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Industry Insights – Valuation Vacuum

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Governments and markets favour REITs (real estate investment trusts) because they (REITs) provide an investment vehicle that puts shareholders in property companies on a level playing field with investors who own property portfolios outright. They enable industrial and service companies to sell off their corporate real estate, leaving it in the hands of property professionals and freeing up capital for core business. That’s because they enable small investors to safely invest in property, enjoying the diversification benefits this asset class has to offer and its qualities as a protection against inflation.
The industry has been looking forward to the setting up of REITs and REMFs (real estate mutual funds) in India since the last few years and there is no doubt they will change the real estate sector dramatically by institutionalising real estate, reducing the whole parallel economy and bringing in more transparency. They would open doors to a lot of institutional money which will help structure the entire financial system within the real estate and enable it to be at par with the international system. These products would also give an opportunity for small investors in India to take professional help in real estate investments without the hassles involved in investing in a project in terms of title, zoning, development etc. The assurance of returns too would be high, as it is managed by professionals. As the Indian economy grows, real estate would be its back¬bone and investor funding would mean more compliance and better products.
Improvement in the global REIT market will positively impact commercial real estate in India. Over the last few months, the global market has recorded an equity infusion of US$8.7 billion, suggesting that there is value and opportunity at current price levels. Property prices have declined 30-50% from their peak raising the probability of investors making attractive long-term capital gains, while enjoying rental yields in the interim. As revival of the economy is around the corner and real estate prices have started to stabilise, this may be the appropriate time to make way for introduction of REMFs and REITs for the public to invest. The prospect of higher realty returns that India offers compared to other countries spells a great opportunity for the success of REITs here.

But, where do we stand?
The draft guidelines for REITs in India were issued by the Securities and Exchange Board of India (SEBI) in December 2007 but have not been finalised yet, while the guidelines for REMF were released in April 2008.
REMFs: Although SEBI issued the REMF guidelines last year, interest so far has been muted primarily because of the unfavourable market sentiment and secondly due to lack of clarity on account of factors such as – calculation of net asset value (NAVs), tax treatment, the number of years for which fund should be closed ended, absence of income distribution criteria and lack of clarity on investment by overseas investors or NRIs.
Another deterrent in players considering setting up a REMF could be the fee structure for an asset management company which isn’t considered in line with the risk and efforts involved in the management of REMF as compared to management of any other mutual funds, especially in the absence of a real estate regulator.
In spite of these bottlenecks, HDIL Constructions and Kumar Housing Corporation have sought SEBI’s approval to float REMFs and the regulator is believed to in the process of ascertaining finer details on the proposed funds, with respect to conduct of fund, safe-keeping of investor money and payout details. Unitech Realty Investors, Aakruti City, Omaxe, HDFC Mutual Fund and ICICI Prudential are also planning to launch their own real estate mutual funds once clarity emerges on the valuation and taxation issues.
REITs: Even as the market turmoil pushed REITs on the backburner, the recent news from SEBI chairman about REIT regulations being worked on is indeed very welcome. While the intent is clearly there, there is plenty of ground work that would needs to be done before REITs can be set up.
It seems to be the chicken or the egg situation for REITs in India. What comes first – REITs or the real estate regulator? While the best way to address lack of institutionalisation and liquidity is by setting up REITs, some form of regulation to tame the unorganised non-transparent real estate market, is critical for the launch and success of REITs in the country.


Overcoming key challenges

Clarity in tax structure: The current REIT draft guidelines are silent on tax regulations and would need to clarify if the unit-holder would be exempt from paying tax. It is also unclear whether REMF will be treated as debt-oriented or an equity-oriented fund. A mutual fund qualifies as an ‘equity oriented’ mutual fund, only if more than 65% of its total net assets are invested in equity shares of domestic companies, and the regulations require that only up to 65% of the net assets of an REMF be invested in securities. Therefore clarity on this front is important from an investor’s perspective in the determination of return and the taxability.
The current regulations in India involve abnormally high stamp duties which along with present problems in ensuring clear land titles and delays in obtaining project clearances result in high transaction costs. As long as the prevalent high stamp duty rates and registration charges are not rationalized, waivers or relaxation made for REITs, the investment returns could be negligible or even in the negative. It is believed that SEBI is propagating the legal and policy reform
agenda and also deliberating on waiving the stamp duty for REITs in accordance with international norms.
The real-estate industry has traditionally been plagued by a lack of transparency in its working and speculative nature. Also, due to the unorganised nature of the real estate sector, lack of yield-generating assets of institutional quality into which REITs and REMFs can invest is a major challenge. It is therefore essential that state level regulators (land being a state subject) are set up to oversee these issues and provide an enabling framework so as to facilitate REITs to become an effective tool for institutionalizing real estate in India. Although the real estate regulation bill has been delayed in the past, it is now being reviewed with a fresh vigour by the expert committee set up under the ministry of housing and urban poverty alleviation.
Market developments have moved ahead and require valuation skills but the hardware to supply these skills has not developed yet. The lack of standard professional valuation practice has become a serious deterrent for both REITs and REMFs. World over, REITs are being traded 5-10% below their asset value due to improper valuation in some cases. In India, they could see additional discounts in light of the problems with valuation.
Here’s a quick synopsis of the valuation requirement – The proposed guidelines make it mandatory for REITs to disclose their valuation methodology as well as the basis of valuation. Each scheme must be appraised by an appraisal agency, rated by a credit rating agency, and valued by a qualified valuer, all of whom have to be pre-approved by the regulator. As per REMFs guidelines, real-estate assets have to be valued at fair price every 90 days since purchase, by two
valuers accredited by a rating agency and the lower of the two values will be taken for the computation of NAVs. Most of these pre-requisites – consistent valuation standards, qualified valuers, rating agencies equipped to rate valuers, valuers approved by SEBI – are currently non-existent and a major roadblock for REITs.
Filling the valuation vacuum
Consistency in, and transparency of, professional standards and the competence of valuers who subscribe to high standards of ethical conduct is essential in order to provide public confidence in valuations. There is a critical need for robust standards that chime with internationally recognised valuation procedures both in respect of the approach to determining market value and in the reporting protocols.

Sachin Sandhir is MD & country head, RICS India. He can be reached at ssandhir@rics.org

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