Introduction of REITs a progressive move by SEC

Real Estate Investment Trusts (popularly referred to as REITs) are a popular asset class in economies with mature primary and secondary real estate markets. Its introduction in Sri Lanka is a progressive move by the Securities and Exchange Commission of Sri Lanka (CSESL) underlying the huge growth in the domestic real estate market and creating a key tool to aid its future growth.

What is a REIT?

A REIT is essentially like a mutual fund of property assets. Like a mutual fund, a pool of investors invests into a funding vehicle (in this case, the REIT). The REIT then uses these funds to invest in a pool of real estate assets such as residential projects, commercial projects, commercial rental property, malls, warehouses, and industrial developments, to name a few. The REIT earns a return either through rental income on properties rented out (such as office blocks and malls) or through profits from the completion of a residential or commercial project. Just like a mutual fund, these earnings are then either paid out to the unitholders of the REIT or invested in other property assets.

Why is it useful for investors?

Generally, real estate investments, by their nature, require big-ticket investment sizes and do not offer the investor much diversification of risk. For example, an individual investor may want to invest Rs. 100 million in real estate. They can buy a few apartments, or a few offices as an investment. This not only requires a significant amount of capital investment, but it also exposes the investor to the risk that a particular apartment or office may have a problem or may be a bad buy. Since they only have a few real estate assets, one bad asset can significantly impact the return on the portfolio.

The other challenge with real estate investments is that disposal or sale of assets can be time-consuming, tedious, and often the market can be illiquid when the investor most needs cash. This low liquidity potential makes investors wary of locking funds into a real estate investment versus other, more liquid investments like FDs (fixed deposits) or stocks.

A REIT helps the investor get around both these problems.

Firstly, as an investor, a REIT allows one to buy a certain number of “units” or “shares” in the REIT. As a REIT is invested in a variety of real estate assets, the investor thus diversifies his risk across a much larger pool of assets. This makes it easy for even small investors to diversify with lower risk exposure in real estate. The investor thus theoretically can enjoy the upside of a real estate investment, while mitigating some of the downside risks through diversification. Thus, the aforementioned investor now has Rs. 100 million invested in a small share of a considerable portfolio of apartments and offices. The risk of one of these apartments having a problem barely has any effect on their overall return.

Secondly, the “units” or “shares” in a REIT can be bought and sold just like a stock or like units in a mutual fund. If our investor needs funds, they could sell their shares in the REIT immediately at the market value on that particular date. They would be able to cash out immediately and enjoy the returns up to that date.

Why is it useful for real estate developers?

Firstly, by pooling together large groups of investors, REITs allow developers access to a much larger pool of capital than they usually have. This greatly helps assuage one of the largest problems of a developer in an extremely cash-intensive industry.

Also, REITs are often able to act as “anchor” investors in the early stages of real estate projects. Purchasing a certain percentage of the apartments or units in a development at an early stage increases the viability of the project and allows the developer to reduce their risk.

Finally, an often-overlooked factor is that REITs greatly help incentivise developers to build more commercial and rental developments. Generally, office and shopping complexes are risky for developers as there are very few actual buyers, and the developer has to earn their return through managing rentals. Apart from not being a core competency for most developers, this significantly increases the project payback period and thus increases the financial cost and reduces the viability of such projects. As a result, many developers avoid building rental assets.

REITs act as key players here as they often purchase malls and office blocks, and are happy to earn long-term rental income and pass this on to their investors. This gives developers a clear exit and encourages them to develop more rental-based projects.

REITs in Sri Lanka

The REIT is the only new product launched by the CSE after 23 years, the last being the introduction of corporate bonds in 1997.

The spiralling property prices in Sri Lanka has made it a challenge for average citizens to finance real estate investments, which means a significant proportion of the population will not benefit from the appreciation of property and infrastructure development values.

Introduced by the SEC together with relevant stakeholders, the regulatory framework has been set in place taking into consideration the local environment in which it will operate. The rules set out by the SEC are an extension of the current Unit Trust Code, and came into effect on 31 July 2020 in the form of a gazette notification.

In order to promote transparency and to distribute ownership among people of Sri Lanka, REITs are only allowed as listed REITs on the Colombo Stock Exchange (CSE). The listing has three primary requirements, namely that the building should be fully completed, there should be 20% occupancy, and it should be an income-generating project.

The new regulation has offered real estate developers and owners of fully completed properties in Sri Lanka the capability of converting their properties to a REIT which will offer the general public the opportunity to invest and thereby benefit from any increase in property values.

Specific provisions have been included for the verification of title and valuation of the property that will form part of the assets. Among the requirements is the mandatory distribution of approximately 90% of the income to unitholders, which is currently not a requirement for any of the listed entities.

Furthermore, due to the availability of the pass-through tax mechanism on unit trusts, REITs could also be a viable business concept to Sri Lanka that will open new horizons for entrepreneurs to take the real estate industry to greater heights.

REITs will give a higher dividend and a relatively stable income through long leases with regulation to protect investors. The rules, however, could change in the future based on industry requirements.

In conclusion, it would be ideal if the stamp duty was reduced or removed at least until REITs became popular in Sri Lanka.

(The writer is the Managing Director of Iconic Developments and an alumni of the Wharton School of Business and INSEAD)