InvITs and REITs: Two Steps Forward, One Step Back
[Varun is a student at University of Petroleum and Energy Studies. The following post was awarded the third-best entry in the IRCCL Blog Writing Competition 2020.]
The 12th and final Five-Year Plan (2012-17) envisaged a new foothold for the Indian Infrastructure sector. Integrated around various developments in the industry over the past two decades, the plan aimed to recalibrate the impending shortfall in infrastructure financing. Whereas various measures had been undertaken to accelerate the growth of infrastructure in India such as the enactment of the Insolvency and Bankruptcy Code, 2016 for a swift resolution of non-performing assets and switching to hybrid-annuity model (HAM) to mitigate the risk for private sector in PPP partnerships, a significant push for this reconditioning came through the introduction of investment trusts exclusively dealing with public funding in these sectors.
The Securities and Exchange Board of India, through a notification dated 26 September 2014, issued the SEBI (Infrastructure Investment Trusts) Regulations 2014 (InvITs) and the SEBI (Real Estate Investment Trusts) Regulations 2014 (REITs). Fundamentally, REITs and InvITs are quite similar to mutual funds given their modus operandi, and they provide for investments in infrastructure and real-estate projects from investors across the entire economic spectrum, especially the investor class that would not be able to invest solely in any of these lucrative and traditionally high-yield instruments. REITs/InvITs are essentially innovative vehicles that allow the unit holder in the case of real estate and developers of infrastructure projects to generate revenue from the commercial property holdings that could be generating either rent for the unit holders or revenue. REITs and InvITs include real-estate ventures, industrial parks, hotels, special economic zones, etc.
Although REITs and InvITs have received widespread acclaim from investors in the US and Canada ever since their inception in the 1960s, they have failed to take off amongst the Indian investor classes and have barely permeated through their investment portfolios. Some of the reasons behind their subpar performance have been their taxation structure and the tax incentives offered, investor mindset, liquidity of the returns offered and their governance among many others. SEBI, in an attempt to clear the regulatory mist surrounding REITs and InvITs, has issued numerous clarifications and circulars, including the recent amendment declassifying the sponsors of REITs/InvITs that have been listed for 3 years and subsequent induction to further allow involvement in listed trusts by new sponsors and subsequent investment opportunities.
Part I of this article discusses the overall functioning and intricacies of REITs and InvITs in India, whereas Part II shall deal with the challenges that have impeded the growth of the REIT/InvIT regime. The author suggests various steps that need to be incorporated in order to enhance their feasibility within the Indian investors' circle.
Deciphering the Indian REIT/InvIT regime
Prima facie, the operational framework of REITs/InvITs features a contemporary shift on real estate and infrastructure financing away from traditional banks and other financial institutions to exclusive venues of financing via these investment trusts. They comprise of various entities such as sponsors, investment manager, project manager, trustees etc. where the sponsor is identical to a promoter of a company.
They are set up under the Indian Trusts Act 1882 by the sponsor, a person who is usually the owner of the asset after making a registration application to SEBI and appointing the trustee who holds the investment assets for the beneficiaries. The trust enters into an investment management agreement with an InvIT project manager who is responsible for supervising the day-to-day operations of the InvIT and remains in control of operation and management until the assets are transferred to the respective InvIT.
A REIT/InvIT can invest through itself. The assets are held via SPVs - an SPV shall be a company or LLP wherein the REIT or InvIT holds at least 50% of equity share capital and such SPV can hold only those assets that are either covered under the InvITs or have been transferred to it after the SPV’s conception. Moreover, in a publicly offered InvIT equity, the asset valuation occurs only once every six months giving the InvIT sponsor/ unit-holder a sufficient stretch to intrinsically evaluate and price the asset.
REITs are required to derive 51% of their revenues from rental and leasing of real-estate assets and shall allocate 90% of their returns barring capital gains as dividends to their shareholders. A 20% valuation cap is emplaced on REIT assets for investing in under-construction properties with a 3-year lock-in period, listed or unlisted companies, mortgage-backed securities, government securities and other money market instruments. Similar to InvITs, the REIT assets worth 80% of valuation are to be invested in other income or revenue-generating real estate assets. REITs/InvITs allow the sponsor to opt for subordinate voting rights, and the regulations also prohibit the InvITs from lending to third parties laying down that InvITs can invest into indexed securities but not to third parties.
InvITs follow a similar investment structure as that of REITs, with a substantial distinction being that they invest in infrastructure projects either directly by themselves or via an SPV established for the PPP undertaking and there is a 10% cap on investing in under-construction projects. In terms of governance, alike REITs, InvIT trustees hold the assets for the beneficiaries and the investment manager is responsible for deciding future investments/divestments in underlying infrastructure projects and assets. The sectors where InvITs are active include energy, telecommunications, logistics, social and community infrastructure, etc. The InvIT model shall provide for revenue and cash flow projections for up to 3 years, along with a 2-year cooling period along with the valuation report that is to be given by an InvIT valuer in the disclosure made to potential investors. Banks are further allowed to check their compliances made in accordance with the Companies Act 2013 every 6 months.
Role of REITs and InvITs in Infrastructure Financing
Both REITs and InvITs were conceptualized with the objective of closing the gap between investors and financing large-scale infrastructure and real estate projects since the latter are capital intensive and entail various debt obligations over their prolonged construction period. These accumulated loan interests can be paid off by the InvIT from the incoming investments. InvITs and REITs allow portfolio diversification for investors looking for stable and consistent returns with minimum risks over a long period of time.
