Tax breaks pave way for final REIT legislation: Edelweiss

Jul 12 2014, 15:04 IST
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As expected, tax breaks for REITs were announced in the Budget, says Edelweiss. (Thinkstock) As expected, tax breaks for REITs were announced in the Budget, says Edelweiss. (Thinkstock)
SummaryThe taxation structure for REITs implies that special purpose vehicles (SPV) will own the rental assets.

The Union Budget has announced tax breaks for real estate investment trusts (REITs), enabling tax pass-through and avoiding capital gains tax and stamp duties on transfer of assets by owners to a newly formed REIT. This has paved the way for REIT legislation in India.

We expect the REIT legislation to compress the cap rates of rental assets by 150-200 bps, in turn, positively impacting their capital values, apart from providing additional source of funding to real estate developers.

As expected, tax breaks for REITs were announced in the Budget. The taxation structure for REITs implies that special purpose vehicles (SPV) will own the rental assets, while the REIT will draw the rental income from the SPV by way of interest, which will be taxed at the unit holders’ end at a marginal tax rate.

In terms of capital gains, we believe the asset owner can transfer the SPV owning the assets to the REIT (still held by the sponsor of the REIT) and the REIT can then issue primary shares to incoming unit holders, thereby avoiding capital gains tax.

This will also avoid the impact of stamp duties on transfer of physical assets. We believe Sebi will be largely ready with the background work and announce final regulations in ensuing months.

While clarity is yet to emerge on treatment of assets with LRDs against them, we see the tax pass-through status as a vital step towards commencement of REITs.

India has Grade ‘A’ office market of 375 million square feet (msf) in the top-six cities, and 50% of this (~175 msf) is potentially available for the REITs. Out of this, 60% or 80-100 msf could be up for REIT listing once it gets introduced. Assuming average rental of R60-65 psf, 80-100 msf provides rental potential upwards of R6,000 crore. Assuming cap rates of 8-10%, REIT has potential market size of R70,000-90,000 crore. In our view, the move is positive for developers with commercial assets. We expect cap rates to compress by 150-200 bps from current levels of ~10-11% to ~8-9%, increasing the value for rental assets.

We estimate that a 1% compression in cap rates can push up capital value of rental assets by ~10%. REITs will also provide additional funding source for developers and improve liquidity for the sector. Further, introduction of REITs addresses liquidity concerns of real estate assets by lowering ticket size, mandated disclosures and by listing

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