Final Regulations Indian REIT

SEBI announced India Real Estate Investment Trust Regulations, 2014. It has made key changes in terms of investment required in completed assets, minimum size of REIT, limit on number of sponsors, and minimum number of assets requirement, in-line with the announcement in Aug’14

Key changes announced in final regulations vs. draft regulations are on minimum asset value of REIT (Rs 5bn vis a vis Rs 10bn in draft), minimum project requirement (atleast 2 projects vs. 1 in draft), limit on number of sponsors (3 sponsors vs. no cap in draft) and value required in completed projects (80% vs. 90% in draft). In addition REITs will be required to make 90% of net distributable profits on a half yearly basis.

Special purpose vehicle is defined as corporate or LLP: a) in which the REIT holds or proposes to hold controlling interest and not less than 50% of the equity share capital or interest; b) which holds not less than 80% of its assets directly in properties and does not invest in other SPVs; and c) which is not engaged in any activity other than holding and developing property. In the SPV no other shareholder/partner shall have any rights that prevent the compliance from REIT regulations. In addition SPV is required to distribute not less than 90% of distributable cash flows. There is no borrowing limit at SPV level.

While REITs have been given a pass-through status, taxes (corporate and dividend distribution) will be applicable at the SPVs controlled by REITs. In a scenario of all equity REIT investment in SPV, limited benefit of tax pass through will be available to investors as all taxes will be applicable at the SPV level. A structured investment in SPVs (Debt/Equity mix) will improve return profile by 80bps. However the yield profile is likely to be below 10 year Gsec for both domestic and foreign investors.

Key monitorable remains the expectations gap between sponsors and investors. While sponsors look to factor in the benefits of capital appreciation in the valuation of assets, investors are still skeptical on building in significant capital appreciation and would keep appreciation as option value for their investments. Lower interest rate scenario is necessary to bridge the gap.

While SEBI has largely addressed regulatory issues, certain tax related issues still need to be clarified by Ministry of Finance inorder to improve viability of REITs in India. MAT arising on revaluation during swap of units and SPV shareholding will lead to cash flow mismatch for sponsors (while actual capital gains matches realisation). In addition capital gains tax imposed on sale of assets by REITs (vs internationally exempted if gains distributed) will lead to a listing discount on NAV. Any clarity on these aspects will improve attractiveness of I-REITs for both sponsors and investors.

Inventory pile-up continues at NCR / Mumbai

The inventory buildup is continuing as evidenced by low absorption rates; and there is a deterioration in the mid- to high-end segment with inventory months of 48 (36 in FY13). NCR and Mumbai stand out with
average inventory months of 56 for unit sizes of >INR 3 Crore. NCR and Mumbai have 45-50 months of
unsold stock. This is mainly due to lower absorption rates and higher project launches in the past two years. For Bengaluru, inventory months are not as high as those at NCR and Mumbai, but they are still much higher than the historical average.

In some segments (at current offtake rates), we believe it may take as much as >5 years to offload the current unsold inventory. Most real-estate developers have a large portion of their portfolio in these segments, implying their absorption/operational data is unlikely to improve until they cut prices and / or launch projects in the mid-end segment

The sector’s contingent liabilities now total 43% of net worth, vs 22% in FY09. Also, gearing (including off-balance sheet risks) has increased in the past five years. We believe the increase in contingent liabilities for some companies can be justified by the potential increase in revenue (SOBHA Developers), but for others it should continue to weigh high in the daily operation of the company.

For now, we do not expect REIT listing to be a big game changer, as clarity on regulations and unattractive yields could dampen investor appetite. Also, the proposed real estate regulatory bill could further elongate the execution cycle, leading to lower ROEs and stretched cashflows.

Residential Demand Weak - No Acche Din Yet

Residential prices have been increasing despite weak volumes over the past 3-4 years. However, now different data points are suggesting some decline in prices in a few areas. At least the sharp price rise has moderated over the past few months. In key cities, the residential prices grew 7% YoY in 1QFY15 – deceleration from 12%-16% YoY increase seen over 2QFY12 - 4QFY13. NHB Residex for 4QFY14 shows significant deceleration in prices with 13 cities (out of 26) showing YoY decline in prices and average (unweighted) price increase of just 0.3% YoY across 26 cities

Residential absorption (area sold) in key cities of India fell 44%YoY/ 13%QoQ in 1QFY15 (Prop Equity
data). The pace of demand destruction has continued unabated. Residential absorption fell 27% YoY in FY14 with 0%/ 25%/ 36%/ 45%YoY decline in absorption in 1Q/ 2Q/ 3Q/ 4QFY14. All these data point to very weak demand environment and it appears that up-tick in GDP growth in 1QFY15 has not impacted demand yet

Commercial absorption in key cities fell 19%YoY/ 29% QoQ in 1QFY15 on an already weak base of FY13 / FY14 which had a decline of 16%YoY/ 12%YoY. High inventory (~60 months of available supply) has kept rentals in check. Rentals are flat to down (~-2%) YoY despite continuing high inflation.

FSI increase in suburban Mumbai

In a major policy move, the Maharashtra government has allowed an increase in Floor Space Index (FSI) from 1 to 3x in suburban township projects. Under this policy, if developers construct affordable housing stock of 0.75x FSI and hand it over to the government, they can avail of higher FSI on their plots. The move is aimed at improving the affordability of suburban residential development and the low cost housing stock with the government. The policy, in our view, is a major positive for suburban township developers in Mumbai like IBREL/ HDIL that have large land parcels for township development in the suburbs.

