major fillip to affordable housing projects where the size of the project is less than 20,000 square metres. A critical element however will be the way 'affordable housing' is defined. The Budget does not lay down the criteria for classification of affordable housing. Under external commercial borrowing regulations, the criteria for affordable housing includes units having maximum carpet area of 60 square metres, and cost of such individual units not exceeding INR 30 lakh. The Companies Act, 2013 has introduced CSR provisions whichh are applicable to companies with an annual turnover of INR 10 billion and more, or a net worth of INR 5 billion and more, or a net profit of INR 0.05 billion or more during any financial year. Companies that trigger any of the aforesaid conditions are required to spend least two per cent (2%) of their average net profits made during the three immediately preceding financial years on CSR activities and/or report the reason for spending or non-expenditure. The proposition of the Finance Minister to include slum development in the statutory list of corporate social responsibility activities is quite encouraging, as it not only provides developers an avenue to meet their CSR requirements, but also at the same time could give a huge impetus to this segment. 17

22 CONCLUSION REITs are beneficial not only for the sponsors but also the investors. It provides the sponsor (usually a developer or a private equity fund) an exit opportunity thus giving liquidity and enable them to invest in other projects. At the same time, it provides the investors with an avenue to invest in rental income generating properties in which they would have otherwise not been able to invest, and which is less risky compared to under-construction properties. For a REIT regime to be effectively implemented, complete tax pass through is essential, as is the case in most countries having effective REIT regimes. Though the tax incentives for REITs introduced in the Budget is definitively a positive move, however, the tax incentives only result in partial tax pass through to REIT, at the maximum. It is hoped that the Finance Minister would address the issues as mentioned in this piece going forward and possibly simplify the REIT taxation regime. Before REITs actually takes off, few other changes need to be introduced, especially from securitiess and exchange control laws perspective. Currently, units of a REIT may not even qualify as a 'security'. Since, units of a REIT have to be mandatorily listed, the first step will be to define units of a REIT as a security under the SCRA. The next step will be to amend exchange control regulations to allow foreign investments in units of a REIT. Capital account transaction rules will also need to be amended to exclude REITs from the definition of 'real estate business', as any form of foreign investment is currently not permitted in real estate business. Under current exchange control laws, investment in yield generating assets may qualify as 'real estate business'. The relaxations proposed in the Budget pertaining to affordable housing is a really positive move as there is a major demand for housing in this segment. All in all, the Budget represents the new government' s positive attitude and willingness to follow throughh on its message of growth and development, especially in the real estate sector. 18

23 Real Estate Investmentt Trusts - A Primer REITs Concept and Practice REIT, a collective, pass through investment vehicle which invests in income producing real estate assets on behalf of its unit holders and is typicallyy listed on a Stock Exchange, where the 'Units' are tradeable like any other financial instrument. Defining attributes of a portfolio held by a REIT should be: Ownership: Widely held portfolio with ownership the hands of couple of sponsors/promoters not being concentrated in Asset Class: A real estate asset which is fully developed and operational and does not require any further developmental activity Income Generation: The properties should necessarily be generating income, primarily through lettings Surplus Distribution: Unlike Joint Stock Companies, REITs have to compulsorily distribute substantial proportion of its net surplus from property income in form of dividend REITs system originated in the Unites States (US) in early sixties. However, it gathered momentum as a preferred investment vehicle in last decade as several other nations introduced REITs in their capital markets and customised it to suit their specific market conditions. Since then REITs have consistently outperformed capital market benchmarks. For instance, Australian REIT (A-REITindex between 2010 and Similarly Japan's Nikkei reported annualized returns of -0.5% against 17.5% of J-REIT for the same period. Given the track index witnessed annual return of 10.2% against 8.8% returns on the ASX record of REITs performance in the capital markets, it could turn out to be a game changer for Indian Real Estate investment market, especially in the public Capital Markets. 19

