What’s Fractional ownership of real estate assets through SM REITs – Quick discussion- INVESTO 101.16

In today’s time,  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 (Le. 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 uniformly in disclosures, lack of transparency in valuation, 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 REIT’S (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, å 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 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 an 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 e certain FOP structures which trip the conditions prescribed in the new definition of REIT would need to migrate their existing structures structures into into an an SM SM REIT. REI 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 ó 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 το 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 1000000 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 IN 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).