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Real Estate India
ATTRACTIVE JULY 16, 2014
UPDATE
BSE-30: 25,229
REIT, a reality? Not yet! Although the Finance Minister made a progressive
announcement on REITs in his budget speech, we believe work still needs to be done
on the fine print and state-level issues need to be sorted for REITs to become a reality.
Our discussions with accounting professionals, law firms and sponsors indicate hurdles
that need to be overcome with respect to the current structure of a REIT . Also, even if
the some stake holders take a hit on tax, high interest rates and a negative spread are
still hurdles.
Key announcement and on REITs—does it really change anything?
The Finance Minister made two major announcements in the recent Union Budget, which directly
affect the tax structure for setting up a Real Estate Investment Trust (REIT).
` Capital gains tax on transfer of interest in an SPV to an REIT will be deferred until the sponsor
monetizes the investment.
ƒ Wish-list. Most sponsors were seeking a one-time exemption in capital gains tax on transfer
of assets (in line with the practise in most of the successful global REIT markets).
ƒ View. Globally, capital gains tax is exempt on transfer of share holding. Change in the
preferential tax regime in the finance bill makes its unviable for the sponsor, we believe.
` The REIT’s dividend distribution tax is a pass-through if the income of the REIT is in the form of
dividend from a subsidiary/SPV. Further, a 10% withholding tax for resident and 5% for non-
resident unit holders is applicable if interest earned by the REIT is distributed as dividend.
ƒ Wish-list: Exemption in dividend distribution tax at the SPV level as 90% of the income
would be distributed to investors.
ƒ View. This is not different from the existing structure for a developer with multiple
subsidiaries/SPVs holding such assets. In case a subsidiary is dividend paying, the tax is set off
at the parent level, which is also paying dividend.
Assuming the current tax structure remains, is it viable for stakeholders?
` We believe India’s property market is at a nascent stage compared with developed markets.
Excluding a few deals in the trough of 2010-11, most pre-let commercial property acquisitions
took place at negative spreads and at high single-digit/low double-digit yields, while the cost of
borrowing is about 11.5%. In most developed markets the yield spread is usually positive. In
India buyers and owners look for capital appreciation and cap-rate compression as rents are still
near all-time lows in most markets.
` Most sponsors with potential REIT offerings command a strong brand equity and thus better
cost of borrowing versus others (11.5-12%, post tax 7.5-8%). Ideally, a sponsor would look at
monetizing value, which is better than its existing funding options. If fund raising takes place at
lower cap rates, it becomes unfavorable for the investor (see Exhibits 4 and 5).
QUICK NUMBERS
• The pass-through
structure is not very
different from the
existing structure
• The current cost of
borrowings of
developers raises
expectations of cap
rates, which are
unattractive for
investors
• Sponsors still do not
get key exemptions
on the lines of
global REITs
Samar Sarda samar.sarda@kotak.com
Mumbai: +91-22-4336-0874
Kotak Institutional Equities Research kotak.research@kotak.com
Mumbai: +91-22-4336-0000
For private Circulation Only. FOR IMPORTANT INFORMATION ABOUT KOTAK SECURITIES’ RATING SYSTEM AND OTHER DISCLOSURES, REFER TO THE END OF THIS MATERIAL.
India Real Estate
2 KOTAK INSTITUTIONAL EQUITIES RESEARCH
How do the tax announcements impact the current structure?
Capital gains are deferred, not exempt
Government has proposed to defer and not exempt capital gains arising to a sponsor from
tax until the units of a REIT are sold. The tax on transfer of the sponsor’s shares in an SPV to
a REIT in lieu of units of the trust is deferred.
The Finance Bill proposes to insert an additional proviso, which denies preferential capital
gains regime available in respect of units of a business trust, to the sponsor of the SPV in
respect of these units when they are disposed of by it. Thus, capital gains will be taxable at
the time of sale of units of business trust received in exchange of shares even if the
transaction of sale of units is carried out on a recognized stock exchange. This makes it
unviable for sponsors.
A pass-through on Dividend Distribution Tax? Not really
The government has proposed a pass-through on distribution tax when a REIT pays dividend
to unit holders. But the SPV that owns the project is subject to corporate tax and the
dividend paid by the SPV to the Trust is also subject to DDT. This makes it no different from
the current structure in which a developer is holding projects in an SPV, which if pays
dividends to the developer could be set-off if the developer in turn pays dividends to its
investors. In fact the current structure is marginally better for the developer as investments in
the SPVs are usually in the form of debt (see Exhibits 1 and 2).
