JLL believes that India’s current office markets have potential REITable space of 294 mn sq. ft. with valuation upwards of USD 35 bn. India’s commercial office space is expected to dominate the REIT market due to robust growth, resulting in rising rental yields and steady rise in capital values. REITable opportunity in new office completions is expected to be 101 mn sq. ft. during 2019-2021 reflecting the huge REIT investment potential in office space alone…
REITs originated in 1960 in USA and were adopted in 35 countries thereafter. It has become an alternate investment instrument with global value exceeding US$ 1.7 tn in 2018. This growth has been driven by returns higher than equity markets over the long term. Since this is a new product in India, we have analysed and shared factors that influenced its evolution across the globe through this report. This helps us estimate the potential of REIT worthy assets, understand return expectations and forecast trends for India.
We believe that the entry of REITs in India is a step towards institutionalisation of real estate assets in the country. Some of its dynamics like mandatory valuations, regular updates, research coverage and disclosures relating to assets managed by REITs could lead the market to transparency. We expect this to help the Indian market mature and become more professional in times to come.
Real Estate Investment Trust (REIT) – A Global Perspective
As India has witnessed the first successful REIT listing, a study of the global REITs scenario would help to put in perspective expected growth in the current product as well as further scope for listing REIT worthy assets in India. REITs originated in 1960 in USA to provide access to all investors, especially small investors, to income-producing real estate. The growth of REITs has been driven by returns higher than equity markets over the long term. It has gradually grown to become an alternate investment vehicle with global value exceeding US$ 1.7 tn. In order to gather a global perspective, we have analysed the international REITs market in terms of adoption timelines, countrywise share and its evolution as witnessed in USA and Singapore.
We have specifically chosen USA and Singapore for our analysis, because USA pioneered the concept and Singapore is similar to India in terms of investment climate and financial tax reforms.
Significant growth in adoption of REIT regulations post 1990s
Though USA was the first to introduce REITs to the world, adoption of REITs picked up around 1990-2000, when countries with major office space markets like Japan, Singapore and Canada adopted regulations to usher in REITs.
– The gradual growth in investments by banks and financial institutions due to low interest and high liquidity led to many countries adopting the REIT regulations to institutionalize real estate sector investments between 1990-2000 period.
– One of the common factors observed across most countries adopting REIT has been slow change in regulations.
– This slow change in taxation norms and other REIT norms has led to delay in listing of REITs in some countries. For instance, the first REIT in Singapore was launched in 2002 despite the regulations being in force from 1999.
Countries with more evolved real estate investment markets account for major share of REITs
Countries with large and developed real estate markets have attracted both domestic and international capital, which is a key factor for the growth of REITs. Development of REITs has also been witnessed in deep and liquid equity and debt markets, as well as markets with a mature and reasonably open corporate environment.
– Large institutional investor classes like pension and insurance funds, private equity funds and corporate and private investors have led to progressive growth of REITs across asset classes and types. They have also helped in making the market deeper.
– Progressive regulations and tax reforms have influenced the progress of REITs across countries.
– Though REITS was introduced in 2000 in Japan (much later than in some other countries like Singapore and Canada), the aggressive role played by banks and corporations led to faster growth of REITs here.
– United Kingdom despite its late start of REITs (in 2007) garnered a larger share of the sector’s market capitalization, compared with some others like Hong Kong and Singapore, due to it being an international finance hub drawing large institutional investments in real estate.
The growth of REITs in the USA, where it originated and in Singapore which adopted it much later in 2002, exhibits one similarity- gradual growth.
The reasons for slow growth are different and a deeper analysis provides insights into various factors that influenced the evolution of REITs in these countries.
Discovering the New Investment World of REITs in India
India witnessed the successful launch of its first REIT- Embassy Office Parks in March 2019 and this has signalled the coming of age of Indian real estate. This first REIT was launched nearly five years after the regulations were notified in 2014. Two factors- progressive regulations and robust investor interest have contributed to the success of this REIT. This coupled with lessons from global experience, enable us to predict the future outlook for REITs in India.
Market friendly regulations have created a favourable REIT environment.
Regulations in India have been market friendly and this has enabled the off take of REITs.
– REIT regulations proposed in 2014 have been progressively reformed to make REITs feasible and ensure safeguarding investor interest.
– Besides tax reforms, the listing of REITs and the holding period of REIT units has also been modifi ed to attract retail investors.
– REITs operators who have prudently managed their debt are in a better position to expand and increase unit holder returns in the future. Indian regulations have been progressive by allowing REITs to raise debt up to 49 percent of the value of REIT assets compared with some other countries like Singapore and Hong Kong.
