Mumbai/Singapore: Credit ratings agency Fitch Ratings says it is in favour of SEBI's draft regulations for the 'real estate investment trusts' (REITs) as proposed by the Securities and Exchange Board of India (SEBI).

SEBI's draft regulations propose that each Indian REIT be required to have a "rating from a credit rating agency" at launch.

''Investors in REITs are equity holders of the entity while the credit rating is targeted at debt investors,'' Fitch said in a statement. It however, qualified this saying, a credit rating assesses the fund's ability to service and repay its debt, which would assist investors in ranking the ability of a REIT to do so, but does not comment on the success or failure of a REIT beyond this.

''While ratings published by ratings agencies such as Fitch Ratings are used by the public and investor community in evaluating credit quality, it is important that users understand the limitations of such ratings,'' Fitch said in a statement.

It cautioned investors to note that the agency's credit and research are not recommendations to buy, sell, or hold any security. ''Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of any payments of any security.''

It clarified that the ratings are based on information obtained from issuers, other obligors, underwriters, their experts, and other sources the agency believes to be reliable, and therefore, does not audit or verify the truth or accuracy of such information. Ratings may be changed or withdrawn as a result of changes in, or the unavailability of, information or for other reasons.

As a supplier of debt ratings and an authorised credit rating agency under Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999, Fitch says its particular area of interest is in the gearing level, property and management quality of REITs in India.

The agency says it believes that in an ideal environment, regulatory restrictions on gearing should not be necessary and that investors should be able to choose the risk-reward parameters that suit their needs. At the same time, Fitch says SEBI's aim of protecting investors, especially in the embryonic stage of the market's development is understandable and other Asian countries have taken the same approach successfully.

Fitch says Singapore's experience where gearing regulations began at 25 per cent and have been subsequently increased to 35 per cent and then 60 per cent is evidence of the ability for the market to develop within the gearing constraints.

The restriction of borrowings to 20 per cent of gross assets is a positive from a credit perspective, and will certainly enhance the credit ratings of any REIT under this regulation, although the limitation also may have the effect of limiting the attractiveness of the REIT vehicle for investors.

While the gearing limitation imposed by the regulations is a fundamental input into the rating of a REIT, Fitch said, it was important to note that when assigning ratings, in addition to considering gearing levels, the agency rating the REIT should also consider the historical and prospective financial condition, quality of management, and operating performance of the issuer and of any guarantor, any special features of a specific issue or guarantee, the issue's relationship to other obligations of the issuer, as well as developments in the economic and political environment that might affect the issuer's financial strength and credit quality. In the case of a REIT, the quality of its underlying assets and the integrity of its legal structure should also be considered.

Highlights:

• Property quality: The proposed regulations are suggested for all REITs regardless of the risk profile. As a result, the regulations imply that all REITs with a gearing ratio of 20 per cent or less are a safe and secure investment. While the gearing ratio is an important aspect of the risk profile of a fund it is only one of a number of elements that should be taken into account by any debt investor.
  
  Typically, when analysing REITs, Fitch will review the type of asset (office, retail, industrial, hotel, etc,), the quality of the property (prime A-grade, B, C, etc,) as well as the historical cash flow, quality and structure of management, any perceived or potential conflicts of interest, its financial profile, including liquidity position and financial flexibility, strategic plan and its ability to withstand a stressed environment.
  
  As the regulations are designed to ensure funds can service and repay their debt, then other aspects of the risk profile should also be addressed. As an example, all things being equal, a portfolio of residential properties will exhibit a lower risk profile than a portfolio of C-grade hotel assets. SEBI may wish to address this issue in the regulations.
  
  
• Limitation of borrowings and timing of measurement of debt ratio: Section 55 (1) of the draft regulations makes the general statement that a "scheme may borrow . . . but aggregate borrowings shall not at any time exceed one fifth of the value of total gross assets of the scheme". What is the implication if a REIT raised 20 per cent debt and subsequently real estate assets fell in value? Should "at any time" be replaced by "at the time of entering into the debt"? This ought to be clarified in the regulations.
  
