Ratings REIT and InvIT A primer August 2016
Ratings 1. What are REITs and InvITs? REITs & Indicative structure 75% 25% Investors Sponsor Asset management fee Trustee REIT or InvIT Investment manager >50% >50% Property or project manager SPV1 SPV2 Asset Asset Asset Sponsor holding mentioned above refers to minimum holding required over the first three years, as per existing guidelines The Securities and Exchange Board of India (SEBI) notified regulations for investment trusts specifically, real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) in September 2014. An investment trust is a vehicle created to primarily invest in revenue-generating real estate or infrastructure assets. These entities are trusts by definition, and their units (shares) are to be mandatorily listed on exchanges and regulated by SEBI. The units are traded based on their net asset value. These entities have a pass-through structure and are therefore required to distribute majority of their earnings to unit holders. Globally, these are positioned as high-dividend-paying investments suitable for investors looking for long-term, stable cash flow with moderate capital appreciation. 2. Key benefits to the sponsor Monetise revenue-generating real estate and infrastructure assets Lower the cost of capital by tapping the right set of long-term investors (pension funds) Enjoy favourable tax treatment, including exemption from dividend distribution tax and relaxation of capital gains tax Have diverse sources of funding Once listed, provide regular source of capital to the sector 2
3. Key benefits to the unit holder Invest in real estate or infrastructure without actually owning the asset Benefit from favourable tax norms (tax-exempt dividend income; no capital gains tax if units are held for more than three years and sold through stock exchange; and withholding tax at 5% for interest income to non-residential unit holders ) 4. Salient features of SEBI regulations on investment trust Structure of investment trust Sponsor to hold not less than 25% of the total units of the investment trust after initial offer, on a postissue basis, for at least three years from the date of listing of such units (unless such holding is 1 disallowed by government or regulatory provisions) Investment trusts to invest not less than 80% of the value in completed and revenue-generating projects, and not more than 10% in under-construction projects. Units of InvITs investing more than 2 10% in under-construction projects to be privately placed Investment trusts to hold assets either directly or through special purpose vehicles (SPV) Investment trusts to hold controlling interest and not less than 50% equity share capital or interest in the SPVs (except in the case of public private partnership projects where such holding is disallowed by the government or regulatory provisions) SPVs to hold not less than 80% of assets (90% in case of InvITs) directly in properties (infrastructure 3 projects for InvITs) and not invest in other SPVs SPVs to not engage in any activity other than those pertaining and incidental to the underlying projects Stipulations to ensure transparency Trustee to hold assets for the benefit of unit holders, oversee activities, and ensure compliance with respect to reporting and disclosure requirements A full valuation to be conducted by an independent valuer at least once every year All related-party transactions to be on an arm s-length basis Distribution requirements Not less than 90% of net distributable cash flow of the SPV to be disbursed to the investment trust in proportion to its holding in the SPV subject to applicable provisions in the Companies Act, 2013, or the Limited Liability Partnership Act, 2008 Not less than 90% of net distributable cash flow of the investment trust to be distributed to unit holders 1 SEBI vide its discussion paper has sought views for reconsidering the minimum sponsor holding from 25% to10% in case of InvIT 2 SEBI vide its discussion paper has sought views for reconsidering the investment limit in under construction properties for REIT from 10% to 20% 3 SEBI vide its discussion paper has sought views for allowing investments by REIT and InvIT in two-level SPV structures, where the intermediate SPV is a holding company 3
Ratings Such distributions to be declared and made at least once every six months for REITs and publicly listed InvITs If any asset is sold by the investment trust or SPV, it can reinvest the proceeds into another property or infrastructure asset and will not be required to distribute the sale proceeds. However, if no such reinvestment is made, it will be required to distribute not less than 90% of the sales proceeds Leverage restrictions The aggregate consolidated borrowing and deferred payment of the investment trust net of cash and cash equivalents should never exceed 49% of the value of the investment trust assets If the aggregate consolidated borrowing and deferred payment of the investment trust, net of cash and cash equivalents, exceeds 25% of the value of the assets, for any further borrowing, credit rating to be obtained from a registered credit rating agency 5. CRISIL's approach to rating investment trusts A B C D E Rating methodology for investment trust focuses on the following aspects: Quality of asset portfolio : Quality of assets determines the quality of underlying cash flow and is, therefore, the key determinant of the trust s business risk profile. Factors that CRISIL considers for its assessment include: - Analysis of contracts governing future cash flow, tenure of contracts and its permanency, and repricing risk of contracts - Potential for increase in cash flow based on demand-supply situation - Counterparty credit risk that cash flow is exposed to - Diversification benefits emanating from both multiple customers and geography Coverage, leverage and financial flexibility: CRISIL evaluates whether the debt service coverage ratio provided by expected cash flow in relation to the debt obligation over the life of the instrument is commensurate with the rating assigned. A part of the debt raised may rely on refinancing and therefore, the financial flexibility of the entity is also critical. Leverage in case of an investment trust is measured with respect to the market value of its investments and is an indicator of the refinancing ability of the investment trust. Management risk: Experience of trustee and investment manager, and stipulation and efficacy of risk management policies carry significance. 4
