Embassy REIT

Verdict: Only for HNIs looking to diversify

IPO Snapshot:

Embassy Office Parks REIT is entering the primary market on Monday 18^th March 2019, to raise Rs. 4,750 crore via a fresh issue of units in the real estate investment trust (REIT, different from a company issuing shares), in the price band of Rs. 299 to Rs. 300 per unit. 4 US investor groups have committed Rs. 876 crore (at Rs. 300 per unit) to the issue as strategic investors, with a 6 month lock-in, reducing the net offer size to Rs. 3,874 crore, amounting to 12.91 crore units. Representing a total of 20.52% of the post issue paid-up units, 75% of net issue is reserved for institutional investors and balance 25% for non-institutions, mainly HNIs, as minimum ticket size is Rs. 2.4 lakh (800 units at Rs. 300 each), while market parlance restricts retail participation to up to Rs. 2 lakh. Issue closes on Wednesday 20^th March and listing is likely on or about 3^rd April.

About REITS:

Before we get into the details of Embassy Office Parks, it is essential to first understand what REITs is, as this is India’s maiden REIT public offering.

1. Real estate properties bundled together, with minimum 80% in value of the assets rent-generating.
2. SEBI requirement of minimum of 90% of net distributable cash flow (NDCF) to be compulsorily distributed among unit-holders, once every 6 months. Embassy Office Parks aims at quarterly payouts, thereby marginally improving yield.
3. No dividend distribution tax on REIT, but distributable surplus taxable in the hands of the unit-holder (on regular income tax rates, as per investor’s tax slab).

• Embassy Office Parks guides 50% distribution as dividend (not taxable, unless investors’ total dividend exceed Rs. 10 lakh, in which case 10% tax rate) and 50% as interest. Hence, blended tax rates to be closer to 18%, as per management guidance.  

4. Capital Gains (on sale of units) to be taxed at 15%/10% for STCG/LTCG respectively. However, holding period for LTCG is minimum period of 36 months (and not 12 months as in case of listed equity shares).
5. While most of the above points are similar to Infrastructure Investment Trusts (InvIT), what differentiates InvIT with REITs is potential of capital appreciation in the latter, which is generally a depreciating assets for former. Hence, chances of capital appreciation in REITs appear higher due to the basic nature of real estate investment, besides returns being more predictable in REIT against InvIT.
6. Minimum application size in this IPO is fixed at Rs. 2 lakh (Rs. 2.4 lakh based on 800 units), brought down drastically by regulations from Rs. 10 lakh applicable for InvIT. Trading lot of minimum Rs. 1 lakh is also reduced from Rs. 5 lakh, applicable for InvIT. 

Thus, as an instrument, REITs fall in between debt and equity as:

• Risk higher than Debt - returns not guaranteed unlike bank FDs or non-convertible debentures (NCDs)
• Returns lower than equity - Nifty has returned 14% in last 20 years. REITs are likely to return lower, although returns will be more stable vis-à-vis equity.

Being a new instrument, poor performance of predecessor InvITs (IRB unit price down 34% despite 8.5x subscription of the maiden InvIT, IndiGrid unit price down 17% in 2 years) may weigh some caution on this issue as well. 

Business Overview:

Coming on to the issue specifics, Embassy Office Parks, sponsored by Bengaluru’s real estate developer Embassy Group and PE firm Blackstone, owns 32.7 million sq. ft. of commercial real estate, comprising 7 office parks and 4 office buildings in Bengaluru, Mumbai, Pune and Noida, with 160+ tenants/clients, having average occupancy of 95% (against 86% in the market) and average rent being 2.7% higher than market rates. In addition to office space, it houses 1,096 keys across 4 hotels (2 completed, 2 under construction) in Bengaluru and a 100 MW solar energy plant in Bellary. Having professional management, the trusts’ properties are concentrated in Bengaluru – single geography deriving 61% of the revenues. 

Objects of Issue:

Fresh issue proceeds of Rs. 4,750 crore will be used for:

1. Loan repayment of Rs. 3,710 crore, of total outstanding debt of Rs. 7,976 crore, as of 31-12-18. Post listing debt may decline to Rs. 4,266 crore, although news report suggest that it may raise additional Rs. 4,000 crore in non-convertible bonds, post-listing.
2. Purchase of Embassy One assets (office, retail, hospitality) for Rs. 460 crore
3. Balance towards general corporate purposes.

Returns: comprises of 2 components

1. Pure yield which is computed as net distributable cash surplus, divided by price per unit.

On FY20E financials shared in the RHP, the yield works out to 7.4%-8.3%, based % of net distributable cash surplus actually paid out. When the price of the units changes post-listing, this yield will obviously change, similar to bond/g-sec yields. 

This yield of 7.4%-8.3% is comparable to some bank FDs. FD yield for RBL Bank stands at 8.3% currently.

(Kindly refer the Taxation for these yields in point 3 above)

2. Capital appreciation: Since the value of the assets the trust holds may change, price of the listed units may also fluctuate. On appreciation in the value of the properties, these may result in capital gains.

Although lumpy, commercial real estate returns are estimated at 3%-5% p.a. over the long term.

RHP states the fair value of assets at Rs. 23,091 crore i.e. Rs. 376 per unit (pre-issue). This is just an indicative number worked out on basis a valuer report (how much one can really rely before public issue), as the trust is not looking to monetise any asset.

Important to note that both these percentage returns are pure guestimates (guess + estimates) without any guarantee on the part of the trust and may be influenced by factors outside its control, like domestic policy rate changes, macro socio-economic policies, global outlook of India, outlook for global IT (50% occupancy by technology tenants) etc.

Valuation:

At Rs. 300 per unit, post-listing equity value stands at Rs. 23,150 crore with enterprise value being at Rs. 27,416 crore. While there are no REITs to do a comparative analysis, as a broad benchmark, one can derive the value of the assets if it were held as a company (instead of a trust), as few listed equity peer is available. Mixed-use developer Phoenix Mills, with 7.7 million sq ft of malls, hotels and commercial properties, earning 10.1% RoE (against Embassy Office Parks’ 7.5% for FY18) is ruling at a market cap of Rs.10,300 crore and EV of Rs. 14,800 crore, translating into FY19E EV/EBITDA of 16x and PE of 38x. Embassy Office Parks valuation multiples are also similar i.e. FY19E EV/EBITDA of 16x, implying that one is paying price of equity to derive returns of “debt + some more”.

One may argue that the yield on this REIT is attractive in comparison to the highest equity dividend yield of Coal India (~8%). However, Indian equity investors don’t buy stocks for dividend yield, but more for expected superior growth in share price. 

Conclusion: 

It is essential to understand that REITs offers the risk of volatility in returns, with down side range at 7% and upside more-or-less capped at about 14%, on an average. Since these are pre-tax returns, investors must understand that post-tax returns range between 5.75-12.00%, depending on their respective income tax slabs, holding period, other sources of income etc. Thus, REITs are not suited for all.

Liquidity condition restrict retail participation, while HNIs may be enthused by it only as a diversification option. It is best suited only for those HNIs looking for commercial real estate exposure as Embassy REIT scores over buying physical property, given its diversified portfolio, marquee clients and professional management. 

Grey Market Premium of Embassy REITs:

Grey Market Premium (GMP) of Embassy Office Parks REITs is an unofficial figure, against guidelines of SEBI. We strongly recommend investors against following the grey market premium. To know more about grey market premium and how it operates, read our article on ‘grey market premium’ in the Pathshala column.

Disclosure: No interest.