Exhibit 1: Little tax leakage in the existing structure Developer earning from an SPV is in the form of interest
Exhibit 2: Pass through of REIT results in tax leakage REIT holding an SPV with equity investment
Distribution tax
can be set off
Investor
Dividend,
no DDT
Unit holder
Developer
REIT
Debt Interest
Equity Dividend
Subsidiary / SPV Subsidiary / SPV
Minimal or no tax;
Hence no DDT
Completed rent
yielding project
Assuming no debt -
corporate tax and DDT
Completed rent
yielding project
Source: Kotak Institutional Equities Source: Kotak Institutional Equities
The government also proposed that in an investment of a REIT into an SPV, if in the form of
debt, the interest income earned by the REIT will have a pass-through, that is, no tax on
interest income of the REIT. But if such interest income is distributed to unit holders as
dividend (90% of the income of the REIT has to be distributed as dividend), it will have a
10% withholding tax for resident unit holders and 5% for non-resident unit holders.
The resident unit holders will be charged at a maximum marginal tax rate with the benefit
of setting off the 10% TDS cut. This structure is marginally better than the previous one
with some saving at the SPV level.
Real Estate India
KOTAK INSTITUTIONAL EQUITIES RESEARCH 3
Exhibit 3: A debt structure is marginally better REIT investment in SPV in form for debt
5% WHT
10% WHT
Non-resident unit
holder
Resident unit holder
REIT
Debt Interest
Subsidiary / SPV
Minimal or no tax; hence no
DDT
Completed rent
yielding project
Notes:
(a) WHT- Withholding tax
Source: Kotak Institutional Equities
Presently trusts are taxed at a maximum marginal rate if they are discretionary trusts, or
those engaged in business. Beneficiaries of these trusts are not taxed. This assumes that
these taxes are all domestic trusts. This basic principle is sought to be retained, where the
constitution of business trusts is concerned. Further, a new section is proposed to be
inserted, which taxes income of the business trust at the maximum marginal rate.
Various industry bodies and sponsors made the following representations to the government,
which largely remain unaddressed.
` As 90% of the net income will be distributed to unit holders/investors, DDT should be
completely exempt. This practice is also followed in successful REIT markets.
` Complete tax exemption of capital gains to the sponsor and the REIT on disposal of assets
as the net proceeds of the disposal of asset in a REIT Is distributed to unit holders.
` Stamp duty exemptions on transfer / purchase of properties directly by REITs: In India land
is a state subject and stamp duty is levied by states. The five states which hold majority of
the assets which could potential be listed in form of REITs are Maharashtra, Karnataka,
Haryana, Uttar Pradesh and Tamil Nadu. The stamp duty on asset transfer varies between
6-9% in these states. Direct holding of a property by the REIT (going away with the step
down SPV structure) will eventually save some tax leakage (DDT). Separate
representations will have to be made to the states for this.
India Real Estate
4 KOTAK INSTITUTIONAL EQUITIES RESEARCH
Assuming current tax proposals are agreeable, it’s viable for whom?
Should a Grade A developer with a strong balance sheet monetize through REIT?
Most banks, financial institutions are keen to lend to Grade A developers. Hence as evident,
cost of borrowing for a Grade A developer, which is already low and falling further. Besides,
the introduction of Commercial Mortgage Backed Securities (CMBS) like structures has
improved the cost and structure of borrowing for the developer. The recent (maiden) fund
raising, initiated by DLF, was at 10.9%, which makes the effective post-tax rate 7.3%. As
seen in Exhibit 4, we believe a developer would be more comfortable raising debt and
keeping the property appreciation for himself if debt is available at the current rate (11-
12%).
Additionally as the commercial property market is emerging from a low, with most rents
being closer to the cost of construction (on capitalized basis), a sponsor would want to keep
the assets on books and earn benefits of an increase in capital values.
Exhibit 4: Amount raised in a REIT gives away more at 10% cap rate
Comparison of the amount raised through debt and through a REIT structure (`)
Case 1: A developer able to raise debt through CMBS
Net rental income 1,000
Existing debt on the project 3,500
Debt raise possible (a) 5,000
Tenure (years) 7.5
Cost of debt (%) (b) 11.5
Yearly interest payment 575
Post tax cost of debt (%) 7.6
Case 2: A developer wanting to monentize the property through a REIT
Net rental income 1,000
Cap rate (%) (c) 10
Value of the asset 10,000
Existing debt on project 3,500
Equity value 6,500
Primary dilution (%) 50
Amount raised 6,500
Notes:
(a) Assuming a Grade A property and tenants.
(b) Based on recent transactions.
(c) Assuming a 150 bps positive spread over the 10 year treasury note (8.5%).
Source: Kotak Institutional Equities estimates
A sponsor will aim at lowering the cap rate (see Exhibit 5) to (a) raise more capital but more
importantly (b) achieve a better rate than the current cost of funds. As seen in Exhibit 5,
even at a 10% cap rate the spread for an investor is negative versus the relative investment
vehicle, given high interest rates in India currently. As cap rates fall by 100 bps, so does the
yield, which makes investment in such a vehicle unviable at the current interest rates.
