Trick or REITs!!

Introduction

When we talk about portfolio diversification, we often talk about assets like equity, gold, bonds, and real estate, and we often assume that the person can easily diversify his or her portfolio. The problem here is real estate investment requires a large outlay of cash, and it's not easy to add it to your portfolio. Well, not anymore thanks to REITs (or Real Estate Investment Trusts), wherein you can invest as little as 5,000 rupees and gain exposure to the best-in-class commercial real estate in India.

What are REITs?

Conceptually, a REIT (or a Real Estate Investment Trust) is very similar to a mutual fund. If you understand how a mutual fund is structured, then understanding a REIT is quite simple. In a mutual fund, the AMC collects the funds from retail investors, pools that money, and the pooled money forms a large corpus, which is then invested in the market. Which stocks to invest in, when to invest, and when to exit is a call that the fund manager and the Chief Investment Officer of the AMC make. Likewise, in a REIT, a trust entity is formed, it then solicits investments from retail investors, pools all that money, and then the money is invested in large commercial real estate. In mutual funds, the underlying assets are stocks for equity mutual funds, bonds for a debt mutual fund, and likewise in REITs, the underlying is commercial real estate. Real estate can be in the form of shopping malls, hospitals, large IT offices, or commercial buildings.

The Major players in the Indian REIT market are namely Nexus Select Trust, Mindspace Business Parks, Embassy Office Parks, Brookfield India Real Estate Trust.

Why do we invest in Real Estate/REIT?

Now think about real estate investments for a moment. Why would you, as an investor, want to invest in real estate? Well, you do that for two reasons.

• One, you want to benefit from capital appreciation, wherein the value of your investment increases over time.

• Two, you want to benefit from rental income.

Well, this is exactly what happens in a REIT.

Against your investment, you get REIT units, just like the mutual fund units. The REIT unit or the NAV (Net Asset Value; the REIT’s NAV represents the market value of its properties minus any liabilities or debts that the trust carries.) of the REIT increases over time as and when the underlying commercial real estate value increases, plus you're also entitled to get the regular rental income against the REIT units that you hold. Think of it as the dividend that you get for the stocks that you hold. By regulation, the REIT entity is supposed to pay out rental income to you at least twice a year, so that's the least minimum you can expect if you hold a REIT unit. In a nutshell, a REIT is a pass-through structure wherein your funds are invested across real estate properties, and you get to enjoy the rental income and the capital appreciation on the properties without the hassle of dealing with actual property transactions.

Why investing in REITs is easier than Real Estate?

It is because you don't have to worry about the paperwork, you don't have to worry about building maintenance, you don't have to worry about negotiating with your tenants for rental income, or in the case that your tenant vacates, you don't have to look around for new tenants. All that headache is outsourced to a REIT entity, and you, as a REIT investor, get to enjoy just the benefits of real estate investment. Another good thing to note here is that by regulation, a REIT entity is supposed to invest 80% of the funds in completed real estate properties only. That means to say that the funds that you invest will not get sucked into the construction of a building. Now, all these things that we just discussed are the easy things to understand about REITs. The real question to ask is: how do you actually analyze a REIT fund?

How to analyze a REIT fund?

A few years ago, there was just one REIT listed on the Indian exchange. Today, there are four. With the boom in the commercial real estate space in India, you can expect many more going forward. In a sense, analyzing a REIT fund is very similar to how you would analyze a debt mutual fund. In a debt mutual fund, you need to dig into the portfolio of the fund. Likewise, in a REIT, you should always start with analyzing the portfolio. Why is that? Well, you need to ensure, as an investor in a REIT entity, that your funds are being invested in good quality commercial real estate.

Step 1 - Evaluate the Portfolio 

You need to evaluate the portfolio, in particular, you need to see what type of real estate the company is investing in and what is the geographic spread.

The next thing to figure out is what kind of properties they're investing in. (Note that there are REITs which have a much more diverse portfolio. They have exposure to hospitals, shopping malls, commercial buildings, IT offices, etc.) If you like diversification, then you can consider a REIT which has a diverse portfolio.

Also, it is also important to pay attention to who the clients are. This will give you a sense of stability in rental income. The idea is to figure out if the REIT is dependent on just one or two clients for a large portion of the rental income. If that is the case, then that's not a good sign. Also, the geographic spread is super important here. You need to ensure that the REIT is making investments in cities and towns where the ease of business is very high. There should not be geographic concentration risk. The cities that they're investing in should not be caught in political limbo, rampant corruption, and minimal progress.

Step 2 - Evaluate the Financials 

In the second step, we evaluate the financials of the REIT. There are three particular things that you need to look for: the revenues (which also makes up the rental income), the net property income, and the attributable share price per unit holder. Revenues largely include the rental income, but sometimes revenues can also include revenue from maintenance services.

Step 3 - Evaluate the Debt Position 

Investing in large commercial space requires a large outlay of cash, so it is inevitable that a REIT borrows funds. Borrowing is fine as long as they can service it and manage it properly. Hence, evaluating the debt position of a REIT is extremely crucial.

Step 4 - Occupancy & Tenant Lease Arrangements 

Step four is looking at occupancy and the tenant lease arrangements. This is straightforward: the higher the occupancy rate, the more stable your rental income. A declining occupancy rate is not a great sign for two particular reasons: one, you don't have sticky customers, and therefore they're not renewing the lease; two, maybe there are better alternatives in the market, maybe more attractive properties. You need to look at the occupancy rate not just on a year-on-year basis but also the historical trend.

Next up, you need to see the average tenure of the lease agreements. In the REIT world, this is called the weighted average lease expiry. The WALE (Weighted Average Lease Expiry) profile of a REIT gives you a sense of how and when the lease agreements are up for renewal. Simply said, the WALE calculates the time left for the asset, the property, to go vacant. So, the higher the WALE, the better it is. A shorter WALE means that the renewals are more frequent, which also further implies that the REIT company is in a position to negotiate higher rentals. But it also means there is more volatility in rental cash flows. Longer WALE numbers imply that the rental income is stable, but perhaps the rental income may not have the kind of increment that you would desire.

Lastly, when it comes to tenants and occupancy details, do look at the tenant retention. The higher the retention, the better, as it provides stability in rental incomes.

Step 5 - Valuation of the REITs 

Here we look at the valuation of a REIT. Under valuation, we look at four parameters: fair value of NAV, price-to-book ratio, dividend yield, and the price movement of the NAV.

1. The fair value of NAV is based on the company's assessment of all the assets it holds. The fair value gives you a sense of how the company perceives its assets and the value it attributes to the real estate assets that it holds on its books.

2. Next up, you can look at the price-to-book of a REIT. You can calculate the price-to-book value of a REIT by dividing the current market price by the book value. The current market price can be fetched from the exchanges, and the book value from the P&L.

3. Next, you need to look at the dividend yield. To calculate the dividend yield, you need to divide the distribution per unit or the DPU by the current market price. Now you need to compare the dividend yield with the risk-free rate in the economy. You can consider a simple bank FD as a proxy for the risk-free rate. It is a good thing if the dividend yield is higher than the risk-free rate in the economy. A good dividend yield, plus a good capital appreciation, makes up for a good investment in a REIT.

4. The last aspect you need to look for in a REIT is the price movement of the NAV. You can apply your standard technical analysis here and evaluate things like support and resistance. It makes sense to buy the REIT when the REIT price is closer to the support value.