Embassy REIT – All that you need to know

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The first REIT in India got listed only in 2019. This was the Embassy REIT, which raised about Rs. 4500 crores in March 2019. The REIT was listed at a price of Rs. 300, went up to Rs 512 and then closed the FY 2019-20 at Rs. 351.

When the pandemic set in, there was a fear that it will have a significant impact since commercial office space requirement was expected to shrink. So far, Embassy REIT has proven that expectation wrong.

It continues to be the only listed REIT in the market today, however, that is going to change in the next couple of weeks with Mindspace REIT (Raheja Group) out with its IPO on July 27, 2020.

I am curious to know more about the Embassy REIT and does it make for a sound investment option. Thankfully, the latest annual report is out to help us get a complete view on one full year of operation in public.

Here are a few questions I have sought to answer. Let’s begin with a basic one.

What is a REIT?

A REIT stands for Real Estate Investment Trust. The primary purpose of a REIT is to invest in rent yielding properties. It has to distribute most of its income (min 90%) to the investors / unit holders.

Minimum 80% of the REIT’s assets have to be completed and income generating.

Real Estate is generally a large ticket size investment, which makes it inaccessible for retail investors. A REIT enables investor participation in this asset class and helps diversify investments into rent yielding real estate with small amounts (minimum is Rs. 50,000).

REITs are governed by SEBI’s Real Estate Investment Trusts Regulation 2015. Several changes have been introduced to the regulations to make them more accessible to retail investors.

Now, what is the Embassy REIT?

Embassy Office Parks REIT owns and operates about 33.3 million square feet of commercial property (including Grade A office space, hotels and solar park). Out of this 26.2 million square feet is complete with 92.8% occupancy.

Its tenant base has over 160 blue chip tenants including several multinationals. There are 11 Commercial office complexes with 78 buildings. These properties are primarily in Bengaluru, Pune, Mumbai and Noida(NCR).

Bengaluru has the largest exposure by value at 62% of the total followed by Mumbai and Pune. In terms of office type, commercial office takes the largest share at 92%.

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Almost all the properties are owned by REIT through SPVs or Special Purpose Vehicles.

The top 10 tenants contribute 42% of the total revenue.

The weightage average lease expiry of the REIT is 7 years, which reflects long term lease commitments.

How does the REIT make money?

The primary source of operational revenue for the REIT is the rental income followed by common area service charges. The office spaces are usually leased out for 9 to 15 years with rent escalation of 10% to 15% every 3 years.

When leases are renewed, there is an opportunity for mark to market the rent, that is, align the rent to the current market rents.

The tenants have long term plans usually and hence provide a stable source of income. Even during the post pandemic period, there were near complete recoveries including rent escalations.

How does Embassy REIT plan to grow?

Organically, rent escalations and mark to market of rent will ensure a steady rise in cash flows. Mark to market is expected to provide 30% delta in rents.

Acquisition of new properties is going to be another way to grow inorganically. India is likely to have a huge uptick in commercial space demand and not just in office space but other commercial projects too.

In the near term, around 7 million + square feet space is under construction and is going to be available starting FY 22-23.

Finally, the REIT manager has to ensure that high quality blue chip tenants continue to lease space from the REIT.

What are the charges of the REIT managers?

The managers charge 3% of all rental income and 1% of the distributions to the unit holders as fees. There are no other fees charged.

What are the debt ratios for the Embassy REIT?

Debt can be used for financing growth / acquisitions for the REIT.

While the REIT regulations allow debt upto 49% of the gross asset value, Embassy REIT has been conservative with use of debt.

The current debt to Enterprise Value stands at 15%. Debt to Gross Asset Value is at 25%. Unit holder approval is required if it exceeds 25%.

Net Debt to EBITDA is 2.7x, which is comfortable.

How does the REIT distribute income to investors / unitholders?

Embassy REIT receives income from its various SPVs and post expenses the same are redistributed to the unit holders.

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As per REIT regulations, minimum 90% of all income has to be distributed to unitholders. Embassy REIT distributed 99.9%+ in year 19-20.

Currently, the distributions happens under 3 line items.

  • Interest – received on loans made to SPVs
  • Dividend – from the SPVs incomes
  • Amortisation of Debt to SPVs – Principal repayments from the SPV Loans

Year 2019-20 witnessed a larger portion of payouts under Interest and Amortisation. The payouts are made every quarter (required half yearly as per regulations). The payout in year 2019-20 totalled Rs. 24.39 per unit for the year.

Once loans are repaid by SPVs, dividends will become the primary source of income.

What is the taxation of the above income from REIT?

The income from REIT is taxed under the respective head at the unitholder’s end.

Interest income is added to the total income and tax paid at marginal income tax rates.

Dividend income is exempt in the hands of unitholders.

Payment under Amortisation of SPV debt is exempt in the hands of unitholders.

When you sell your units in the REIT, then capital gain tax applies. If holding period is less than 3 years then a 15% Short Term capital gains tax is payable.

For more than 3 years, capital gains upto Rs. 1 lakh is exempt, post which 10% long term capital gains tax is payable. Surcharge on tax is extra.

What is the yield from the REIT investment?

Yield is dependent on the price you pay to acquire the units. Here is a quick reference table

Embassy REIT - Yield scenario analysis
Source: Annual Report, Market prices

As you notice, for someone who bought at the time of IPO, the yield (based on distribution for the year FY 20-21 of Rs. 24.39 per unit) stands at 8.1%.

The current market price of Rs. 362 (as on Jul 23, 2020) has added a capital appreciation of another 21%.

However, during the course of the year, the price of the REIT went upto Rs. 512. Say, someone who bought at Rs. 500, the yield (annualised) is only 4.9%. However, the capital appreciation is negative and hence a total loss of 22.7%.

This helps you get an idea of how your buying price will determine the yield and overall returns.

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What is the minimum investment required to invest in Embassy REIT?

The minimum lot size to invest in the Embassy REIT is 200 units. At the current market price of about Rs. 360, that makes it Rs. 72,000.

Should I invest in the Embassy REIT?

Weren’t you waiting for this one all along? 🙂

Embassy REIT has a good commercial portfolio and it appears to be managed well. It is a good option for portfolio diversification too. I can’t afford to invest and then manage in a commercial property worth crores. This is a simple, small way to get that exposure.

Having said that, there are other things that I need to consider.

How will the pandemic effect play out further on the REIT?

Given the last quarter’s positive news, let me assume that with all the adjustments, they manage manage a similar distribution as financial year 19-20, that is, Rs. 24 per unit for the year. The current market price is Rs. 360 approx. That results in a yield of 6.7%. (Better than residential, eh!)

Now, if they manage a 5% increase in distribution, the yield inches up to 7.1% (at the current price).

What is the capital appreciation I can expect?

As per the annual report, the current fair value of the asset is Rs. 360 per unit ( as on March 31, 2020). The current market price is already there. As per conventional rules of investing, I have no margin of safety available.

The question I am asking is if in the case capital appreciation over the next few years works out to about 3% to 4% on average, does it still make sense? Anything more than 5% as an assumption is venturing into the unknown.

Yet another aspect is that as more REITs come to the market, investors may look at other options favourably. The attention Embassy REIT gets as the sole listed entity may go away. What if I buy today only to realise that my future liquidity comes only at a lower price?

You see, it all comes down to the price.

The decision is still a work in progress.

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Vipin Khandelwal
Vipin is a SEBI Registered Investment Adviser. He works with investors to make better decisions and create behaviour alpha.
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