Real Estate India
KOTAK INSTITUTIONAL EQUITIES RESEARCH 5
Exhibit 5: Cap rate expectation the key Yields to investors at various expected cap rates
Case1 Case 2 Case 3 Case 4 Case 5 Net yearly rental income 1,000 1,000 1,000 1,000 1,000 Cap rate expected (%) 6 7 8 9 10 Value of the asset 16,667 14,286 12,500 11,111 10,000 Existing debt on project 3,500 3,500 3,500 3,500 3,500 Equity value 13,167 10,786 9,000 7,611 6,500 Primary dilution (%) 50 50 50 50 50 Amount raised 13,167 10,786 9,000 7,611 6,500 New asset purchased at entry yield (%) 10 10 10 10 10 Rent on the amount invested (assuming zero debt co) 967 729 550 411 300 Yield to an investor post dilution 7.5 8.0 8.6 9.3 10.0 Current 10 year treasury paper 8.8 8.8 8.8 8.8 8.8 Spread (1.3) (0.7) (0.1) 0.5 1.3
Notes:
(a) Loading of debt will impact yield calculations.
Source: Kotak Institutional Equities estimates
Experts on the subject—key highlights
Post the recent Union Budget we attended a panel discussion at Asia Pacific Real Estate
Association (APREA) conference, on the budget implications on the real estate sector. The
discussion was moderated by a CEO of a real estate fund and participants included South
Asia Head of a global property consultant, CEO of one of one of the largest office
developers, senior partners from the two of the big four accounting firms, managing
director of a global asset management and chief economist of a global bank. Discussion
revolved around REIT legislations. Key highlights:
` Panelists agreed that most global REITs do not have a tax structure of more than 20%
and the current budget’s tax proposal makes it slightly more complex than what is
proposed by the market regulator.
` The developer sounded optimistic about steps taken by the government; but opined that he
has different options to raise funds and not necessarily a REIT, on the current dynamics.
` A lot of capital is chasing too few investible assets in India, due to which the yield spread
is negative. The consultant validated, citing an example that over US$2 ban of assets
were being chased only in Mumbai with cap rate expectations of 9.5%.
` The sponsor expectations on the cap rates for listing are near 6% while those of investors
are 10%. But in markets with REITs, the spread on yield with a 10-year treasury note is
200-300 bps.
6 KOTAK INSTITUTIONAL EQUITIES RESEARCH
Disclosures
"I, Samar Sarda, hereby certify that all of the views expressed in this report accurately reflect my personal views about the
subject company or companies and its or their securities. I also certify that no part of my compensation was, is or will be,
directly or indirectly, related to the specific recommendations or views expressed in this report."
Kotak Institutional Equities Research coverage universe
Distribution of ratings/investment banking relationships
70%
Percentage of companies covered by Kotak Institutional Equities,
within the specified category.
60%
50%
40%
30%
20%
10%
23.5%
35.6%
25.5%
15.4%
Percentage of companies within each category for which Kotak
Institutional Equities and or its affiliates has provided investment
banking services within the previous 12 months.
* The above categories are defined as follows: Buy = We expect
this stock to deliver more than 15% returns over the next 12
months; Add = We expect this stock to deliver
5-15% returns over the next 12 months; Reduce = We expect this
stock to deliver -5-+5% returns over the next 12 months; Sell =
We expect this stock to deliver less than -5% returns over the next
12 months. Our target prices are also on a 12-month horizon
basis. These ratings are used illustratively to comply with applicable
2.0% 0.7% 2.0% 0.7%
0%
BUY ADD REDUCE SELL
regulations. As of 30/06/2014 Kotak Institutional Equities
Investment Research had investment ratings on 149 equity
securities.
Source: Kotak Institutional Equities As of June 30, 2014
Ratings and other definitions/identifiers
Definitions of ratings
BUY. We expect this stock to deliver more than 15% returns over the next 12 months.
ADD. We expect this stock to deliver 5-15% returns over the next 12 months.
REDUCE. We expect this stock to deliver -5-+5% returns over the next 12 months.
SELL. We expect this stock to deliver <-5% returns over the next 12 months.
Our target prices are also on a 12-month horizon basis.
Other definitions
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designations: Attractive, Neutral, Cautious.
Other ratings/identifiers
NR = Not Rated. The investment rating and target price, if any, have been suspended temporarily. Such suspension is in compliance with applicable
regulation(s) and/or Kotak Securities policies in circumstances when Kotak Securities or its affiliates is acting in an advisory capacity in a merger or strategic
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CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.
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fundamental basis for determining an investment rating or target. The previous investment rating and price target, if any, are no longer in effect for this stock
and should not be relied upon.
NA = Not Available or Not Applicable. The information is not available for display or is not applicable.
NM = Not Meaningful. The information is not meaningful and is therefore excluded.
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