Introduction

The real estate sector holds considerable significance in the growing Indian economy. It also provides large employment opportunities after agriculture and manufacturing. Real estate sector thus has a multiplier effect on the overall economy. The economic growth of the country has in turn, stimulated demand for property to help meet the needs of businesses, such as modern offices, warehouses, hotels, and retail shopping centres. One of the major challenges faced by the sector is long term financing. The introduction of Real Estate Investment Trusts (REITs) by Securities Exchange Board of India (SEBI) through SEBI (Real Estate Investment Trusts) Regulations 2014 and its subsequent amendments (last amended on August 03,2021) is an attempt to garner long term capital for the real estate sector. Traditionally real estate sector has been a favored asset class by Indians for investment and they have primarily invested in plots, houses, and apartments but the option of investing in commercial properties such as shops and office space has been explored less. This is primarily because investment in commercial assets requires large investment amounts, long-term leases from viable tenants ensuring timely receipt of lease rent. Introduction of REITs have given the retail investors an opportunity to participate in commercial real estate, which would otherwise be out of their reach.

REITs are an investment vehicle like mutual funds that benefits both the developers and the investors. The developers can access long term capital and use the released capital to invest in new projects. The investors are provided with regular income, an investment vehicle with a diversified income generating asset base, liquidity as it is listed and traded on the stock exchanges, and an exposure to real estate sector without being burdened by purchasing and managing properties themselves.

What is a REIT?

A REIT is a collective investment scheme and is set up in the form of a trust that owns, operates, and invests in completed income producing properties as well as under construction real estate assets. These primarily are commercial properties such as office spaces, shopping malls, warehouses etc. The regulations have also included hotels, hospitals, and convention centers, forming part of composite real estate projects, whether rent generating or income generating and common infrastructure for composite real estate projects, industrial parks, and special economic zones. REIT consists majorly (80 per cent) completed rent generating properties and only 20% or less may be under construction properties. Unlike a listed real estate company, a REIT is not created to develop real estate properties and resell them, rather the main objective is to acquire the real estate properties with sole aim of leasing such properties and manage the same to ensure a consistent yield as part of an investment portfolio. Generally, the real estate assets are held by the developers under Special Purpose Vehicles (SPVs). A REIT allows multiple such assets to be pooled under one single entity, the trust which is governed by SEBI. The performance of REITs primarily depends on how well its real estate holdings are performing. A unit of REIT represents part ownership of the real estate assets held by the Trust. This entitles the unit holder(s) to receive a share of the income generated by the REIT from its real estate holdings. Currently, distribution of 90% of net distributable cash flows (NDCF) is mandatory to the unit holders of a REIT. The REITs units are listed and traded on the stock exchange like equity stocks. The aggregate consolidated borrowings and deferred payments of the REIT, net of cash and cash equivalents is restricted to 49% of the value of the REITs assets. Also, as per SEBI’s regulatory requirement, if the aggregate consolidated borrowing and deferred payment of the investment trust, net of cash and cash equivalents, exceeds 25% of the value of the assets, for any further borrowing, credit rating must be obtained from a registered credit rating agency.

Scope of Credit Rating of REIT

Infomerics’ rating of REITS is an opinion on the ability of the trust to make timely payment on its debt obligations. Infomerics does not rate the units of these trusts which are like shares of a company nor does the rating have any bearing on the market performance of the trust. The rating does not in any way signify or indicate the returns to unit holders nor does it signify any potential yield levels to unit holders, and therefore, the rating on the debt of REIT should not be construed as a rating on REIT’s units. The credit rating involves assessing the combined adequacy of cash flows to service its debt obligations after assessing the operational and financial risk profiles of the underlying portfolio of real estate assets. Infomerics considers consolidated debt on the books of the REIT and its SPVs while arriving at the rating of the REIT. The external debt could be either raised at the REIT level or at the level of the SPVs. The debt raised at the SPV level could be guaranteed by the REIT, if the cash flows at the SPV level are expected to be inadequate or volatile. The rating is also in no way a reflection on the credit worthiness of the individual assets/SPVs as these assets are part of a portfolio and evaluated as a pool.

