Real Estate Investment Trusts (REITs): Unfit for Goal-based investing

A real estate investment trust (REIT) is like a mutual fund that invests in property. Here is why I think REITs are not suitable for goal-based investing.

I know very little about how REITs work and I have sourced my information primarily from three articles.

If you wish to understand,

  1.  how REITs work, check this illustrated article from the Economic Times: How can you buy property for Rs 2 lakh? REITs to help investors 
  2. why they will not work, read Subra's post: Will REITs work in India?
  3. the nitty-gritty, read Deepak Shenoy at his brilliant best:  REITs: The New Way To Make Less Money Than Inflation, in Real Estate

I don't claim to understand everything because I stopped trying when I learnt about two crucial aspects from Deepak and the ET article.

  • "REITs must distribute 90% of the income they get. It can’t be reinvested. Also, if the underlying assets are sold the income generated must be distributed too" - Deepak Shenoy (CapitalMind)
  • Much of the income will be rental income and it will be taxed at 30% before distribution (much like DDT). Deepak quotes, Nishith Desai in this regard. There are also tax rules concerning interest received and capital gains!

REIT seems like a risky debt mutual fund with dividend option.

Even if the dividends were free from DDT, even if real estate in India is well regulated with no black money in it, even if rental yields are attractive, I see no point in investing in REITs.

For the simple reason that there is no 'growth option. Had there been no mandate to distribute 90% of the income, I would have considered REITs for diversification. I would like to think RE volatility is lower when compared to gold. So instead of the usual 10% exposure to gold that 'experts' recommend, one could have a 10% exposure to REITs.

Unfortunately, REITs appear to be a dividend product, with a focus on 'income'.

When I am in the so called 'wealth accumulation stage', where I am creating a nest egg for retirement, and a corpus for my other long term goals, why on Earth, would I choose a dividend-based product?

I have better things to do than to receive dividends and reinvest them.

KISS: Keep it simple and sufficient

Stick to a well defined diversified asset allocation. Invest each month in 'growth' oriented products. I cannot think of a simpler way to keep track of a portfolio in every conceivable way.

Not convinced? 

If your goal is ten years away, would you choose an instrument in which you will have to declare gains each year and pay tax on it (like a fixed deposit) or would you choose a debt fund (growth option!) in which gains are taxed on upon redemption?

Investing in an REIT is like trying to fill a bucket with holes!

If I understand the power of compounding, why would I willingly choose to interrupt the compounding with taxes (assuming I am disciplined enough to reinvest the dividends)?!

What about retirees?

Can they invest in REITs to receive periodic (if not regular) income?  The title of Deepak Shenoy's post answers that, does it not?!

So if you have two lakhs (or more) to spare, you are better off investing in 'growth' products irrespective of your age.

What do you think?

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10 thoughts on “Real Estate Investment Trusts (REITs): Unfit for Goal-based investing

  1. Senthil Nathan

    Thanks for a wonderful article Pattu.Excellent Eye Opener !.I was thinking of investing in REIT earlier .I dropped the idea after considering the drawbacks mentioned in your article.

    Reply
  2. Senthil Nathan

    Thanks for a wonderful article Pattu.Excellent Eye Opener !.I was thinking of investing in REIT earlier .I dropped the idea after considering the drawbacks mentioned in your article.

    Reply
  3. Sridhar Ch

    Hi Pattabiraman,
    Good article on REITS and interesting observations. Its too early to assess whether REITS will work or not. SEBI is trying to make it an income product and giving utmost importance to safety for various reasons. First, it doesn't want REIT to retain and divert funds to risky assets or new projects without careful thought. Secondly it wants investors to receive dividends so that despite the illiquidity in RE investors have some income or pay back. What if real estate prices crash for a year? the NAV will crash and money gets trapped, and if you sell you make a loss, so dividend distribution (pref. free of tax) is necessary. Since there is DDT dividend returns will be less.
    Neverthless, REITs are currently designed to fund RE developers or projects, and not for retail investors. So its only for HNIs and sophisticated investors. The product may or may not work or it may see poor response. Anything can happen.