REITs/InvITs as an innovative vehicle have minimized the cumbrous process of shortlisting real estate and provide the potential investors with the best REITs that guarantee maximum returns, and since REITs/InvITs are obligated to return 90% of their returns to the unitholders, they facilitate accrual of fixed income for the investors as well. The impact of project managers and trustees supervising the allocation of InvIT/REIT resources further enhances their transparency and ensures distinctive management of assets.
The REIT/InvIT regime in India has also provided a nascent perspective to private equity investments in infrastructure and real estate since private equity investors would now prefer consistently rewarding real-estate investments, given the direct investments made in real estate have largely plummeted owing to the COVID-19 pandemic.
Accelerating Investments in REITs/InvITs
One consistent issue that has troubled the actively listed REITs/InvITs in India is the lack of investors, albeit the existing security on returns commonly associated with real estate and long-term infrastructure projects. The SEBI regulations introducing REITs/InvITs in India were effected in 2017, three years after their issuance, and since then, only Embassy Office Parks REIT has managed to take off and is the only active REIT in India. Nevertheless, the initial regulations mandated a few conditions that prevented REITs/InvITs from being accessible to ordinary Indian investors and were viewed as instruments exclusively accessible to high-net individuals (HNI’s) and FPIs. Fortunately, multiple amendments in the REIT/InvIT regulations ever since their enactment have eased access for the investors. For instance, the minimum subscription limit was lowered from INR 2,00,000 to INR 50,000. Nonetheless, despite various efforts, REITs/InvITs have met with a few impediments that require immediate attention and possible intervention to strengthen the viability of REITs/InvITs in India.
First, the REITs/InvITs and their assets are subject to multiple risks that are generally associated with the real estate and infrastructure industry. For instance, any regulatory modification in bye-laws or essential compliances can jeopardize the under-construction real estate unit or a long-term infrastructure project, an event that is usually observed in long-term power projects and leads to renegotiation of existing contracts between developers and unitholders. A sudden trigger of the change in law clause in a continuing real estate or infrastructure project can derail the projected returns and the subsequent dividends, a drop in earnings will significantly hinder the short-term sustainability of REIT/InvIT that is likely to distress the investors.
Second, the exorbitant operation and management costs associated with REITs/InvITs assets are prone to inflation caused by unprecedented economic circumstances. There is a persisting possibility that in the event of exceeding prices, that are imperative to be met by the developers to achieve the commercial operations date (COD), the InvIT may have to forego substantial amounts of expected returns and in this process, could risk a cost-overrun resulting in poor returns for the investors.
Third, REIT/InvIT assets, due to their long-term nature, are unlikely to reward the investors in the short term and usually take the prolonged route to start churning lucrative returns for the trusts. This is likely to result in investors falling back to an exit strategy en masse. In order to mitigate such risks, appropriate disclosures to the potential investors are crucial since REITs/InvITs operate in the debt markets, ordinary investors are more likely to be familiar with equity investments.
Finally, despite SEBI’s best efforts to incorporate ordinary investors within the Indian trusts instruments, the FPIs have managed to carve out a niche for themselves in the REIT/InvIT regime, as observed in the Embassy Park REIT and IndiGrid InvIT where the FPIs hold 39% and 55% of shareholdings respectively. This paints a contrary picture to the ideal REIT/InvIT scenario imagined by the Indian securities regulator, as the primary target of Indian retail investors is outnumbered. Therefore, in order to enhance the popularity of REITs/InvITs within the investor space, it is imperative that a few investor mindset-specific measures are incorporated that encourage a wider outlook for investing in real estate and infrastructure.
The REIT/InvIT regime is expected to accelerate the bailout of severely affected real-estate and infrastructure industry amidst the COVID-19 pandemic. However, simultaneous government intervention has exacerbated the issue, as a state government advised homeowners to recluse from collecting rent, and MORTH suspended toll collection on highways, notwithstanding the fact that both rent and toll charges constitute a major earning resource for REITs and InvITs. And although the InvITs are expected to recuperate as delayed infrastructure projects have partially resumed all over India, a similar assessment for REITs is hard to contrive. The growing work-for-home culture is likely to result in subdued demand for commercial office space, a prime asset for REITs. Therefore, a relinquishing market for shared workplaces is going to impact the real estate sector and subsequently the REITs.
Another concern post COVID-19 shall be to ensure that the assets endorsed by REITs and InvITs are free of any encumbrances arising from the corporate governance of the assets and their functioning. The WeWork debacle reignited the debate on ethical corporate governance practices, especially in the real estate sector, and the subsequent IPO brought to light the discrepancies that can be promulgated in commercial real estate.
Nevertheless, retail investment in REITs/ InvITs is likely to improve once investments are back to normalcy as the amendments to REIT and InvIT regulations are expected to fructify. The various efforts undertaken to synchronize a vastly disorganized real estate sector by the enactment of Real Estate (Regulation and Development) Act 2016 and inclusion of homebuyers as operational creditors under the Insolvency and Bankruptcy Code 2016 have reshaped the public’s perception of the real estate sector, that may be rewarded with increased investments in future REITs. The NHAI’s move to raise INR 5,000 crore from its InvITs early next year is further expected to accelerate investments and nurture the investor’s faith in infrastructure trusts instruments.
To conclude, the silver lining of REITs/InvITs will not be realized until a later stage where the Indian securities regulator, as well as investors, have tussled with a few options. Similarly, REITs/InvITs have to be assessed until they have tested the unclear waters of changing regulatory provisions and inflation risks.