  
• Dividend policy: The draft regulations, like those for REITs in other jurisdictions require a REIT to distribute at least 90 per cent of its annual net income after tax but also states that "revaluation surplus credited to income . . .shall form part of net income for distribution to unit holders". A gain on revaluation is not a cash item and represents an increase of the asset value of the REIT. If required to pass this increased asset value through as dividends, a REIT may need to either sell assets or borrow to pay dividends.
  
  If valuation increases by a large amount, the gearing limitation would prevent borrowing to pay sufficient dividends. For example, if a REIT had assets of INR100,000 and these were revalued to INR200,000 under Section 56, INR90,000 (90 per cent of INR 100,000) would be passed through as dividends.
  
  As this is not a cash gain, the REIT would either have to borrow the INR90,000 which would conflict with the Section 55 requirement of the maximum 20 per cent gearing or would be required to sell assets or raise equity to facilitate payment. An alternative to this would be to allow revaluation gains not to be passed through as dividends but to let the unit price adjust to changes in asset value, or to let the entity choose whether to pass it through as dividends.
  
  
• Secured v/s unsecured v/s entity ratings: When referring to the ratings of a US REIT or an Australian property trust one typically refers to the issuer default rating or entity rating. This rating may be different to the secured and / or unsecured rating of a particular REIT depending on its chosen capital structure.
  
  While the rating on a secured debt offering will give an indication of the likelihood of serviceability and repayment of that particular debt obligation, it does not necessarily give any indication as to the credit worthiness of the entity itself. The distinction between secured and unsecured debt ratings is not made in the proposed guidelines. A distinction is needed to ensure ratings across REITs are comparable.
  
  
• Rating Level: According to Fitch, while credit ratings are required under the draft regulations, the level of the rating will not to be regulated. ''We view this as a positive development as it will allow investors to choose their own risk / reward parameters and, hopefully, encourage the development of a broad REIT market''.
  
  A precedent was set in Singapore REIT legislation whereby regulations were different for REITs with a better risk profile as identified by the credit rating of an entity. Given the distinction made by ratings agencies between "investment grade" ('BBB-' and above rated securities) and "speculative grade" (entities or securities rated below 'BBB-') ratings, ''it may be appropriate to propose a rating requirement of "investment grade" for cases when the property fund wishes to borrow in excess of 20 per cent of the fund's deposited property in a similar manner to that undertaken by the Monetary Authority of Singapore regulations.
  
  
• Concentration limits: The draft regulations include concentration limits including, limitation on exposure to a single real estate project (15 per cent) and limitation on exposure to real estate projects developed, owned, marketed or financed by a single group of companies (25 per cent).

Fitch feels that while these concentration limits undoubtedly improve the credit quality of any REIT offering, ''our experience would indicate that the limitation on single real estate exposure and single group / developer / sponsor exposure would make it difficult for a REIT in its formative stages to comply. Experience in Singapore shows that the majority of REITs started out by being sponsored by a particular real estate or finance entity, and many have continued to have this link.

As an example, Fitch says the Suntec REIT began with exposure to a single development - the integrated Suntec City office towers and retail mall, while the inaugural and most successful Singapore REIT, CapitaMall Trust, started out with just three retail shopping malls in its portfolio, all contributed by its sponsor CapitaLand.

''Although not stated, it is likely the concentration limits have been devised to minimise conflicts of interest between a sponsor and the independently operated REIT and to minimise concentration risk on a single asset,'' noted the rating agency.

However, ''Given the practical difficulties with these limits in a fledgling industry such as that of Indian REITs, it may be possible to mitigate these risks in other ways such as limiting exposure to a single tenant, rather than property, or by strengthening valuation practices to require multiple valuations using multiple methods or by requiring internal managers (as used in typical US REITs) rather than external managers.

Besides the credit issues, it would be helpful if SEBI could take up the following tax issues involved with the tax authorities for the benefit of the market:

- The guidelines propose that the REIT will be a trust under the Indian Trusts Act, 1882. As per the guidelines, the taxation will be at the trust level. But it would be good to clarify if the unitholder would be exempt from paying tax.