[The following guest post is contributed by Dhanush. M, a 5th year student at the Jindal Global Law School]
`Leverage without supporting cash flows could be the death knell for the real estate industry`. The present state of the Indian real estate industry could be a testament to this adage where the total net debt of the top ten real estate firms by market capitalisation stood at Rs. 45,723 crore as on 31 March 2015.
Also, as real estate developers are holding unsold stock inventory of nearly 12 to 15 quarters, they are barely generating enough cash flow to meet their obligations of interest repayment and construction finance. In a phase of dampened sales, launching new projects will only make levels of unsold stock unmanageable for developers.
It is in this context that SEBI introduced the Real Estate Investment Trusts (REITS) Regulations, 2014 setting forth a regulatory regime governing REITS which could alleviate the debt and the liquidity crisis plaguing the real estate industry. REITS refer to securities that are sold on the stock exchanges representing investments in real estate directly, either through properties or mortgages.
REITS are proposed as listed entities that primarily invest in leased office and retail assets, allowing developers to raise funds by selling completed buildings to investors and list them as a trust. REITS would also give foreign investors a chance to invest in lease rental generating assets, an asset class otherwise prohibited for foreign investments.
The regulations have proposed the minimum size of assets under management as Rs. 1,000 crore. The minimum denomination for a trading lot has been set at Rs. 1 lakh and at least 80% value of the REITS assets have been mandated to be invested in finished properties generating revenue. REITS would have to distribute at least 90% of their net distributable income after tax to investors. Vacant and agricultural lands are proposed to be kept out of the reach of REITS. Investment by a REIT in foreign assets is barred.
The Regulations include several conditions that REITS will have to comply with. Assets held by REITS will have to be valued, including through physical inspection of the properties at least once a year. The value will have to be updated every six months and the net asset value would have to be declared every six months.
To protect investors from abusive related party transactions, the regulations have proposed that a 75% approval of disinterested shareholders be sought.
Investors globally have sought a stable yield return on REITS over capital appreciation and have benefited enormously because of low interest other asset classes have yielded. However, to grow as a viable asset class in India, REITS would have compete with other stable yield returning asset classes like government bonds and bank deposits which yield 8 percent to 9 percent in comparison to a REIT which would yield 4.34% by global standards. Therefore, it is pertinent that a favourable tax regime is afforded to REITS for it to grow as a viable asset class.
The Government has in the Finance Bill, 2015 exempted REITS from long-term capital gains tax when special purpose vehicles (SPVs) which hold rent-yielding properties exchange shares for units of REITS and a pass-through of rental income to unit holders on assets held by REITS; but a short-term capital gains tax of 15% still applies.
It is recommended that short-term capital gains on REITS be taxed at 10 per cent, in line with equity-oriented mutual funds. Also, it should be specifically clarified that any interest paid by SPV to the REIT is a deductible expenditure from a tax perspective.
The Government has also stated that rental income would be taxed only when it is in the hands of the unit holder. However, the requirement of holding the REIT units for more than thirty six months to qualify as a long term capital asset may act as a disincentive for investors to invest in lieu of the fact that an equity share held for more than twelve moths qualifies as a long term capital asset.
It is recommended that there be parity in provisions between an equity share and a REIT so that REIT becomes viable asset class from taxation perspective for retail investors.
Also, the Government has exempted REITS from the applicability of Minimum alternate tax (MAT) but the application of dividend distribution tax (DDT) could prove to be a stumbling block for the listing of REITS in India.
REITS in India also do not receive any sort of preferential treatment in regard to the imposition of stamp duties as the stamp duty paid on transfer or acquisition of property by REITS is similar to that of any other property transactions. It is recommended that the Government consider a proposal for remission of stamp duty similar to the mechanism introduced by the Singapore government which had provided for a remission of stamp duty on acquisitions of property by REITS for a period of ten years on introduction of REITS.
A favourable stamp duty regime becomes relevant in Indian real estate market in the absence of corporate tax related concessions at the SPV level prompting the REITS to hold properties directly. However, a REIT’s holding properties directly could also be burdensome given the high rate of stamp duties and registration costs applicable in various states on acquisitions of properties; it may have an adverse effect on the ability of a REIT to generate a stable yield.