6. Frequently asked questions Given that investment trusts have pass-through structures and are being rated for the first time in India, CRISIL has tried to elucidate their nuances here: a b c d How is rating an investment trust different from rating a corporate? The principles of rating debt in investment trusts and in corporates are basically the same. In case of corporates, management has the discretion of reinvesting cash flow. However, in the case of investment trusts, the nature of the product and investor expectation require majority of the cash flow to be distributed. Therefore, quality of assets and cash flow coverage are key drivers of rating an investment trust. Given regulatory oversight of these entities (such as mandatory listing and strict guidelines on distribution of cash flow), transparency and discipline in cash flow as well as investment management are expected to be higher than real estate and infrastructure companies per se, lending a positive credit bias to them. From a rating perspective, is there any difference between REIT and InvIT? No. CRISIL assesses the quality of the assets and cash flow coverage, which are the primary drivers of rating for both. Having said that, real estate assets have a longer life and enjoy a contractual agreement to increase rental rates. With upfront visibility of future increase in rental rates, real estate enjoys an established track record of lending against valuation of the asset. However, in the case of InvIT, the life of the asset is restricted by the concession period and any upfront visibility on the upside to cash flow is relatively limited. Therefore, ability to favourably structure debt at REIT is higher compared with an InvIT. This, in turn, may get reflected in the cash flow coverage. Is rating mandatory for these entities? The regulator has capped the net consolidated debt at 49% of the market value of assets. As per SEBI guidelines, rating is mandatory if the net consolidated debt exceeds 25% of the market value of assets. Given the current debt levels in real estate and infrastructure assets, CRISIL believes almost all investment trusts will probably need to be rated. Even if there is no debt, the trust can seek a 4 corporate credit rating (CCR). Will CRISIL rate units of investment trusts? Units of investment trusts are akin to shares of a company and derive their value from the value of underlying assets. Though these are equity-like, their returns are expected to be stable and benchmarked to debt market instruments. Given that investment trusts are equity-like, CRISIL does not rate the units of investment trusts on a credit rating scale. e Will the investment trusts be rated or the underlying SPV? As debt can be raised by both the investment trust and the SPV, rating can be sought for debt residing in the books of both. SEBI mandates rating of debt if the consolidated net debt exceeds 25% of the market value of assets. 4 CCR reflects the relative degree of strength with respect to honoring debt obligation; refer http://www.crisil.com/ratings/corporate-credit-rating-scale.html 5
Ratings f g h If debt in an SPV needs to be rated, what is the approach that CRISIL follows? CRISIL assesses debt in SPVs based on cash flow coverage in them. CRISIL may also assess the possibility of a notch-up in the rating based on articulated support from, and credit risk profile of, the investment trust. Is it possible for debt at the investment trust to have a different credit risk profile compared with the aggregate credit risk profile of the underlying SPVs? The credit risk profile of the debt in the investment trust may be different from that of the aggregate credit risk profile of the SPVs based on the following: 1 Debt repayment and other safety mechanisms inbuilt in the structure of the debt residing in the investment trust 2 Possible subordination of cash flow from the SPVs 3 Diversification benefits on account of accessing cash flow from multiple SPVs 4 Headroom for additional debt based on the value of assets in the SPVs What are the factors that influence subordination of cash flow from the SPVs to the investment trust? Factors that may typically influence the subordination are as follows: 1 Level of external debt in SPVs 2 Any working capital requirement in SPVs 3 Any ongoing capital expenditure in SPVs 4 Percentage of shareholding held by the investment trust in SPVs i j k How does CRISIL view the presence of a holding company as an intermediate layer while arriving at the rating? In case there is an intermediate holding company between the investment trust and the SPVs, CRISIL evaluates the possibility of cash flow leakage at the intermediate level and thereby its impact on the quality of cash flow at the REIT or InvIT. How does CRISIL factor in the presence of construction loan at an SPV level while rating an investment trust? In case the debt in the SPV is exposed to project execution risk, it will be reflected on the cash flow trickling from SPVs to the REIT. What is the acceptability of the asset class globally and what has been the experience on rating of these entities? REITs and InvITs (commonly known as business trusts elsewhere) have been prevalent in the overseas market, with REITs being more popular. More than 30 countries have REITs, which were introduced in the US in the 1960s. The US currently has over 200 REITs with a market capitalisation of about $1 trillion. Historically, dividend yield of these entities has been around 1% more than the treasury yield. S&P Global Ratings, CRISIL's parent, has a rated portfolio of over 80 REITs, with a median rating of BBB. Its approach to rating these entities is similar to its approach to rating corporates. 6
Analytical Contacts Criteria Contacts Sudip Sural Senior Director Corporate & Infrastructure Ratings Email: sudip.sural@crisil.com Sushmita Majumdar Director Corporate & Infrastructure Ratings Email: Sushmita.Majumdar@crisil.com Manish Gupta Director Corporate & Infrastructure Ratings Email: manish.gupta@crisil.com Pawan Agrawal Chief Analytical Officer CRISIL Ratings Email: pawan.agrawal@crisil.com Somasekhar Vemuri Senior Director Rating Criteria and Product Development Email: somasekhar.vemuri@crisil.com Ramesh Karunakaran Director Rating Criteria and Product Development Email: ramesh.karunakaran@crisil.com In case of any feedback or queries, you may write to us at Criteria.feedback@crisil.com. 7
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