24 REIT SEBI Regulations Given the extreme shortage of institutional risk capital for real estate, especially following the drying up of the IPO market for real estate development companies, theree was a need for a capital market product which can open up a capital market avenue for raising long term capital for real estate sector. Moreover, the reluctance of private equity financing for non-residential real estate projects owing to lack of exit options could have created a shortage of adequate commercial office space in near future, as economic growth is expected to recover. Following its initial attempt at ntroducing a collective Real Estate Investments scheme like Real Estate Mutual Funds (REMFs) in 2008, SEBI came out with Draft regulations for REITs in October 2013 inviting public comments followed by its finalization in August 2014, which although haven't been notified yet. The salient features of the proposed regulations are as follows: Key Parties Asset/Portfolioo Size Sponsor Maximum of three entities the sponsor(s), on a collective basis, have a net worth of not less than one hundred crore rupees; provided that each sponsor has a net worth of not less than twenty crore rupees who may Set(s) up the REIT with a holding not less than 25% of the units of the REIT Trusteee Holds the REIT assets in trust for the benefit of the unit holders Manager Manages REIT's assets and investments, undertaking all operations with respect to activities of REIT Principal Valuer Appointed by manager u/s 247 of the Companies Act 2013, to undertakee independent valuation of the REIT properties for estimating NAV of REIT units INR 500 Crore (reduced from INR 1,000 Crore in draft Size regulations) 20

25 Investment Guidelines Property Ownership Income Distribution Investment in real estate comprising land with attached buildings; excluding TDRs/Mortgages Investment in at least two assets with maximumm 60% of asset value from a single asset At least 80% of asset value to be invested in complete and income generating assets, wherein properties having received occupancy certificate to be treated as completee with 75% area let out Ownership may be Direct or through SPVs, which need to have at least 80% direct ownership of underlying asset with REIT owning not less than 50% of the said SPVs Minimumm 90% of the net distributable surplus of the REIT to be distributed amongst the unit holders at least twice a year Leverage and Liabilities IPO and Listing Consolidated borrowings and deferred payments not to exceed 49% of the value of underlying REIT assets, with credit rating required for any borrowings above 25% of the asset value IPO within 18 months of registration of REOT with SEBI and a minimum public float of 25% with subscription of at least 75% of IPO for successful listing Roadblocks to Realisation of REITs Taxation Structure: Taxation regime applicable for REITs has been spelt out only recently through the Budget Speech of the Finance Minister in July Therein two key pronouncements have been made relating to Capital Gains Tax and Dividend Distribution Tax (DDT). According to this, the levying of Capital Gains Tax on transfer of ownership interestt in an SPV to REIT shall ONLY be deferred tilll the time the sponsor divests the units of the REIT. Industry is seeking a one-time exemption on this incidence of Capital Gains, citing instances in more successful REIT markets like US and Singapore. 21

26 In addition to the Capital Gains, incidencee of DDT, especially through a SPV structure, is likely to addd to the tax burden of REITs in India, as the pass through is applicable only on dividend being distributed by REIT to the unitholders, whereas the dividend payable by SPV to REIT shall be subject to DDT. This seems to be similar to the existing taxation structure, wherein the DDT paid at SPV level is any case set off at the parent level. In orderr to make REIT tax efficient, industry is seeking complete exemption from DDT payable by the SPV to REIT which owns the underlying properties. Given the current taxation regime of 5-10% Withholding tax on distribution of interest income (for NRI and Residents respectively) to units by REIT against the DDT impact of 20% at SPV level, the tax regime tends to favour investment in form of debt by REIT in the SPV holding the underlying asset Valuation framework for Indian REITs: Unlike other established REIT markets like US, Singapore or Australia, India did not have a robust Investment Sales market for operational/stabilized rent yielding assets, at least in the institutional investment market. The market for rent yielding assets had been generally dominated by strata sale of commercial office buildings to individual investors. This resulted in lack of transparent dissemination of acceptable market yields and consequent cap rates that could be objectively applied to arrive at market value of these assets. Secondly, India lacks presence of quasi regulatory industry bodies of professionals like RICS, HKIS, AIA etc, which issues valuation standards and govern the conduct of its members towards undertaking valuation assignments. Under the current set of guidelines, the audit committeee or the board is entrusted the responsibility of appointing a valuer with 'adequate experience and expertise'. This may expose potential REITs to Corporate Governance issues in absence of a robust code for principal valuers to undertake valuation of REIT assets, as these valuations would require a comprehensivee understanding of physical as well as economic/financial imperatives of underlying real assets to arrive at their market values. Availability of REITable Assets: Industry experts indicate thatt income yielding investable assets amenable for acquisition or ownership by REIT is in the order 22

