Is it a right time for REITs?

When financial markets face a shock and regular bets turn jittery, it is often a good time for investors to look at adjusting their portfolios to match their risk appetite. With equity and fixed income instruments being volatile now, there may be some merit in looking beyond these asset classes. And choices such as Real Estate Investment Trusts (REITs) ― which offer potential for income as well as capital gains ― can be among ideas to consider.

REIT basics

REITs are a well-known asset class globally, with a return history of multiple decades. A REIT is a way for a retail investor to bet on a property asset, with a small amount relative to the full price. These are typically traded on the exchanges and investors earn dividends from the property’s rental income (and capital appreciation). The earning is often unrelated to the existing interest rates in the market, as it depends on the rent potential of the underlying asset. It hence, provides diversification from other income-giving assets such as bonds.

In theory, data shows REITs offer good returns when interest rates rise. This is because higher interest rate is often an indicator of economic growth, which will increase occupancy and rent. Prices may also increase as there is more demand. When rates fall, REITs have a looser connection, as returns are linked to asset-type and rent. So, there may be unit price appreciation due to more demand; but it depends on the rental stability of the underlying.

There are many advantages of REITs over buying property, for an investor. For one, it is listed on the exchange and hence, more liquid than property, which is a very illiquid asset. The quantum of investment is also low, as one can buy units of the asset instead of the full property. So, it can provide better diversification potential compared to investing a big chunk in a property, which creates concentration risk.

Buying choices

An investor however, has a complex choice when picking REITs. For instance, REITs come with different profiles for risks and returns, based on the property sector and region. For example, some REITs own hospitals and these have a price and rent appreciation profile that differ from those that own retail space.

And these differences in the asset profile also reflect in the return and volatility over the years. For example, a look at the performance in the US market (where REITs have been in existence since the 1960s and account for 96 per cent of the market capitalisation of property assets) shows that the office property segment has given an average total return of 12 per cent between 2009 and 2019. The volatility has been high ― with a peak of 35 per cent in 2009 to a low of -14.5 per cent in 2018. Residential property gave a higher average return of 16.7 per cent in that decade. The peak return year was 2010, while the low was 2013 at -5.4 per cent.

India market

Unlike developed markets, the choice for REITs in India is very limited. In fact, there is only one listed REIT ― Embassy Office Parks, listed in April 2019, with a subscription price of about ₹300. Embassy owns 33 million square feet of office space, spread over seven office parks and four city-centre office buildings, in four cities (Bengaluru, Pune, Mumbai and Noida). Its occupancy rate was 95 per cent in FY18 and about half the rentals were from Fortune 500 firms.

In the three quarters since listing, Embassy has paid ₹17.5 per unit ― an annualised yield of 7.8 per cent based on the price of ₹300. The unit price had jumped 60 per cent ― to a peak of ₹480, on March 5, 2020. Together, it has provided great return for its investors, even if a part of the return may be due to scarcity premium. Its portfolio occupancy remained high at 95.1 per cent, as of December 2019.

However, given the crisis caused by Covid-19, it is possible that there would be a change in the rental profile ― tenants vacating or negotiating lower rents. These could lead to potentially lower dividends to investors. This downside may already somewhat be factored into the unit price, which corrected sharply to a low of ₹320 on March 24, 2020. Even assuming a 30 per cent reduction in rental income, the yield would be a decent 4.4 per cent at the current price of ₹374 per unit.

Bottomline

Investors, especially those who prefer regular income options, can take a closer look at REITs. We are in very early years and the REIT market has been very slow. There may however, be a pick-up in retail and office property listings, as developers may look to this vehicle to raise money. It is also possible to see more asset varieties, such as data centres, and residential, for REITs in the future, giving a broader array to choose from. So, it may be good to be in the know and test the waters in a small way to understand this asset class.

(The author is an independent financial consultant)