IBREL (+20msf) / HDIL (50msf) and Godrej (4 msf) have large suburban township projects in Panvel and Virar regions and hence stand to benefit in the longer term from this policy. The additional FSI comes in lieu of additional construction done for providing housing stock to the government and as such is not free. Nonetheless, it still is accretive for value on a marginal cost basis. FSI increase additionally should keep longer term price inflation in check in these areas allowing for more sustainable demand.

As with other major cities in India, Mumbai’s population growth is now concentrated in the suburbs. As per the last census (2011), population growth over a 10-year period in suburbs like Navi Mumbai (+56%), Virar (221%), Panvel (113%), and Thane (44%) have outgrown the city center (-5%) or main city (only 5%) growth.

FSI levels (1-2x) in most Indian cities are way below most global city standards despite each individual city (NCR/ Mumbai 20MM+) having populations to rival small countries. FSI increase, in our view, is the only possible way to reduce pressure on land & infrastructure rollout costs. Some cities have at the margin started to increase such levels (i.e., Noida, and now Mumbai) but this still is yet to become a more generalized trend across major cities.

REIT Regulations in India for Dummies

SEBI has approved the SEBI (Real Estate Investments Trusts) Regulations. In its Finance Bill 2014,
the Government cleared a majority of tax regulations for the eventual listing of the REITs in India.
SEBI is yet to release a detailed notification, which is expected in the next two months. Most
regulations from the proposed draft (REIT regulations 2013) were passed, with a few relaxations.

• 80% should be invested in rent yielding projects versus 90% mentioned in the drafts
• Value of the REIT for an IPO has been reduced to Rs 5 bn from Rs 10 bn.
• Multiple sponsors are permitted with a maximum of three.
• Borrowings shall not exceed 49% of the value of the REIT assets, versus 50% in the draft
• Minimum size of the IPO shall be 25% of post issue share capital or `2.5 bn whichever is higher,
  versus Rs 2.5 bn in the draft
• REIT shall have at least two assets with a maximum 60% investment in one asset; versus REIT can invest 100% in one asset.

We await clarity from detailed notifications over the next one-two months. The Finance Act 2014
has already specified tax related incentives proposed by the Government. We wait further/changes
if any in the tax structure for the eventual listing of REIT instruments.

#NaMo Government Pushed for Affordable Housing

Under the directions from Finance Ministry, the RBI, in a notification today, eased credit availability for the affordable housing sector in India. We believe the central bank’s fresh measures will enhance availability of funds to the sector, while not having material impact on affordability. The above measures along with key
announcements in Budget 2015 highlight the government’s intent to give impetus to the real estate sector.

Banks can issue long-term bonds with a minimum maturity of seven years to raise resources for lending to affordable housing (defined as housing loans eligible under priority sector lending by RBI and also housing loans to individuals upto INR5mn for property valued up to INR6.5mn in Mumbai (clarity awaited whether intent is Greater Mumbai or MMR), New Delhi, Chennai, Kolkata, Bengaluru and Hyderabad, and INR4mn for property valued up to INR5mn in other cities.

The above measures will enhance availability of funds to the affordable housing sector. The measures will not significantly impact interest rates and accordingly affordability, as current home loan rates (~10.25%) are already near base rates (10%) but in the Medium Term will help Small & Genuine Home BUYERS across India as Interest Rates Will begin to Fall in the next 24 months.

Residential Demand / Launches Dull - Price Stable

Residential absorption (area sold) in key cities of India fell 31%YoY/ 51%YoY in FY14/ 4QFY14 (Prop Equity data). The pace of demand destruction has accelerated through FY14 with 3%/ 27%/ 39% 51%YoY decline in absorption in 1Q/ 2Q/ 3Q/ 4QFY14. Absorption fell 19%QoQ in 4QFY14. Though the monthly numbers are volatile, April 2014 (1MFY15) saw an absorption decline of 53%YoY in key cities tracked. All these data point to sharp deterioration in residential demand due to ongoing economic slowdown and stubbornly high prices.

 Residential Property Prices in India have been increasing despite weak volumes over the past 3-4 years. However, now different data points are suggesting some decline in prices in a few areas. At least the sharp price rises have moderated over the past few months.

REIT in India Could be Simple With Taxation / Rules

The very act of setting up a REIT requires a sponsor to contribute assets (either directly to the REIT or shares of an SPV that owns immovable property into the REIT). Any such contribution, under the current law, will mean a capital gains tax incidence of at least 20% on the difference in value between the holding cost and the transacted fair market value in terms of contribution to the REIT. The industry has lobbied hard to the Finance Ministry that such a tax incidence on contribution will be a non-starter, as it would entail a 20% outflow in order to do an IPO and a liquidity element of at least 20% will be required just to pay taxes. Experts on our call opined that the Finance Ministry is coming around to the view that the contribution of assets or contribution of SPV shares into a REIT should be treated as restructuring and hence, should be tax exempt.

Secondly, any income generated at the SPV level or property income at a trust level is subject to corporate tax and a dividend distribution tax in order to upstream income and be distributable to unitholders.
The industry is seeking a zero-tax regime on the grounds that: (a) income stands distributed to unitholders and unitholders, depending on their character, may or may not be taxed; and (b) being a new investment product, the REIT, as an investment instrument, needs a fiscal impetus. Whilst zero-taxation is the ask, our
experts felt that the Finance Ministry may agree to a single point of taxation but it may not be in a position to provide complete exemption.

Whilst these tax concessions impose a minimal cost on the exchequer, our experts opined that the benefits to the Government and the economy, in the form of foreign inflows, comfortably outweigh the implicit costs. REITs will not only attract foreign inflows that positively impact the economy’s current account deficit but also channel household savings towards investment in REITs (as against the current habit of Black Money Investment in Physical Gold and Real Estate Assets)