MR JAI MAVANI, EXECUTIVE DIRECTOR, KPMG INDIA PVT LTD, MUMBAI.

Hot in the Indian investment scenario is something `real': REIT. Pronounced to rhyme with `sweet,' the acronym, as you may know, stands for real estate investment trust.

Sweet, perhaps, could be the fruits of the long wait investors closer home have had to endure for the arrival of REITs. For, the new kid on the investment block, which is still in the works, is expected to `boost and help stabilise capital access, and reduce capital costs,' apart from helping the real estate sector `by creating conditions for building integrated property businesses,' as the market regulator SEBI (the Securities and Exchange Board of India) has stated in the recently issued draft REIT regulations.

REIT means "a trust registered under the Indian Trusts Act, 1882 and registered with the Board under these regulations, whose object is to organise, operate and manage real estate collective investment," defines SEBI. REITs have become a preferred public property investment vehicle around the world, it notes.

Business Line contacted Mr Jai Mavani, Executive Director, KPMG India Pvt Ltd, Mumbai, for answers to a few questions about REITs.

Excerpts from the e-mail interview:

In terms of returns, how different from REITs are mutual funds (MFs) focussed on real estate companies?

Real estate mutual funds (REMFs), as per June 2006 press release, would be permitted to invest both in real estate directly as well as in securities, including mortgage-backed securities and shares of companies owning/developing real estate. As opposed to that, under the draft regulations, REITs are permitted to invest only directly in real estate.

The return profile under both these investment approaches would also differ. Whereas REMFs can take development risk and trade in securities, therefore having a potential for higher returns, albeit with a higher risk, REITs would generally invest in stabilised income-yielding assets with lower returns and commensurate risk.

In some ways, very loosely defined, REMFs are like balanced MFs, whereas REITs are like pure debt funds.

One issue that might make valuation of schemes floated by REITs difficult would be availability of independent property valuers. Do we currently have sufficient number of valuers who can take up the job? Are there any qualifications for these valuers?

It may be premature at this stage to comment on how the valuation game will evolve, as the detailed guidelines are awaited. Personally, I am not much in favour of having rigid and watertight valuation norms as this may kill enterprise. For example, a REIT acquiring a strategic portfolio of malls in a certain geography may value it differently, as this could give them a higher leverage with retailers, as opposed to another REIT which is acquiring a standalone neighbouring asset.

That said, one can also understand SEBI's concern for pricing discipline, considering the regulator's responsibility to small investors who may be severely hurt if such a discipline were not maintained.

Ultimately, like in all industries, the market will discover its own pricing norms and conventions but until then it is in the interest of the market players to self-regulate and adopt a transparent and disciplined approach.

After the sub-prime crisis, there has been a re-look at the business conducted by rating agencies. In that light, how far do you see the annual requirements to have each REIT scheme's financial statements audited, assessed by an appraising agency and rated by credit rating agency, making headway?

There are lessons to be learnt from every market aberration and cycle. No process is perfect and looking back, whether in India or overseas, whenever there has been a breakdown of the kind we are seeing around sub-prime exposures, controls have tightened and greater governance has been introduced.

It may not be fair to fault the rating agencies alone. They have a responsible role to play - in helping both the investors in making informed decisions, and the regulators in defining filters for market entry and transaction level exposures.

Auditors too have an important role, perhaps more so as they exercise much more of a direct oversight on the quality of financial reporting and controls.

So it is in the interest of investors that auditors and rating agencies do their job efficiently.

Coming to the taxation issue, world over REITs are required to distribute 90 per cent of their income, which may be taxable in the hands of the investors. Do you see such a scenario evolving here in India?

The current draft REIT regulations also compulsorily require REITs to distribute 90 per cent of its income after tax. However there is no guidance in the draft REIT regulations on the basis of taxation of REITs or its investors.

Applying the general principles of trust taxation, it is most likely that REITs would be taxed at 30 per cent plus surcharge and cess.

This is materially different from taxation of mutual funds, which are specifically exempt under the Income-Tax Act, and taxation where applicable is only at the investor level.

In any financial product, the biggest devil is uncertainty. Investors hate it; and investment managers dread the thought.

It would therefore be helpful if the basis of taxation is clearly provided through suitable amendments in the income-tax law.

Is there a case for making REITs pass-through for tax purposes?

India has a progressive basis of taxation for individuals - you pay a tax at a rate based on your applicable slab. If tax were to be imposed at the level of the REIT, at say 30 per cent plus surcharge and cess, the returns to a marginal investor or a pensioner who is at a lower bracket would be unfairly impaired. This would defeat the very underlying philosophy behind REITs which is to enable retail investors take small positions in a professionally managed portfolio of assets and share the returns - something they could not do directly.

What is the global situation regarding taxation issues on REITs?

In many countries REITs are pass-through for tax purposes if they satisfy certain conditions (relating to distributions, minimum number of investors, etc).

Given the high transaction costs, should SEBI have done better if it would have included a waiver on stamp duty on purchase of land/sale of property?

Indeed. Globally, as REITs mature, the effective yields drop to sub-five per cent. Even if one were to consider yields at 10 per cent in India and benchmark the same with stamp duty and registration costs of over 12 per cent in many States, in the first year investor returns would be in negative territory (since stamp duty is generally borne by the buyer).

Clearly, this would make REITs non-starters. Many countries rebate/exempt stamp taxes on asset acquisition by REITs, especially in the initial years.

It is very important therefore that stamp duty concessions are provided not just on purchase/sale of assets but also on long-term leases. For example, in many States, long-term leases are subject to stamp duty levels almost as high as in the case of conveyance.

In recent practice, world over many REITs distribute all of, or even more than, their current earnings, often resulting in dividend yields comparable to bond yields. If an investment company such as a REIT distributes more than its taxable income, the excess distribution is considered "return of capital" for tax purposes and is not taxed as ordinary income. Can distribution requirements hamper a REIT's ability to retain earnings and generate growth from internal resources?

This should not arise, as under the draft regulations, the REIT scheme is required to distribute 90 per cent of its net income and therefore return of capital should not happen.

Also, REITs deliver capital appreciation by churning the assets as interest rate compressions happen and at times by re-rating the applicable capitalisation rates after refurbishing and renovating the same.

Can you explain the rationale behind listing units of schemes floated by REITs? Unlisted REITs in particular have been demonstrated to distribute higher quarterly dividends than listed ones.

Unlisted REITs obviously have lower cost structures as reporting requirements are mostly contractual and, therefore, less regulated. However, they lack liquidity. Also, if the corpus of the fund is large, ordinarily the difference in the cost structures should not be very material.

REITs as a product should be compared to debt funds which deliver low but stable returns with high levels of liquidity. In some ways, the lower returns are a cost of liquidity.

D. MURALI
INDRA NATH