Why invest in REITs? Karan Bhagat of 360 ONE outlines four compelling reasons

KV Prasad Jun 13, 2022, 06:35 AM IST (Published)

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Karan Bhagat, Founder, MD & CEO of 360 ONE, says many of their high-net-worth clients typically allocate 50 to 60% of their portfolios to stocks, with another 30 to 40% dedicated to fixed-income investments.

Within this fixed-income category, real estate investment trusts (REITs) are considered a viable option, accounting for 15 to 20% of the fixed-income portion.

Consequently, REITs generally make up about 5 to 10% of the total portfolio for most clients.

Currently, with only four listed REITs in the country, Bhagat expects this allocation to potentially increase from 5% to 10% as the sector expands

Q: REITs are a newer asset class. How do you see its potential and how do you feature this in a diversified portfolio? What are your thoughts on that?

A: REITs are a very interesting asset class especially from a portfolio allocation perspective. Given the change in debt taxation in the last budget, REITs have become especially attractive. All fixed-income mutual funds are now taxed at marginal tax rates. REITs, however, continue to have slightly preferred tax, because the tax has already played in the special purpose vehicle before getting distributed to the clients. So if you compare it to the 10-Year G Sec, today, REITs are giving us about 5.8 to 5.9% on a post-tax basis.

So a client, effectively, is getting four things. One, he is getting a 5.8-5.9% on a post-tax basis. Second, he is able to allocate and take advantage of the capital appreciation in commercial real estate over the next 10 to 15 years. Thirdly, he can take advantage of the increase in rental over the next 5, 10, 15 years. And lastly, take benefit of the fact that there is a multiple set of properties rolled into one, and as occupancy increases from the current yields of 80 to 83% to 100% that benefit would also flow into the REIT.

So overall, I think the 5.8% to 6% can move towards the 9% to 10%. It’s nowhere close to equity alternative. It does not substitute equity in a client’s portfolio. But some very interesting part of his fixed income portfolio, which can potentially give 8 to 10% post-tax over the next three to five years.

Q: If you really compare this with investment in other property asset classes, like a real estate company stock, or a property investment, how do you rate REIT vis-a-vis them?

A: So maybe I will correct myself a little bit, I don’t think it can be compared to equity so I think the risk-reward is really very different. Because a REIT by definition has a yield distribution of approximately on pre-tax 7.15-7.50%. Obviously, when you buy a stock, you’re subject to slightly much more volatility and you are seeking higher returns from a growth perspective. So from a risk REIT, I wouldn’t compare it to stocks.

But overall, I think both have their place in the portfolio. Most of our high net worth clients today would have 50 to 60% of their portfolio in stocks, and still would have about 30 to 40% of the portfolio on the fixed income side, within the fixed income side of 30 to 40% REITs offer a serious alternative to be around 15 20% of that 40%. So effectively for most clients today, REITs would make up close to 5 to 10% of their portfolio. We only have four listed REITs in the country but as the sector becomes deeper and wider, I think this allocation would move from 5% to 10%.

Q: How do you see the potential going forward for this particular asset class? You said it’s only 5% to 10% and obviously it is only in the commercial real estate segment. We haven’t even touched on the residential side and other subsets of real estate which are really growing in a meaningful way. How do you see the potential going forward and your company also has a licence for REIT, what are your plans for that, given the potential outlook that you have?

A: Overall, the potential for REITs as a broad asset class continues to be fairly large. I think globally apart from having REITs on the commercial side, even residential housing REITs are very popular and extremely large. Apart from that you have got co-living REITs, you have got hostel REITs and so on and so forth. I think generally speaking in India, residential real estate prices have always been slightly on the higher side for the right set of reasons and therefore the yields on residential apartments continue to be lower at 4 or 5% as compared to commercial at 7 to 8%.

Once kind of, there is a little bit of more stability in the rental yields on the residential side, you will see some of them converting into REITs. I think it’s not a question of if, it’s a question of when. So eventually it will happen. Whether it happens over the next 12 to 18 months or the next 24 to 36 months is something which time will tell. But overall, I think REITs will grow across all of these spaces, whether it’s senior living, hostel living, co-living, commercial REITs, or even residential REITs.

Commercial REITs obviously are the easiest to understand and now we have got also mall REITs, which is listed which is Nexus. So I think across these six broad strategies, you will see enough increase in the depth and the width of the market over the next three to five years. On our own side, I think we have got our own REIT licence we have approximately 12 to 15 months to still decide whether we launch our own REIT or not. So we are still forming our plans there, early days, but over the next three to six months, we like the space. If we find ourselves having a sweet spot or a unique opportunity to develop our own REITs, we will definitely look at it.

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Q: In terms of the suggestions how this can become a more attractive asset class, what would you say? Because on the tax side, it is attractive, but more can be done there. Even equity classification is what the industry is lobbying for any suggestions that you have?

A: Overall tax has come out well, I think both the regulator, the ministry, as well as the tax department have done a good job. I think it’s going to pass through. So the taxes rightfully paid in the special purpose vehicle at the recipient’s level, it is exempted from tax. So honestly, I think from a tax perspective, a lot has been done. Obviously more can be done. But a lot has been done. So I am quite comfortable there.

One pending demand was really the SEZs regulation being modified, which too has kind of come in some format or the other over the last two and a half, three months. So I think the utilisation of the REITs definitely has moved up from the current 80 to 83% closer to the 90-95% which will also help the REITs. Finally, maybe both classification as equity and also more importantly, the REITs trade in larger lot sizes, if they can be traded in smaller lot sizes, especially the larger ones, I think it will allow a greater pool of people to access the REITs.

Q: What’s your view on the market in the near term? Some of the big events happening in election season, interest rate cut, expected geopolitics, how do you see all this really impacting our markets in the near term?

A: We can’t escape from the fact that the markets are slightly expensive on the valuation side, I think if you look at price to book, historical multiples for the last 10 years, 15-20 years, we are closer to towards the 3.5 to 3.7 times as compared to the long term average of closer to the 3 to 3.2 times. So we are definitely a one, one and a half standard deviation away from the long-term averages.

Having said that, I think generally speaking, if I look at the largecap and the large midcap space, which broadly would include the top, maybe 300 to 400 stocks, as well as some midcap stocks, which have large institutional ownership, I think these two categories may correct a bit, but they definitely are not going to correct in such a meaningful way that you have an opportunity to get out of equities and get in again.

I think broadly FII investors across the world over the last 24 months have under allocated to India, and especially these two segments, if the markets correct, will get a huge amount of investor appetite from these set of investors. So for these set of stocks, I wouldn’t really worry I would stay invested. There will be a little bit of volatility, a little bit of shocks, which event will cause it, we really don’t know, but I think I would kind of hang in there.

On the midcap side and the smallcap side, there are again very stock-specific but there are excesses there. And that’s where it would be a little bit wary. And if there’s a deep correction in the market, some of those stocks could potentially correct 15 to 40% and therefore we need to be very, very careful on which small midcap and smallcap stocks we own. But outside of that from a five-year perspective, the markets continue to look constructive.

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KV Prasad Journo follow politics, process in Parliament and US Congress. Former Congressional APSA-Fulbright Fellow