The blog is written by Amitabh Abhijit and Ritik Nandan, who are 5th-year students at NLIU, Bhopal.

Introduction

The Securities and Exchange Board of India (“SEBI”) recently issued a consultation paper which proposed the inclusion of Fractional Ownership Platforms(“FOPs”) under its regulatory ambit. The recommendations cited for their inclusions ostensibly deal with bolstering the functionality of FOPs, through rendering of a uniform mechanism and a robust regulatory authority to oversee the nuances of FOPs. Over the past few years, there has been a heavy indulgence by investors in the real estate sector through fractional ownership and it has become imperative for regulatory bodies like SEBI to be vigilant about the protection of investors’ interests and the corresponding market stability.

Investment in the real estate sector is not something inchoate and has been in prevalence since long. With the introduction of the concept of Real Estate Investment Trusts(“REITs”), the concept of investment without absolute ownership of any property has gathered traction and thus, required an elaborate and thorough framework for their operation.

The SEBI (Real Estate Investment Trusts) Regulations, 2014 (“REIT” Regulations”), was implemented with the aim to mitigate discrepancies in the real estate investment market, so as to ensure the safety of the investors and facilitate healthy trading practices. In lieu of the REIT Regulations, SEBI envisions a systematic and corroborative framework for FOPs, which would eventually result in the prospering of the said market. In the recommendations put forth by SEBI, various provisions have been drawn from the existing paraphernalia dealing with REITs, as FOPs strike resemblance and are an improvised extension of REITs. Evidently, however, the regulating authority believes that an added layer of compliance is required in this context. Therefore, the issue of regulating FOPs separately have come up, primarily due to its increasing popularity as an investment opportunity not just amongst the institutional investors, but the retail ones.

Fortifying Foundations: REIT Regulations Bolster Investor Confidence

Real Estate Investment Trusts are companies which own, manage and financially operate various real estate properties, which are well equipped to generate income, such as office buildings, residential complexes, malls and shopping outlets, hotels and resorts, medical facilities, storage areas and other recreational and purposeful units. Akin to the concept of mutual fund investments, the fundamental objective of any REIT is to provide a mode of investment to individuals, wherein a person may procure benefits without purchasing properties, but through the income generated from these holdings, in the mode of dividends.

REITs have emerged as a preferred mode of investment for individuals for a multitude of reasons. The pre-requisite for REITs is to distribute at least 90% of their taxable income to their shareholders, which results in higher dividend yields, compared to other modes of investment. Additionally, the liquidity factor in REITs is forbearing, with most of them trading on major stock exchanges, assuaging any hassle for their buying and selling, thus making the exercise more convenient for shareholders. Besides, the REITs provide an exposure to various real estate sectors, which results in mitigating the risk for investors, through diversification of investment. The REITs have garnered much support from investors, of late, for the convenience it provides to them to obtain benefits, without the hassle and expense of direct ownership of any real estate property.

The REIT Regulations have been laid down to facilitate the functioning and to stabilise the REIT market. These regulations play a crucial role in governing different facets of real estate investment, such as:

1. Protection of  interest of the investors:

As per the regulations, a minimum stipulated threshold has been specified as a seed amount for investing, in order to eradicate any frivolous or meagre investments. This provision helps in avoiding unnecessary hindrances and risks in the market. Apart from that, the REITs must ensure a mandatory disbursal of at least 90% of their taxable income as dividends, to the investors, thus protecting them from hoarding of the profits by REITs. Strict governance and regular audited reports ensure financial transparency, empowering investors to make informed decisions about MSM REITs.

• Stability of Market:

As mentioned previously, the REITs provide diversity to the investors, as they deal with various real estate properties, which results in confining the concentration of assets in any particular sector, abating the risk of overexposure to fluctuations in the market. Mandatory liquid assets and curbs on self-dealing and excessive leverage shield Micro, Small, and Medium (“MSM”) REITs from financial distress and market manipulation. SEBI’s vigilant oversight, including audits and inspections, maintains market integrity and curbs fraud.