Structure of REIT

The REIT is established as a Trust under Indian Trusts Act 1882 and registered with SEBI. The parties to a REIT are a trustee, a sponsor, and a manager (See diagram below). SEBI has laid down guidelines notifying as to which entity can qualify for each, in terms of experience in relevant areas, net worth, assets owned as well as each of their duties and responsibilities.

Sponsors are people who promote and refer to any organisation or a corporate entity with a capital of Rs 100 crore, which establishes the REIT. The sponsor sets up the REIT and appoints the trustee. The sponsor shall transfer its ownership of the real estate assets to the REIT.

The trustee shall hold the REITs assets on behalf of the REIT for the benefit of the unitholders. The trustee appoints manager(s) and oversees its activities. The Trustee cannot be an associate of the sponsor or the manager.

The manager is an entity that is responsible for decisions regarding actual investment, divestment, and related investments of the REIT. The trustee enters into a management agreement with the manager on behalf of the REIT. If the REIT invests in under-construction properties, the manager may undertake the development of the properties, either directly or through the SPV, or appoint any other person for development of such properties and shall oversee the progress of development, approval status and other aspects of the properties up to its completion.

Refer to Annexure 1 for current regulatory framework on REITs.

Diagram of Structure of REIT

 

Rating Methodology

The credit rating of borrowings of a REIT primarily involves assessing the credit quality of the underlying asset portfolio, the cash flow coverage, leverage, financial flexibility, and the management risk. The credit rating reflects the combined strength of the REITs assets/SPVs cash flows to meet debt obligations in a timely manner. The ratings approach is similar to that of rating debt in a corporate. Infomerics applies the ‘Rating Criteria for Real Estate Entities’ while assessing the assets/SPVs of the trust.

Business Risk:

Portfolio Credit Quality:

The most important driver for assessment of the business risk profile of the REIT is the assessment of the underlying real estate assets or SPVs. The cashflows available at the REIT level are a consolidation/ pooling of the cash flows available from each of the assets/SPVs for servicing the debt obligation of the REIT. Therefore, it is important that cash flow adequacy at individual asset level is assessed. REITs are also allowed to invest in hotels, hospitals, and convention centres but majority of the portfolio would comprise rent generating assets like office premises, malls etc. Parameters like asset location and quality, demand supply dynamics of the geographies, trends in occupancy and rentals, covenants in lease agreements, profiles of tenants, counterparty credit risks, and project implementation risks are assessed while evaluating the underlying assets.

Presence of the REIT’s assets in prominent locations like business districts, shopping hubs of a metro along with good connectivity with residential areas, multiple transportation options available in the vicinity and are also well maintained will favorably impact the occupancy levels and rentals of the property on a long-term basis and thereby result in long term stable cash flows. Geographical diversity also becomes important as demand supply dynamics in real estate tend to be local in nature. Development happening around the area, likelihood of tenants moving out in search of cheaper properties, the market position of developers and brand equity of the developers in maintaining competitive attractiveness of the properties all impact the occupancy levels and rentals in the long term. The salient features of lease agreements are also evaluated in terms of lease tenure, lock in period and rental escalation clause. Properties that have been operational for a few years have seen multiple business cycles would be a credit positive. Further timely payment of rentals by tenants and diverse tenant profiles across sectors in case of commercial properties with low single counterparty concentration is viewed favorably.

The portfolio credit quality at the REIT level could be higher than the credit quality of the individual assets in the pool. This emanates from possible diversification benefits across geographies, multiple counterparties, diverse profiles of tenants, and a mix of asset types. Thus, the cash flows at the REIT level can exhibit less volatility as compared to the cash flows at the individual asset/SPV level. Hence a well-diversified asset base with strong cash flows and low receivables concentration will be looked at favorably. This has even been mandated by REITs regulations to an extent as no project can contribute to more than 60% of the value of the assets of the REIT.

The rating normally corresponds to the current portfolio and may factor any planned additions in its analysis. However, any unplanned addition or divestment will trigger a rating review of the REIT. Infomerics would review the rating of the REIT each time a new asset is added or divested from the portfolio and if there is any deviation from the stated investment philosophy of the REIT. The new addition would be assessed both at the individual level and at the consolidated level and if there are any deviations from the stated investment philosophy it may impact the rating of the REIT.

