Reits and InvITs: Should investors sell these after recent taxation changes?

The recent taxation changes made by government led to a substantial increase in the taxation for investors on the gains from Reits and Invits. While presenting Union Budget 2023, FM Nirmala Sitharaman has proposed to tax a part of distributions by Reits and InvITs, classified as ‘repayment of loans’ (or return of capital) in the hands of unitholders, will be taxed as ‘other income’. As per the current system undertaken by the three existing REITs, the new taxation changes would levy an extra 60 -150 basis points of taxation on investors which is likely to discourage investor enthusiasm in the sector.

In a conversation with Livemint, Sudarshan Lodha, co-founder and CEO of Strata said that given the levying of the marginal income tax on Reits and Invits, fractional ownership investment can be a new tax efficient avenue to invest in CRE.

Today, fractional ownership gives small-scale investors unheard-of access to these prospects with lower initial outlays. In this avenue a premium CRE is preleased through the funds pooled in from multiple investors through an SPV.

Commercial real estate has always been an area of fascination for retail investors but has been limited to HNIs and institutional investors due to the market complexities and humongous ticket size. In an effort to democratize this promising investment avenue and to encourage retail investment in the segment products like Reits, Invits and fractional ownership emerged in the last few years.

While Reits and Invits act like mutual funds for real estate, fractional ownership model is completely different offering a greater investor control and superior returns on the asset.

With the recent taxation changes imposed on Reits and Invits in the budget 2023, the taxation burden on the unitholders by upto 1.5% thereby reducing the absolute returns. Compared to this the taxation system for fractional ownership is simple and convenient.

About 40 percent of retail investors have prefer to invest in fractional ownership of commercial real estate as a means of providing an additional income stream for their family in India.

Should investors sell Reits and InvITs?

Among the various tax ideas in this year’s budget impacting rich investment vehicles is one to tax a hitherto tax-free component of income distributed by Real Estate Investment Trusts Reits and Infrastructure Investment Trusts (IITs) (InvITs).

In terms of the proposed tax adjustment, this means a greater tax bill and potentially a reduced return on investment for Reits and InvITs investors. A prospective additional tax could be viewed as a disruption to the long-term return on such investments. The reduction in the surcharge for those in the highest tax bracket ensures that the net impact is balanced. The price correction following the budget release has been significant, and it accounts for the increased tax impact if one purchases now.

Current investors who invested based on the asset’s fundamentals in order to diversify have no compelling reason to switch. Current investors can also buy at lower prices. Aside from the immediate uncertainty induced by the budget announcement, price corrections for Reits and InvITs must be viewed through the lens of superior options in terms of fixed income return now that the interest rate cycle has gone up. With interest rates rising, existing bond prices are correcting, as are the prices of REITs and InvITs, which are considered part of fixed income assets due to their steady and defined income stream.

Considering this, it is tempting to question the long-term durability of these assets when the interest rate cycle favours other debt products. Today, there are alternatives with comparable risks but higher payoffs. While Reits with a yield disadvantage following the tax proposal can be sold, InvITs with no yield impact can be held until the dust settles. For the latter, it is a long-term rather than a short-term decision. Not only have corporate bond yields increased, but short- to medium-term debt funds are also yielding 7%–7.5% annualised.

Disclaimer: The views and recommendations made above are those of individual analysts, and not of Mint.