Returns Expectation in India
The launch of REITs in India has opened the most important question of returns. Returns expectation in an economy is guided by the risk free rate at the lower end of the returns spectrum and equity returns at the higher end. JLL analyses the long-term returns from equity, mutual funds and risk free bonds to understand the returns scenario in India:
– Equity markets returns – based on the movement of the SENSEX over the last t en years have given a compounded annual returns of 13.9 percent
– Returns from equity markets have fluctuated over the decade indicating the volatile nature of investments. 10-year bond yield has generated a CAGR return of 7.3 percent in line with the repo rates set by the Reserve Bank of India (RBI).
– Retail investments in mutual funds has increased over the years and influenced return expectations:
(a) Multi-cap funds have generated CAGR in the range of 15-17 percent over 5-10 year horizon.
(b) Equity linked savings scheme with large retail participation has given CAGR returns of 16-17 percent over 5-10 year horizon setting the benchmark for expectations.
The comparison of the various existing investment options indicate that REITs returns have to compete with other investment options to attract retail investors. However, insurance and pension funds that look at asset classes with long term returns perspective would actively consider REITs due to their ability to provide stable returns over longer horizon.
The Case for Higher Returns
High risk free rate governs return expectations in India – In India, the repo rates have been higher due to underlying inflation rates and the risk premium for investments in the India. This has led to higher yields from risk free instruments compared to other developed markets globally.
The higher risk is also reflected in higher capital appreciation from stocks. And this is one of the reasons why return expectations from REITs in India is higher compared to other developed markets where the risk free rate is much lower.
Apart from the inflation linked return expectations, REITs returns from rental income are expected to see an upward trend, due to robust demand-supply scenario in office space markets. The flow of investments in office spaces is expected to drive capital values upwards, providing capital appreciation to REIT valuations. The combined impact is expected to drive higher returns from REITs in India.
India office rentals and capital values trends – India’s office market with 541 mn sq. ft. Grade – A stock has seen average annual demand of 30 mn sq. ft . over last 4 years. In 2018, the office absorption has exceeded 33 mn sq. ft., with an expectation that the absorption will be even stronger during 2019 with a forecast number of about 38 mn sq. ft.
This strong demand for office space is attributed to the growing interest from domestic as well as multinational companies. India offers good quality Grade A office space at competitive rentals when compared to several matured markets of APAC, EMEA or USA. Bengaluru, Mumbai and Delhi NCR are the top Indian cities which will lead the office market in terms of overall activity – new supply and leasing, while the cities such as Hyderabad and Pune are also attracting large number of IT occupiers in recent years. These cities are likely to drive the office growth to a large extent owing to their competitive rents, better infrastructure and good quality assets.
Growing transparency, urbanisation, healthy economic fundamentals and positive sentiments are the key underlying drivers of Indian real estate. All these factors along with proactive reforms are attracting several investors in a big way to invest in India’s commercial real estate. Emergence of new office space occupiers, continued demand from IT/ITeS, GCC along with BFSI space is expected to keep office demand robust over next three years.
The mismatch in demand and supply is expected to push up rentals in prime markets in line with past trends. Apart from demand-supply conditions, the secular escalation of rentals tracking the inflation/ currency deprecation effectively keeps the dollar rentals unchanged.
The optimistic REIT scenario, with a long-term outlook of gradual growth, makes it imperative to look at the real estate assets which are RIET worthy. We have looked at the commercial office space in India as the preferred choice for REIT due to the favorable factors discussed above. While selecting the REIT worthy assets we have used the following criteria, to arrive at the potential REIT stock and its value based on current market conditions.
Parameters for REITable Assets
Commercial office assets that meet all the below parameters are considered REITable:
– Includes operational leaseonly projects from top 7 cities
– Office properties with area greater than or equal to 200,000 sq.ft.
– Projects with vacancy less than or equal to 20 percent
– Assets under single ownership or Strata sold assets owned by institutions
The recent success of the first REIT in India underlines few key trends that will guide the growth of REIT in India. Some of the key trends that will pan out are:
– REITs are expected to make a gradual start in line with global trends.
– Positive factors like progressive policies, smaller lot size, tax efficiency, strong investor interest, presence of global investors would act in favour of REITs.
– Some challenges like limited knowledge of the new product, lack of returns record and alternative investment options would lead to gradual pace of growth of REITs.
– Buoyant equity markets would affect returns expectations of the investors.
– Office market REITs driven by strong demand – supply conditions would drive returns of REITs.
– The successful listing of India’s first REIT would attract more players to list their assets through REITs.
