Looking to invest in real estate? Here's why REITs deserve a place in your portfolio

Where REITs place themselves in an investor's overall portfolio strategy is in a unique middle ground between equity and debt. While the potential returns from REITs are generally lower than from equity markets, they come with a much lower degree of risk. Therefore, REITs provide very strong risk-adjusted returns, which are particularly useful to investors who are seeking to diversify beyond standard stocks and bonds.

Notably, REITs are not restricted to only office buildings. They also encompass other assets like shopping centers, each with unique underlying economic factors. For example, commercial REITs are strongly interlinked with growth in employment, economy, and increasing participation of Global Capability Centers (GCCs) in India, which are amongst the biggest occupiers of Grade A office space in India.

Mall REITs, in contrast, draw their resilience from increasing discretionary spending as well as emerging demand for organised retail infrastructure. With a limited supply of high-quality retail space, malls are increasingly able to reap better rentals, boosting income potential for investors.

Also read: Finance Ministry backs equity status for REITs, InvITs; Decision likely in SEBI's next board meet

Long-term growth potential

Returns should be seen in the context of total return, yield, and growth. Besides the distribution, which is in the range of 6 to 7 percent, REITs provide a number of growth levers that can increase total returns. Rental escalations that are part of contractual agreements frequently bring a 15 percent rise every three years and represent guaranteed income growth.

Increasing occupancy levels, rental adjustments in line with the market, and the addition of new properties, either acquired or developed, can also contribute to enhanced performance over a period. When put together, REITs have the potential to generate long-term low to mid-teen returns, which are comparable to equity investments but with a more stable risk profile.

Scaling up in India

The Indian REIT market, although still fairly young, is set to experience significant growth. REITs currently represent an AUM of approximately Rs 1.6 lakh crore, and InvITs ~Rs 7 lakh crore. But recent estimates indicate that almost Rs 20 lakh crore of real estate and infrastructure assets would be potentially taken under REIT or InvIT platforms in the future.

With international investors showing significant commitments to Indian real estate, the pipeline for new REITs is likely to grow substantially, getting investment-grade assets into the public space. From a portfolio construction perspective, REITs provide a useful diversification advantage.

Historically, investments have been split between equity or debt, but REITs provide a third column—moderate levels of risk, income-producing, real asset-backed investment. Not all REITs are the same, though. Each has its own risk-reward profile based on the nature of the underlying asset, lease arrangements, tenant profile, and quality of management. Investors need to consider each REIT on a standalone basis instead of as a homogenous class.

Also read: REITs hold 13% of India's Grade-A office stock, record 15% capital growth in last 12 months

Tax efficiency

Another significant benefit of REITs is their tax efficiency. Distributions are broken up into dividends, interest, and returns of capital. Dividend income from stocks, while taxed at the investor's highest marginal rate, is exempt from taxation when paid out by REITs.

Interest income gained via REITs is taxable. Return of capital is deducted against acquisition cost and taxed only at the sale of the REIT units, which is usually done with lower capital gains tax rates. This deferral, as well as lower taxation, makes REITs a more economical option for most investors than regular income-generating instruments.

As investment in real estate is increasingly democratised by REITs, investors can now take part in a previously inaccessible asset class that offers stable income, long-term capital appreciation, as well as tax benefits. In an increasingly changing financial environment, REITs are increasingly finding their way into diversified, forward-looking investment portfolios as a core element.

(The author is the Investment Director at WhiteOak Capital AMC)

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