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

Coverage view. The coverage view represents each analyst’s overall fundamental outlook on the Sector. The coverage view will consist of one of the following

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

transaction involving this company and in certain other circumstances.

CS = Coverage Suspended. Kotak Securities has suspended coverage of this company.

NC = Not Covered. Kotak Securities does not cover this company.

RS = Rating Suspended. Kotak Securities Research has suspended the investment rating and price target, if any, for this stock, because there is not a sufficient

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.

Corporate Office Overseas Offices

Kotak Securities Ltd.

27 BKC, Plot No. C-27, “G Block”

Bandra Kurla Complex, Bandra (E)

Mumbai 400 051, India

Tel: +91-22-43360000

Kotak Mahindra (UK) Ltd

8th Floor, Portsoken House

155-157 Minories

London EC3N 1LS

Tel: +44-20-7977-6900

Kotak Mahindra Inc

50 Main Street, Ste. 890

Westchester Financial Centre

White Plains, New York 10606

Tel:+1-914-997-6120

Copyright 2014 Kotak Institutional Equities (Kotak Securities Limited). All rights reserved.

1. Note that the research analysts contributing to this report may not be registered/qualified as research analysts with FINRA; and

2. Such research analysts may not be associated persons of Kotak Mahindra Inc and therefore, may not be subject to NASD Rule 2711 restrictions on

communications with a subject company, public appearances and trading securities held by a research analyst account.

3. Any U.S. recipients of the research who wish to effect transactions in any security covered by the report should do so with or through Kotak Mahindra Inc

and (ii) any transactions in the securities covered by the research by U.S. recipients must be effected only through Kotak Mahindra Inc at

nilesh.jain@kotak.com.

Kotak Securities Limited and its affiliates are a full-service, integrated investment banking, investment management, brokerage and financing group. We along with

our affiliates are leading underwriter of securities and participants in virtually all securities trading markets in India. We and our affiliates have investment banking

and other business relationships with a significant percentage of the companies covered by our Investment Research Department. Our research professionals

provide important input into our investment banking and other business selection processes. Investors should assume that Kotak Securities Limited and/or its

affiliates are seeking or will seek investment banking or other business from the company or companies that are the subject of this material and that the research

professionals who were involved in preparing this material may participate in the solicitation of such business. Our research professionals are paid in part based on

the profitability of Kotak Securities Limited, which include earnings from investment banking and other business. Kotak Securities Limited generally prohibits its

analysts, persons reporting to analysts, and members of their households from maintaining a financial interest in the securities or derivatives of any companies that

the analysts cover. Additionally, Kotak Securities Limited generally prohibits its analysts and persons reporting to analysts from serving as an officer, director, or

advisory board member of any companies that the analysts cover. Our salespeople, traders, and other professionals may provide oral or written market commentary

or trading strategies to our clients that reflect opinions that are contrary to the opinions expressed herein, and our proprietary trading and investing businesses may

make investment decisions that are inconsistent with the recommendations expressed herein. In reviewing these materials, you should be aware that any or all of

the foregoing, among other things, may give rise to real or potential conflicts of interest. Additionally, other important information regarding our relationships with

the company or companies that are the subject of this material is provided herein.

This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would

be illegal. We are not soliciting any action based on this material. It is for the general information of clients of Kotak Securities Limited. It does not constitute a

personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any advice

or recommendation in this material, clients should consider whether it is suitable for their particular circumstances and, if necessary, seek professional advice. The

price and value of the investments referred to in this material and the income from them may go down as well as up, and investors may realize losses on any

investments. Past performance is not a guide for future performance, future returns are not guaranteed and a loss of original capital may occur. Kotak Securities

Limited does not provide tax advise to its clients, and all investors are strongly advised to consult with their tax advisers regarding any potential investment.

Certain transactions -including those involving futures, options, and other derivatives as well as non-investment-grade securities - give rise to substantial risk and are

not suitable for all investors. The material is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should

not be relied on as such. Opinions expressed are our current opinions as of the date appearing on this material only. We endeavor to update on a reasonable basis

the information discussed in this material, but regulatory, compliance, or other reasons may prevent us from doing so. We and our affiliates, officers, directors, and

employees, including persons involved in the preparation or issuance of this material, may from time to time have “long” or “short” positions in, act as principal in,

and buy or sell the securities or derivatives thereof of companies mentioned herein. For the purpose of calculating whether Kotak Securities Limited and its affiliates

holds beneficially owns or controls, including the right to vote for directors, 1% of more of the equity shares of the subject issuer of a research report, the holdings

does not include accounts managed by Kotak Mahindra Mutual Fund. Kotak Securities Limited and its non US affiliates may, to the extent permissible under

applicable laws, have acted on or used this research to the extent that it relates to non US issuers, prior to or immediately following its publication. Foreign currency

denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of or income derived from the

investment. In addition, investors in securities such as ADRs, the value of which are influenced by foreign currencies affectively assume currency risk. In addition

options involve risks and are not suitable for all investors. Please ensure that you have read and understood the current derivatives risk disclosure document before

entering into any derivative transactions.

This report has not been prepared by Kotak Mahindra Inc. (KMInc). However KMInc has reviewed the report and, in so far as it includes current or historical

information, it is believed to be reliable, although its accuracy and completeness cannot be guaranteed. Any reference to Kotak Securities Limited shall also be

deemed to mean and include Kotak Mahindra Inc.

This report is distributed in Singapore by Kotak Mahindra (UK) Limited (Singapore Branch) to institutional investors, accredited investors or expert investors only as

defined under the Securities and Futures Act. Recipients of this analysis / report are to contact Kotak Mahindra (UK) Limited (Singapore Branch) (16 Raffles Quay,

#35-02/03, Hong Leong Building, Singapore 048581) in respect of any matters arising from, or in connection with, this analysis / report. Kotak Mahindra (UK)

Limited (Singapore Branch) is regulated by the Monetary Authority of Singapore.