Business

Good news, REIT here, right now!

By Vasula Premawardhana

The recent announcement by the Colombo Stock Exchange (CSE) with regard to the introduction of REITs or Real Estate Investment Trusts by end of the year is certainly great news.

What exactly is a REIT, and how would it help you?

Say you already have your own home, some savings in fixed deposits, a steady job, and a growing income. Moreover, you believe that over the next decade or so apartment housing prices and rents will get even more expensive in Colombo and other major cities in Sri Lanka. You think it’s a good time to invest in an apartment to capture rising property prices obtain a stream of rental income.

Yet, you don’t have tens of millions of rupees to purchase an apartment outright, and you understand that taking a housing loan to purchase an apartment would not work as associated financing costs would not cover rental revenue and will instead eat into your household cash flow as opposed to generating extra income.

Or perhaps, you have disposable income, savings, and even an investment portfolio of stocks and bonds, but you believe that there might be higher potential in the commercial real estate market in Sri Lanka over the next decade or so. Perhaps, you feel you should diversify your portfolio risks over the short term, or even allocate a higher portion of it into the real estate sector.

However, perhaps, like most others, you need to be near-liquid in your investments, and you are aware that disposing the asset cannot be done in a rush. Moreover, you also have to face the associated risk of non-paying tenants, vacant possession, costs of maintenance and refurbishment, legal action to enforce evictions, etc., time for which you may not have.

Or perhaps your company or corporate may have identified above average potential in developing and operating rent-earning large-scale properties such as shopping malls and complexes, office complexes, car parks, warehousing in Colombo, and other rapidly developing cities in Sri Lanka and want to participate in this sector more aggressively.

But, you don’t necessarily want to be a property developer, nor do you have the operational capacity or expertise to manage such an enterprise.

As highlighted in the above scenarios, even if you are aware of the potential and willing to participate in the property markets, directly investing in the sector is not for everyone.

Moreover, the barriers to entry are high. It takes capital, time, and resources, and expertise that you may not have as an ordinary investor, an entity, or a corporate engaged in another industry. Perhaps all you want is to be a passive investor in this sector – and that’s where Real Estate Investment Trusts (REITs) come in.

A REIT is more or less a listed company that holds and operates income-producing real estate and is required to distribute a bulk of its profit to its shareholders as dividends.

The US Securities and Exchange Commission should serve as an authoritative and credible source for a brief introduction to REITs, and goes as follows: “A real estate investment trust (REIT), generally, is a company that owns – and typically operates – income-producing real estate or real estate-related assets. REITs provide a way for individual investors to earn a share of the income produced through commercial real estate ownership – without actually having to go out and buy commercial real estate. The income-producing real estate assets owned by a REIT may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans.

Most REITs specialise in a single type of real estate – for example, apartment communities. There are retail REITs, office REITs, residential REITs, healthcare REITs, and industrial REITs, to name a few. What distinguishes REITs from other real estate companies is that a REIT must acquire and develop its real estate properties primarily to operate them as part of its own investment portfolio, as opposed to reselling those properties after they have been developed.

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. In addition to paying out at least 90% of its taxable income annually in the form of shareholder dividends, a REIT must:

· Be an entity that would be taxable as a corporation but for its REIT status

· Be managed by a board of directors or trustees

· Have shares that are fully transferable

· Have a minimum of 100 shareholders after its first year as a REIT

· Have no more than 50% of its shares held by five or fewer individuals during the last half of the taxable year

· Invest at least 75% of its total assets in real estate assets and cash

· Derive at least 75% of its gross income from real estate-related sources, including rents from real property and interest on mortgages financing real property

· Derive at least 95% of its gross income from such real estate sources and dividends or interest from any source

· Have no more than 25% of its assets consist of non-qualifying securities or stock in taxable REIT subsidiaries.

REITs generally fall into three categories: equity REITs, mortgage REITs, and hybrid REITs. Most REITs are equity REITs. Equity REITs typically own and operate income-producing real estate. Mortgage REITs, on the other hand, provide money to real estate owners and operators either directly in the form of mortgages or other types of real estate loans, or indirectly through the acquisition of mortgage-backed securities. Mortgage REITs tend to be more leveraged (that is, they use a lot of borrowed capital) than equity REITs. In addition, many mortgage REITs manage their interest rate and credit risks through the use of derivatives and other hedging techniques.