Financial Risk:

The financial risk assessment involves Infomerics evaluating the stability and adequacy of cash flows, debt service coverage metrics, overall leverage, financial flexibility, in the form of headroom for further borrowing and liquidity of the REIT.

REIT regulations allow REITs to raise debt at REIT level or at the SPV level. Hence there could be external debt only at REIT level, or only at SPV level or at both levels. At first cash flows of individual SPVs after meeting their operational expenses are assessed that can be up streamed to the REIT. Then all such cashflows of SPVs are consolidated to arrive at the cash flows of the REIT. The adequacy of such cash flows is evaluated for meeting REIT’s expenses and debt obligations. This is applicable when there is no external debt at SPV level. Even if there is external debt at any SPV level and such debt does not have restrictive covenants in terms of up streaming of cash flows to REIT similar approach is followed. If there are any restrictive covenants only surplus cash flows after servicing debt obligations of that SPVs available are consolidated for the cash flows of the REIT. The debt service coverage ratio (DSCR) both at the REIT level and at the SPV level is evaluated based on the available cash flows. Sensitivity analysis on DSCR under various stressors such as levels of occupancy, rent rates are carried out to establish adequacy for the rating category. Creation of debt service reserve account in the structure provide cushion against temporary cash flow mismatches.

The aggregate debt, including those in the SPVs is considered in arriving at the gearing of the REIT. REIT regulations permit 20% of assets to be under construction properties. Funding and pricing risks of such properties are also factored in the debt of a SPV facing project execution risk. The extent of distress support that may be provided by the REIT to a weaker SPV is also factored in. Further in case of REIT the leverage restrictions and requirements at various levels of leverage are detailed in the SEBI guidelines. A conservative leverage will be viewed favorably and will provide financial flexibility and headroom for further borrowing in case of future growth plans or exigencies in terms of existing under construction properties. Unencumbered cash balances, undrawn lines of credit at consolidated level further provide liquidity support in times of temporary cash flow mismatches. Well staggered debt repayment is also considered a positive from liquidity perspective.

Cash flows adequacy analysis is crucial when it comes to real estate entities. The nature of the underlying assets impact cash flows. For example, cash flows from office premises can be more predictable and stable as they have longer lease rental agreements and higher probability of renewals compared to cash flows from retail space as they have shorter lease rental agreements and a higher variability in rentals depending on competition and shopping spends. Further, REITs have 80 per cent rent generating properties in its pool. For properties that have been operational for a few years a demand pattern would have been established. Occupancy rates, contractual terms relating to rental rates, rental escalations, diversified tenant profile, geographical diversity and dynamics, and maintenance costs of properties all have a bearing on the cash flows of the assets.

The foreign exchange variation risk is also assessed in case of unhedged foreign currency borrowings. Adjustments to interest rate assumptions are factored in the sensitivity analysis while calculating the available cash flows of the SPVs. Any financial implications of contingent liabilities and off-balance sheet exposure of the SPVs and the REIT are also evaluated.

 

Management Risk:

All ratings necessarily capture an assessment of the quality of the issuer’s management. The experience and track record of the trustee and the manager are of key importance. The SEBI guidelines requires the manager to have at least five years of experience in fund management/ advisory services/property management in the real estate industry or in development of real estate. An evaluation of the track record helps understand how well qualified the manager is to manage the activities of the REIT. A detailed discussion with the management is done to understand the issuer’s business objectives, investment policy, leveraging policy, return policy, and risk appetite in terms of asset acquisition and diversification. The credit profile and track record of the sponsor is also assessed. The experience of the top management in the real estate sector, capability in terms of managing medium to large sized projects, past accomplishments are evaluated. A strong sponsor may lend financial flexibility in terms of refinancing debt and may also attract equity investments in the fund based on its past track record or being part of a strong group.