Therefore, the possibility of a provision of stamp duty exemptions on transfer of properties by an SPV to the REIT and acquisition of properties by a REIT would be very beneficial to the REIT industry as the transaction costs for physical assets typically ranges between 5-12 per cent which could act as a barrier to acquisitions by India-REITs and hamper growth.
Foreign Investment in REITS
It is pertinent to tap interest from foreign investors as Indian REITS would be a very viable asset class from the foreign investors’ viewpoint on the background of low interest rates prevailing globally. Therefore, amendments to the foreign exchange control regulations is required to enable foreign private equity players who are currently invested in commercial stabilised assets to sponsor/manage the REIT.
Furthermore, foreign sponsors should be allowed to acquire units of REITS by swapping existing shares of SPV held by a non-resident sponsor with the units of a REIT under the automatic route. Also, foreign portfolio investors (FPIs) and non-resident Indians (NRIs) should be permitted to invest in units of a REIT without any cap or restriction on the units that can be acquired.
Income accruing from a REIT should be accorded complete pass-through status as against the current provisions which allow pass-through only with respect to interest income from SPV and rental income which is taxed in the hands of the investors directly while capital gains and other income is taxed at a REIT level and exempt in the hands of the investors.
Foreign sponsors should be allowed to acquire units of REITs under automatic route. In such a case, swap of existing shares of SPV held by a non-resident sponsor with the units of a REIT should be permitted under automatic route. It should be clarified that a REIT with majority foreign ownership would not be subject to downstream conditionality related to FDI.
Also, it is recommended that managers of a REIT having FDI should be treated as a non- fund based activity and should not be subject to the capitalisation norms applicable to fund based activities.
In consideration of the fact that the REIT market in India is in its early stages and the sentiment of retail investors is expected to be dull, support from institutional investors becomes very relevant, therefore amendments to Insurance Regulatory and Development Authority (IRDA) investment regulations, provident fund regulations be considered to prescribe REITS as an eligible investment.
In construing the fact that most real estate developers in India hold properties through SPVs and that a REIT is not allowed to invest in other REITs, it is foreseeable that going forward, there would be acquisition of SPVs by a REIT and there is need of a special provision to govern such transactions.
However, the Regulations are silent on the procedure to be followed on the acquisition of a SPV by a REIT and there is a need for a provision which mandates that on acquisition of a SPV by a REIT a report be prepared reporting the profit and loss of the SPV in respect of three financial years preceding the transaction, the assets and liabilities of the SPV vehicle as on the last date the accounts of the SPV were prepared and a full valuation of the real estate assets of the REIT be carried out in the report.
Corporate Governance in REITS
With regard to corporate governance, there are several laxities which the Regulations have failed to consider. First, no statutory duty has been imposed on the REIT manger and the directors in regard to the unit holders; the code of conduct governing REIT managers merely prescribes that the manger shall take investment decisions solely in the interest of unit holders. The statutory duty would impose civil and criminal liability on the REIT manger.
Second, there has been guidance on the composition of the board of a REIT. It would be beneficial if the regulations prescribe a threshold for the composition of the board. Ideally, one-third of the board should comprise of independent directors.
Third, the regulations fail to prescribe a duty on a REIT to disclose remuneration of the manger and other top executives of the REIT. Ideally, the Regulations should mandate disclosure and manner of computation of remuneration of the manager and other top executives of the REIT.
Fourth, the Regulations fail to empower the unitholders to call for a vote for removal of the REIT manger, where the manger has failed to perform his duties.
Fifth, with regard to voting on a related party transaction, there is a need to align the requirements of the REIT provisions with that of the Companies Amendment Act, 2015 which proposed a simple majority approval of by disinterested shareholders with regard to approving a related party transaction. Therefore, it is recommended that voting requirement on a related party transaction in regard to the REITS be reduced from a special resolution to a simple resolution.
Sixth, the delisting regulations governing REITS fail to provide for `squeeze-out` provisions on takeover of a REIT and a `Scheme of arrangement` in the privatisation of a REIT.
I conclude stating that the listing of REITS in India would be greatly beneficial to the Indian real estate industry as it would be viable exit options to the relevant stakeholders. However, to ensure the success of the REIT market in India, the Government needs to move quickly on the reforms to the REITs market as there is a danger of developers opting for overseas listings of their REITS.
- Dhanush. M