27 of 100 million sq ft. Moreover, given the current financial situation of most of the real estate developers, a stabilized and mature rent yielding property tends to give much needed operational cash flow, thereby increasing the barrier towards its divestmentt through REITs. This makes the asset availability for REITs fairly restrictive, at least in short term. 23

28 Benefits of REITS & Its Impact on Real Estate Market What are REITs? Just like mutual funds, REITs willl pool money from investors and invest them in income-generating (rental assets) offering them a way to diversify their portfolios by nvesting in property. After collecting money, REITs will issue units to investors, which will then be listed on exchange for buying and selling. This will be most attractive for risk-averse investors as it will fetch them dual benefits of yield as well as capital appreciation. Key Benefits Portfolio Diversification: REITs will provide small investors and institutions an opportunity to have exposure in large scale commercial real estate, whichh would have otherwisee been only possible for HNIs and wealthy individuals. A compulsory dividend payout (>90% ) makes the underlying asset similar to a fixed income instrument along with a growth component built-in through price appreciation. Liquidity and cost of capital benefits: The decision to allow listing of REITs in India as an investment product will boost the liquidity situation of cash-starved activities. For developers, which are struggling to find funds for their construction one, developers are excited to reduce their high debt levels and lower their cost of capital. Tax Benefits Tax concessions ensure that dividend payouts are healthy and less impacted by changes in central tax laws. Improved transparency and Information Symmetry: REITs improve transparency in the real estate markets as information is periodically disclosed on average rents, occupancy levels, etc thereby reducing volatility in the market. Moreover, availability of such information reduces information asymmetry, which is typically seen in real estate markets and is a key reason for volatility. 24

29 Nature of instrument Due to the underlying cash flow stability (recurring annual rental income) of the asset, and predictability of dividends (compulsory distribution), REITs are commonly viewed as a yield instrument. They typically tend to have a high correlation to bond yields. Thus, in a softening interest rate environment, cap rates will fall (assuming spreads remain same). In most cases, REITs trade at a positive spread over bond yields to account for market risks and individual property riskss such as local market demand-supply, vacancies, tenancy risk, gearing risk, etc. The key basic Indian REIT structure is broadly in line with REIT legislations in Asia, especially on limits on gearing (currently set at 50 percent), payouts (90 percent), and investmentt in real estate (80 percent). Investment in foreign assets is not allowed. The Future The office sector appears to be a silver lining for real estate developers given its declining vacancy levels and improving rents. Softening yields and increasing exit options (such as CMBS, potential REITs) are likely to positively impact cap rates and improve asset valuations. Large developers continue to be burdened with debt in their balance sheet and a weak cashflow generationn profile, which is likely to make them closely pursue equity options (including REIT). As residential markets remain sluggish due to inventory overhang, and weak sales, REIT listings can offer a potentially attractive exit option to such developers to improve their balance sheets. 25

30 Guiness Corporate Advisors Pvt. Ltd. Major Offices Mumbai P.J.Towers, Room No. 216, 2nd Floor, Dalal Street, Fort, Mumbai Jaipur 2nd floor, Room No.201 A, Shyam Anukampa, 0 11 Ashok Marg, C Scheme, Jaipur Kolkata GUINESS HOUSE. 18, Deshapriya Park Road, Kolkata Amritsar Sco No.36, District Shopping Complex, Ranjit Avenue B Block Market, Amritsar Delhi B 41A,1st Floor, Main Road, Kalkaji Nehru Place, New Dehli Ahmedabad 201 Subh Complex, Near Jain Dairy, Swastik Cross Road, off C G Road, Navrangpura, Ahmedabad

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32 DE S I GNE DB YGUI NE S SI T&I T es