Conclusion

REITs are investment vehicles that invest in real estate assets. They are governed by SEBI guidelines. There are laid guidelines on listing, distribution of cash flows, leverage, and investment. Infomerics’ rating of the REIT is an opinion on the ability of the trust to make timely payments on its debt obligations. This opinion is based on the detailed assessment of the underlying quality of asset portfolio, cash flow and adequacy, cash flow coverage, financial flexibility, and management expertise.

Annexure 1:

Current Regulatory Framework

SEBI has laid down the framework for setting up REITs in India and has specified eligibility criteria for various parties to the REITs.

1.         Structure of REIT

  1. The REIT may invest in properties through SPVs.
  2. The REIT may also invest in properties through holdco in which it holds 50% equity share capital subject to the ultimate holding interest of the REIT in the underlying SPV(s) is not less than twenty-six per cent.
  3. REITs/Holdco to hold controlling stake and not less than 50% equity share capital or interest in underlying SPVs.
  4. Eighty per cent of value of the REIT assets shall be invested in completed and rent and/or income generating properties
  5. Not more than twenty per cent of value of the REIT assets shall be invested in other permitted assets such as under construction projects, which shall be held by the REIT for not less than three years after completion.
  6. REIT shall invest in at least two projects, with one project attributing to not more than 60% of the value of REIT assets.
  7. The sponsor should hold a minimum of 25% of the units issued by the REIT with a lock in period of three years from the date of issuance. There is a one year lock in for holding in excess of 25%.

 

2.         Eligibility Criteria for Various Parties

            Sponsor

  1. The collective net worth of sponsor(s) is a minimum of Rs.100 crores and provided the individual net worth is a minimum of Rs.20 crores.
  2. Minimum experience of five years in real estate development or fund management in the real estate industry and provided where the sponsor is a developer, a minimum 2 of his projects should have been completed.

            Manager

  1. Net worth of at least Rs. 10 crores in case of body corporate or a company or net tangible assets of Rs. 10 crores in case of a limited liability partnership.
  2. Minimum experience of five years in fund management or advisory services or property management in the real estate industry or development of real estate.
  3. Minimum two employees who have at least 5 years of experience in fund management or advisory services or property management in the real estate industry or development of real estate.
  4. Not less than half of the directors/ members should be independent, and they should not be directors/ members of another REIT.

            Trustee

  1. Registered with SEBI under Securities and Exchange Board of India (Debenture Trustee) Regulations, 1993.
  2. Not an associate of the sponsor or investment manager.
  3. Sufficient resources with respect to infrastructure, personnel, etc. as specified by SEBI.

 

3.         Distribution Requirements

  1. Holdcos are required to distribute 100% cash flows received from underlying SPVs to the REIT and 90% cash flows generated by the Holdco on its own to the REIT.
  2. Not less than 90% of net distributable cash flows of the SPV to be distributed to the REIT/ Holdco in proportion of its holding in the SPV subject to applicable provisions in Companies Act, 2013 or Limited Liability Partnership Act, 2008.
  3. Not less than 90% of net distributable cash flows of the REIT to be distributed to the unit holders.
  4. Distributions are to be made once in six months by the REITs.
  5. If any property or shares is sold by the REIT / SPV / holdco, it shall distribute at least 90% of the sale proceeds, unless the REIT proposes to reinvest the sale proceeds into another property within a period of one year.

 

4.         Borrowing Restrictions

  1. The aggregate consolidated borrowings and deferred payments of the REIT net of cash and cash equivalents should not exceed 49% of the value of the REIT assets and provided that such borrowings and deferred payments shall not include any refundable security deposits to tenants.
  2. If the aggregate consolidated borrowings exceed 25% of the value of the REIT assets, for any further borrowing upto 49%, REIT must obtain credit rating from a credit rating agency and seek approval of unitholders.

 

5.         Valuation of Assets

  1. The valuer should not be an associate of the sponsor(s) or manager or trustee and should have not less than five years of experience in valuation of real estate assets.
  2. The valuer should conduct a full valuation not less than once in every financial year.
  3. A half yearly valuation of the assets of the REIT should be conducted by the valuer for the half-year ending September 30th for incorporating any key changes in the previous six months.