Real Estate Mutual Funds - Complete picture

How often have you stared at a gleaming skyscraper in a tony address in your town and wished you could afford to buy a house there? If you have ended up sighing wistfully and walking away, here's some good news. Now, you may easily be able to own a small portion of a very swanky address.

After years of deliberation and planning, the Securities and Exchange Board of India has approved the launch of real estate mutual funds and issued a detailed set of guidelines on 16 April. All you may now need to shell out is a sum as low as Rs 5,000 to Rs 10,000 to invest in real estate.

How will it work?

An REMF is a scheme much like any other closed-end MF scheme (that invests in shares and bonds) except for the fact that the new entity will invest in real estate. There are two conditions of investment set by Sebi.

First, it is mandatory for an REMF to invest at least 35 per cent of its corpus in completed real estate assets (read flats, row houses, bungalows, shops). These could be either residential or commercial properties, but must be finished and ready-to-use and not under construction.

The REMF will get title deeds and will be the owners of these premises - it's like you are buying a second home or a small office. Simply stated, instead of reading a moniker like 'Ms Shirin Batliwala' on the name-plate against, say, a first floor flat number at your building's entrance, you could now have a neighbour called 'HDFC Real Estate Fund'.

Your REMF will then rent out these properties and earn rental income that it will pass on to you - the unitholder. When your REMF's tenure ends, it will sell these properties and generate capital appreciation and eventually pass on these earnings to you. With as low as Rs 5,000, you can now own a part of this flat through your REMF.

Let us assume your REMF collects Rs 500 crore (Rs 5 billion) and invests Rs 200 crore (Rs 2 billion) out of it (40 per cent of the collections) in 40 flats costing Rs 5 crore (Rs 50 million) each. If you have invested Rs 10,000 in this fund, then your share out of the appreciation and rental income of these flats would be 0.0002 per cent.

The second investment condition of Sebi mandates that at least 75 per cent of the corpus should be invested in real estate or related securities. These can be debentures of real estate companies and mortgage-backed securities and equity shares of real estate companies listed on the stock exchange.

Under this, your REMF can also invest in 'under-development' properties. But it can neither buy barren land, nor can it undertake construction activities. What then?

It will partner with a real estate developer and then take a stake in a special purpose vehicle that the developer will have set up for constructing a particular project. Note that your REMF will take a stake in that project and not in the developer company or its other projects across the country.

Your REMF will buy unlisted shares in that SPV, not more than 15 per cent of its own corpus. Once the project is completed, the gains arising out of it are yours to the extent of your REMF's stake in the SPV. An REMF will be closed-end (this means limited tenure and no ongoing sales of units) and units will be listed on the stock exchanges. You will be able to trade units on the exchanges very much like shares.

REMF not the same as REIT

In the 31 January 2008 issue of Outlook Money, we had carried the news about Sebi issuing a draft set of guidelines for Real Estate Investment Trusts or REITs (Blueprint Out For Real Estate Funds). So, what is the difference between a REIT and an REMF, considering they sound a little similar? REITs are also investment vehicles dealing in real estate. Like REMFs, they, too, are closed-end schemes and listed on stock exchanges. But there's a big technical difference between the two.

First, a REIT is mandated to distribute at least 90 per cent of the gains it makes in a year to those holding its units. Second, a REIT can invest only in finished projects and not those that are under construction.

Hence, it earns its major chunk from rental income. "While REITs help you earn a regular income, REMFs give you capital appreciation too," says Milind Barve, managing director of HDFC MF and head of the sub-committee appointed by the Association of Mutual Funds of India to recommend norms for REMFs.

Sebi guidelines mandate REMFs to invest at least 35 per cent in completed and ready-to-use properties. They do, in that sense, resemble Reits to an extent and can, in fact, invest this portion in Reits.

REITS and REMFs run simultaneously in many countries across the world, especially in developed markets like that in the US. India is set to follow that path as Sebi has shown enough intent to allow the launch of both the products.

Checks And Balances

For a beginning, the Sebi REMF guidelines cover a lot of ground. They mandate valuing of each real estate property by two valuers, which must be rated by a credit rating agency. The REMF will have to invest in a property at the lower of the two values.

Each property will be valued once in 90 days. So, if your REMF invests in four properties, say, in March, June, September and December, respectively, then each of those four properties will be valued once they complete their respective 90 days.

However, your REMF will have to declare its net asset value daily.

The NAV will change on a day-to-day basis because, apart from real estate assets, the REMF would also have invested in marked-to-market securities such as debentures and mortgage-backed securities.

While your REMF will charge you an expense ratio of up to 2.50 per cent, just like equity funds, the tax status is unclear. Sources say that the tax incidence in the case of REMFs will be akin to that for debt funds - long-term capital gains tax of 11.33 per cent and short-term capital gains tax as per the income tax rates applicable. This compares well with investing in physical real estate directly, where long-term capital gains tax kicks in after three years as against a year in the case of REMFs.

Beware of risks

Although REMFs open up a new asset class to investors that was otherwise restrictive, they come with a set of risks.

The 'others'. REMFs are free to invest the 25 per cent of the corpus that is left after investing in real estate or related securities in any security, related or unrelated to real estate. This can be either directly in the equity markets and debt instruments, or kept as cash. Sebi has allowed REMFs to take a call on this. But, how an REMF opts to invest this portion can have a bearing on its risk profile.

Flexible asset allocation. That is not the only flexibility that Sebi has allowed for REMFs. Beyond the mandated 35 per cent in finished real estate projects and within 75 per cent of the scheme's corpus, they have about four different types of securities to choose from.

Here's where one REMF can significantly look and behave differently from another. An REMF may choose to hold 35 per cent in completed real estate assets and deploy 40 per cent in equity shares of real estate companies and then invest the balance 25 per cent in another set of equity shares.

Asset allocation will be riskier in cases like above as against those that have a healthy dose of mortgage-backed securities and debentures of real estate companies and money market securities that earn a fixed interest income. Do look up the REMF's asset allocation before you finalise your investing plan.

Mis-selling. The same agent through whom you invest in MFs will now also sell you REMFs. Only time will tell whether agents will be able to differentiate the nuances of one REMF from another.

And although Barve says that the MF industry is gearing up to train agents and spread awareness, it will take some time - and probably some heart-burn too - before investors are able to realise the true worth and potential of REMFs. Your only genuine hope in the current scenario will be your REMF's offer document.

Apart from Sebi's nomination of cities in which REMFs can invest their finished projects and the taxation incidences on unitholders, most other things are in place. If all of what we have said has inclined you to sign up, then, hopefully, you will be able to do so in another three months, when India's first REMF ought to be born.