    Growth: Yes retaining funds would help in growth or increase in NAV. But the problem here is the retained funds can only be invested in real estate. Bonds or other instruments will provide poor returns if we adjust for inflation. In case of REIT growth will come from buying new assets which are under development, which is highly risky thats why SEBI has restricted that to 10%. This break up between rentable and developable properties could change in future. New its 90:10, may be after a year they might change it to 80:20. But restricting the %age of growth/new development is good for two reasons - one to avoid unnecessary diversion of funds, and two to ensure that trustees/fund mangers take careful/meaningful bets given limited funds.

    Dividends: Initially dividend yield is going to be less or negligible as rental yields will be poor. However, once the investments are made and operating costs are under control, the yields will go up. For example for a Rs.1 crore property if rents are Rs.8 lakhs it works out to a 8% yield. In future lets say the rents move up to 12 lakhs (say in 4 years). At 12 lakhs the yield works out to 12%. Given that RE is for serious and sophisticated long-term investors its not like debt mutual fund or FMP. The yields will go up overtime if one is patient. The good news is if 90% of the income is distributed you can take out the dividends rather than waiting for capital appreciation which is uncertain anyways. The distribution kills growth but investor has the option to invest in other asset classes such as equity, gold, etc. Unlike in equitty/companies the REITs dont need much funds once they have acquired a good portfolio of properties. SEBI wants to ensure that investors get exposure to rented/income-generating properties to a large extent so they are capping the growth aspect.

    Reply
  4. Sridhar Ch

    Hi Pattabiraman,
    Good article on REITS and interesting observations. Its too early to assess whether REITS will work or not. SEBI is trying to make it an income product and giving utmost importance to safety for various reasons. First, it doesn't want REIT to retain and divert funds to risky assets or new projects without careful thought. Secondly it wants investors to receive dividends so that despite the illiquidity in RE investors have some income or pay back. What if real estate prices crash for a year? the NAV will crash and money gets trapped, and if you sell you make a loss, so dividend distribution (pref. free of tax) is necessary. Since there is DDT dividend returns will be less.
    Neverthless, REITs are currently designed to fund RE developers or projects, and not for retail investors. So its only for HNIs and sophisticated investors. The product may or may not work or it may see poor response. Anything can happen.

    Growth: Yes retaining funds would help in growth or increase in NAV. But the problem here is the retained funds can only be invested in real estate. Bonds or other instruments will provide poor returns if we adjust for inflation. In case of REIT growth will come from buying new assets which are under development, which is highly risky thats why SEBI has restricted that to 10%. This break up between rentable and developable properties could change in future. New its 90:10, may be after a year they might change it to 80:20. But restricting the %age of growth/new development is good for two reasons - one to avoid unnecessary diversion of funds, and two to ensure that trustees/fund mangers take careful/meaningful bets given limited funds.

    Dividends: Initially dividend yield is going to be less or negligible as rental yields will be poor. However, once the investments are made and operating costs are under control, the yields will go up. For example for a Rs.1 crore property if rents are Rs.8 lakhs it works out to a 8% yield. In future lets say the rents move up to 12 lakhs (say in 4 years). At 12 lakhs the yield works out to 12%. Given that RE is for serious and sophisticated long-term investors its not like debt mutual fund or FMP. The yields will go up overtime if one is patient. The good news is if 90% of the income is distributed you can take out the dividends rather than waiting for capital appreciation which is uncertain anyways. The distribution kills growth but investor has the option to invest in other asset classes such as equity, gold, etc. Unlike in equitty/companies the REITs dont need much funds once they have acquired a good portfolio of properties. SEBI wants to ensure that investors get exposure to rented/income-generating properties to a large extent so they are capping the growth aspect.

    Reply

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