India REIT Office Space Worthy Assets – 294 mn sq. ft. Potential Valued at US$ 35 bn
India’s Commercial office segment has been the favorite asset class of institutional investors over the years. This is borne by the fact that nearly US$ 17 bn has been invested in the form of direct investments as well as through entity level investments during 2006- 2019. A detailed analysis of the office market based on asset ownership, size of the property, leased space and asset quality has been used to arrive at REITable office space.
In order to arrive at the REITable assets in India, the focus has been on low hanging fruits in terms of single ownership, larger floor space with good occupancy rates. JLL research indicates that 294 mn sq. ft.* of office, space stock would be eligible for REIT. This would translate to potential investment of US$ 35 bn*.
– Bengaluru with large IT spaces occupied by prominent global players with quality asset spaces will be the most favoured for REIT. Most of these assets are singly owned by developers or large funds make it easier to aggregate the assets and manage them for REITs.
– Bengaluru has the highest REITable assets totalling 97.8 mn sq. ft., worth US$ 10.7 bn, followed by Mumbai at 49.7 mn sq. ft., worth US$ 8.6 bn.
– Legacy commercial office markets of Mumbai and NCR would supplement the IT/ ITES occupied REIT space in terms of diversification and competitive yields.
– Mumbai being half of REITable basket of Bengaluru commands USD value almost close to Bengaluru. This is mainly attributed to the high per sq ft office capital values of Mumbai.
– Chennai, Pune and Hyderabad are the other preferred choices by IT/ITeS and GCC would drive the next order of REIT space in these cities. Presently, Chennai contributes about 13% of the total REITable stock with 12.6 percent share in total value.
– Hyderabad and Pune, both have similar share in REITable space and value as well.
Out of the office space completion expected in 2019, we expect 34 mn sq. ft. of REITable office space opportunity as the existing regulations allow investment in under construction projects. This could help REITs to gain from the upside in rentals as well as capital appreciation. Similarly, 2020 and 2021 will open up 32.8 and 34.3 mn sq. ft. of new completion of REIT able space respectively.
Though commercial office space is expected to offer a large opportunity for development of REITs in India, other asset classes like Retail, Warehousing and Hospitality also offer scope.
India’s organized retail with 253 malls in top cities occupies ~ 80 mn sq. ft. space. Large institutional investors have already picked up stakes in fully operational malls, while many have invested in greenfield assets. The retail sector is becoming more and more organized in terms of its mall spaces and would see emergence of REIT ready space after some years.
The listing of India’s first REIT heralds the institutionalisation of real estate assets and indicates increased maturity of real estate markets. While the launch of REITs symbolises that markets have definitely become more professional and transparent, this new investment vehicle will in turn, ensure further transparency and maturity. This is because mandatory valuation of properties, regular updates, research coverage and disclosures relating to assets managed by REIT will be essential, resulting in increased professionalism and transparency in real estate markets.
Growing knowledge of the product will ensure acceptability and gradual increase of retail interest in this segment. The instrument will enable retail investors to partake of the massive opportunity in the commercial markets real estate pie, which until now was only a dream. This was largely on account of lack of access/restricted access to these assets, due to the value and volume of funds required.
From the developer’s perspective, a large source of funding is opening up. A small percentage of mutual fund investments made by retail investor getting channelised into REIT, would enable access to large funds for the real estate developer as well as PE player.
JLL believes that India’s current office markets have potential REITable space of 294 mn sq. ft. with valuation upwards of USD 35 bn. India’s commercial office space is expected to dominate the REIT market due to robust growth, resulting in rising rental yields and steady rise in capitalvalues. REITable opportunity in new office completions is expected to be 101 mn sq. ft. during 2019-2021 reflecting the huge REIT investment potential in office space alone. Apart from Office, Retail, Warehousing and Hospitality segments will off er additional scope for REITs as these sectors are expected to see growth in scale and enhanced investor interest over the years.
The growth of REITs as an investment vehicle would hinge upon the policy push given. Tax efficiency resulting from investment in REITs will help Indian REIT players compete with other countries to attract investors. Firstly, tax benefits provided to investors and REIT sponsors would be crucial for the growth of the REIT market and the policy needs to be consistent in this regard. Secondly, the current regulations permit only rent yielding assets for listing under REIT. Residential real estate segment (which accounts for 85 percent of the total under construction real estate value) is effectively left out. Regulations that will help to bring this segment under REIT need to be evolved for Indian real estate.
Despite certain challenges in terms of investor awareness about the product currently, interest is expected to increase over the years, based on our understanding of other REIT markets. And the success of this first REIT is a definite promise that there will be many more in the offing.