You should understand the risks of these strategies before deciding to invest in these types of REITs. Hybrid REITs generally are companies that use the investment strategies of both equity REITs and mortgage REITs.

Many REITs (whether equity or mortgage) are registered with the SEC and are publicly traded on a stock exchange. These are known as publicly traded REITs. In addition, there are REITs that are registered with the SEC, but are not publicly traded. These are known as non-traded REITs (also known as non-exchange traded REITs). You should understand the risks of the different types of REITs and their strategies before deciding to invest in them.

As with any investment, you should take into account your own financial situation, consult your financial adviser, and perform thorough research before making any investment decisions concerning REITs. You can review a REIT’s disclosure filings, including annual and quarterly reports and any offering prospectus at ww.sec.gov. You can invest in a publicly traded REIT, which is listed on a major stock exchange, by purchasing shares through a broker (as you would other publicly traded securities).

Generally, you can purchase the common stock, preferred stock, or debt securities of a publicly traded REIT. You can purchase shares of a non-traded REIT through a broker that has been engaged to participate in the non-traded REIT’s offering. You can also purchase shares in a REIT mutual fund (either an index fund or actively managed fund) or REIT exchange-traded fund.”

That was the US SEC’s “fast-answer” explanation verbatim as it covers and introduces the topic quite succinctly. There’s no need to reinvent the wheel. As we are still at the policy-making stage, this is sufficient at the moment. The main takeaway for us is that investing in a REIT is the same as investing in the stock of a listed company, the difference being that unlike in a listed company, where the management decides on the amount and time of dividend disbursement, a REIT is structured to payout a steady stream of dividends. Moreover, just as in the stock market, investors in REITs also benefit from any property value increases and the capital gains on their holding.

The introduction of REITs will facilitate broad-based investment into the real estate sector, just as the stock market facilitates broad-based investment into other industries and sectors in the economy. Not only will it facilitate participation, but will also allow the public to directly benefit and profit from the economic and infrastructural development of the country.

Why the introduction of REITs was long delayed here is certainly a question. Having said that, I believe it’s better late than never.
The economic purpose of REITs is well established, as real estate asset class as an investment option has been available to ordinary investors and institutions for decades in other jurisdictions.

As the Sri Lankan economy is at a different stage to US, it is expected that the pass-through taxation benefits, dividend distribution percentages, etc. may perhaps be different to what’s stated in the case of a US REIT.

However, in essence, the REIT structure as an exchange-traded instrument need not be reinvented and moreover, the economic intent and impact will be the same.

Instead of federal and state taxes, in Sri Lanka, we will have the central and provincial-level taxation considerations. Moreover, not being a fully developed state with more infrastructure facilitation and rural sector development required in our economy, the Government of Sri Lanka (i.e. the Ministries of Finance/Treasury/Housing) should encourage and enable the SEC and CSE to facilitate the introduction of REITs more actively.

As far as the SEC the CSE are concerned, it’s a low-hanging fruit. REITs can be facilitated by introducing a few definitions and rules and regulations to its by-laws. The exchange trading mechanism, infrastructure, oversight, and supervision measures are already in place.

It’s the Ministry of Finance in this instance that must pull its weight and bring in the necessary taxation measures, work with other governmental line ministries, as well as help bring in Provincial Council-level collaboration to ensure the introduction of REITs to the capital market as the SEC and CSE will not have the capacity to bring forth such initiatives on its own.

The introduction of REITs will help broad-based investment and capital formulation and encourage more private sector involvement, pave the way for the next level of its infrastructural development, both at national and provincial levels.

Premawardhana is a professional with over 15 years of capital markets and Risk Management exposure both locally and internationally. He holds an MA in Financial Economics from the University of Colombo and a BSc in Computer Science from the University of Southern California USA. He is a former Director of the Securities and Exchange Commission (SEC) of Sri Lanka.