Fractional ownership of real estate assets through SM REITs - ET RealEstate (2024)

Fractional ownership of real estate involves multiple individuals or investors collectively owning a property, with each owner holding a share or fraction of the property. This concept allows investors to pool their resources and collectively invest in real estate assets that may otherwise be financially out of reach on an individual basis. Fractional ownership of real estate can offer diversification, accessibility to high-value properties, and potential investment returns, but it also comes with risks and complexities (such as low rental yield during COVID-19).

In pursuit of fractional ownership, real estate investment trusts (REITs) were established as a separate asset class allowing investors to pool investments through which the REIT acquires “completed and rent generating” commercial real estate projects in consideration for regular distributions of rental income to REIT investors. Thus far, 5 REITs have registered with the Securities and Exchange Board of India (SEBI), whereas 3 REITs have invited capital through public offers.

Whereas real estate focused funds (RE AIFs) permit pooling investments from multiple investors on a scheme-wise basis through which the relevant scheme of the RE AIF can acquire (equity or debt) in one or more under-construction, under-development or completed residential or commercial projects. While investors in RE AIFs are entitled to distribution of proceeds (in the form regular dividends and/or interest payments from project companies), given that RE AIFs need to have a fixed tenure and fund life, the underlying real estate assets are required to be transferred or sold (failing which, they need to be liquidated) and proceeds from such sale or liquidation are required to be paid to investors by redeeming units held in the relevant scheme of the RE AIF.

Neither REITs nor RE AIFs are fit for purpose when it comes to implementing fractional ownership of real estate assets with respect to small and medium scale commercial real estate projects. REITs do not work because of requirements such as minimum asset size (i.e. more than INR 500 crores), minimum public issue size (i.e. more than INR 250 crores), sponsor net worth, sponsor support and sponsor lock-in requirements (15% holding locked-in for 3 years). RE AIFs do not work because of its limited fund life, minimum ticket size of INR 1 crore per investor, concentration limit (not more than 25% in any single project) and requirement to sell and/or liquidate underlying assets prior to end of fund life.

Normally, fractional ownership platforms (FOPs) identify the real estate opportunity and list it on web-based platforms to elicit expression of interest (or the interest is gauged through its social media handles), once the FOP receives 100% expression of interest, a private placement offer letter is circulated to the potential investors requiring them to subscribe to securities to be issued by the project company (inviting up to 200 shareholders). Investors are allotted securities by the project company upon depositing subscription amounts. The FOP acts as the manager, operator and booking agent for the real estate asset in respect of which it is entitled receive management or service fees. All revenue collections earned through rental payments are up streamed to investors by the project company after deducting management or service fees.

In its consultation paper issued in May 2023 (Consultation Paper), SEBI noted that FOP structures raise concerns regarding investor protection, lack of uniformity in disclosures, lack of transparency in valuation, management fees, maintenance costs, redressal of investor grievances, lack of market leading to liquidity concerns and failure to comply with KYC and anti-money laundering norms which are typically imposed on market participants by financial regulators. Pursuant to the Consultation Paper, conclusion of the consultation process and receipt of approval from SEBI vide its board meeting dated 23 November 2023, the SEBI (Real Estate Investment Trusts) (Amendment) Regulations, 2014 (2024 Amendment Regulations) were notified on 8 March 2024 pursuant to which SEBI amended the existing regulations governing REIT and introduced a new category of small and medium REITs (SM REITs).

Prior to the 2024 Amendment Regulations, the definition of a REIT simply meant a trust registered under the regulations. However, following the amendment, a REIT now means a person which pools investments which are equal to or more than INR 50 crores for the purposes of issuing units to at least 200 investors so as to acquire and manage real estate assets entitling the investors to receive income from such assets without giving investors day to day control over management and operation of the real estate assets. It has been clarified that any company which acquires and manages real estate assets and issues securities to investors will not be construed as a REIT.

Even though the Consultation Paper proposed that any person or entity (including FOPs) which facilitate or have facilitated fractional investment in real estate by any structure whatsoever shall be required to register with SEBI for operating as SM REIT in the manner specified by SEBI, it is apparent that only certain FOP structures which trip the conditions prescribed in the new definition of REIT would need to migrate their existing structures into an SM REIT. Therefore, each FOP structure would require analysis on a case-to-case basis to determine if they need to migrate to an SM REIT. Similarly, those FOPs which do not fulfill requirements prescribed in the 2024 Amendment Regulations and consequently do not require registration as an SM REIT, would nevertheless need to build in guardrails to continue operating existing FOP structures.

Existing persons, entities and FOP structures have been given a period of 6 months commencing from 8 March 2024 to assess if they fulfil eligibility requirements and to apply to register the FOP as a SM REIT in terms of the 2024 Amendment Regulations. Investors holding units through a business trust may be entitled to certain tax benefits which would not be available to a project company or its investors (in an FOP structure), however during the assessment process, managers should consider if a swap of shares of the project company in exchange for issuance of units by the SM REIT would remain tax neutral for the investors in the SM REIT. An additional period of 6 months from the receipt of registration certificate has been granted to undertake the actual migration of persons, entities and structures from the FOP into the SM REIT. In both the cases (i.e. applying for registration and subsequently undertaking the migration from FOP to SM REIT), SEBI has discretion to grant any additional time for compliance.

As part of the Consultation Paper, the minimum and maximum asset size for each scheme of an SM REIT was proposed to be INR 25 crores and INR 499 crores respectively (it is possible to issue one or more schemes in an SM REIT, however, the same is not possible in a REIT). The minimum price of each unit of the SM REIT and minimum subscription from an investor shall in each case not be less than INR 10 lakhs. Both these proposals were also approved by the Hybrid Securities Advisory Committee (HSAC) and referred to SEBI for approval. While SEBI approved INR 10 lakhs to be the minimum unit price and subscription by investor, SEBI has only permitted schemes in a SM REIT with a minimum asset size of INR 50 crores presumably to attract investors with higher risk appetite and to potentially offset downside risk from smaller real estate assets (the maximum asset size permitted in a SM REIT remains unchanged at less than INR 500 crores).

On the basis that SM REITs would hold single property or highly concentrated portfolio and the potential investor base for an SM REIT would consist of non-institutional investors, a no-leverage mandate has been contemplated for SM REITs in the Consultation Paper meaning that neither the SM REIT nor the project company owning the real estate asset would be permitted to obtain financing. However, while the 2024

Amendment Regulations do not permit the project company to raise debt financing or to grant any loans, it does not restrict the SM REIT from availing leverage. If any leverage is availed by the SM REIT, the same can be undertaken after making necessary disclosures in the offer document and the total borrowings aggregated with deferred payments (net of cash and cash equivalents), at a scheme level, cannot exceed 49% of the value of the assets (for borrowings to exceed the threshold of 25% of the asset value, SM REIT is required to obtain credit rating and approval from unit holders).

There are a plethora of costs associated with setting up and operationalizing an SM REIT, such as, registration fees to SEBI (INR 11 lakhs for registration and INR 5 lakhs or 0.1 per cent (whichever is higher) for each scheme which is launched), cost to appoint independent directors (manager’s board to consist of a majority of independent directors) and key personnel (fund managers or real estate industry personnel with adequate experience need to be appointed).

In addition, offer related expenses would need to be incurred in respect of each scheme of the SM REIT, such as, listing fees, underwriting fees, auditor fees, valuer fees, legal counsels, registrar to an issue, merchant banker, processing fees to process ASBA forms, printing and stationary expenses, advertising and marketing expenses and fees incidental to listing of units on stock exchanges.

Following the issuance of SM REIT units, there would ongoing costs as well which would be deducted from revenue generated by the real estate asset, such as, payments to manager (on account of management fees, booking agent fees, operations and maintenance fees), custodian fees (for storage of property title documents), costs to appoint valuer and valuation fees, legal and professional fees, trustee fees, disclosure and compliance costs for each scheme. Applicants must consider the entire gamut of expenses as part of their financial model and its impact on investor returns.

Even though the overall process to set up, operationalize and keep operational SM REITs and its various schemes involves a bunch of disclosures, compliances, and costs, it is a significant step by the regulator in making an asset class out of small and medium commercial property and rentals therefrom in which we can expect participation from high net-worth individuals. It remains to be seen if existing players in the market are quick to migrate their FOPs into SM REITs and if new players see commercial value and feasibility in attracting retail investors to offerings by SM REITs (given that adoption of traditional REITs has been relatively slow until now).

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