• Promote Growth and Development:

Tax benefits on REIT dividends and capital gains, coupled with steady income streams from real estate holdings, attract investors and inject capital into the sector. Standardized regulations protect investors, ensuring transparency and a level playing field for all. By requiring moderate minimum investments, MSM REITs broaden access to real estate, opening doors for individuals previously excluded. Moreover, the regulatory framework is adaptable, incorporating innovations like self-sponsored entities to promote market dynamism and diversification. This balanced approach fosters investor confidence and propels the growth of the MSM REIT landscape.

In summation, the REIT Regulations play a crucial role in regulating the market in a fastidious and equitable manner. These are the necessary guardrails for building a sustainable and thriving real estate investment ecosystem. The only shortcoming, in this view, is the fact that the scope of SEBI’s authority is rather limited under these regulations and this is the very issue that the FOP regulations seek to rectify so as to gain comprehensive control over real estate investments.

The Necessity of Further Regulation:

It has been made abundantly clear that investment in fractional real estate through FOPs raises concerns regarding potentially manipulative sales tactics. FOPs may leverage the perceived prestige of high-value properties, prominent tenants, or artificial scarcity (waitlists, sold-out claims) to entice investors. Absent are standardized selling practices, independent valuation of assets, and due diligence on provided information. The lack of regulation makes it easier for FOPs to sell investments using misleading information, putting investors at risk. 

In the backdrop of this context, SEBI, with the intention to “consider whether it is an appropriate juncture to require registration and regulate these FOPs”, released a consultation paper on 27^th May 2023 asking for public comments on their proposed scheme of regulation.

The proposed scheme particularly seeks to provide enhanced investor protection, particularly for non-institutional investors considering they are more susceptible to misleading or manipulative marketing tactics. Retail Investors, in general, have been known to be prone to cognitive biases like overconfidence, fear of missing out, and anchoring, which can lead them to make irrational investment decisions. This can be further exacerbated by the emotional manipulation tactics sometimes used by unscrupulous actors. A lack of knowledge pertaining to the complexity of financial products and instruments is often a major risk associated with retail investors as well.

Unravelling SEBI’s Consultation Paper:

1. Mandatory Registration and Multi-Layered Framework:

At the very outset, the scope of proposed regulations identify the need to have mandatory registrations for REITs who would have to meet an eligibility criteria that would be notified and updated by SEBI from time to time. It also sheds light on the structure of an MSM REIT that is analogous to the one from the Board’s REIT Regulations as it would require them to be set up under the purview of the Indian Trusts Act, 1882 acquiring real estate through independent, wholly-owned SPVs established as companies. These SPVs would directly hold ownership of individual properties.

MSM REIT regulations target inclusivity in real estate via smaller entry points (listed REIT units) for diverse, even modest assets (min. Rs.25 crores). This prioritizes transparency and investor protection against potentially unfit management by mandating higher standards.

• Sponsor:

The proposal also seeks to bring accountability, obligation and liability to the position of the Sponsor of the trust, who must possess at least five years of experience in the real estate industry honed either as a seasoned developer or a skilled fund manager. Furthermore, in order to ensure his/her commitment, the Sponsor is mandated to hold a minimum of 15% of the total units in each MSM REIT scheme for a period of three years after listing. This “skin-in-the-game” principle aligns the Sponsor’s interests with those of the investors, solidifying a relationship built on mutual success. 

Additionally, the minimum net worth requirement for a Sponsor is set at INR 20 crores. However, mere net worth is not sufficient; the regulations further stipulate that at least INR 10 crores of this net worth must be in the form of “positive liquid net worth.” This term, defined as unencumbered assets readily convertible into cash, underscores the importance of readily accessible financial resources to navigate unforeseen market fluctuations or operational challenges. Such high financial thresholds shield against risky manoeuvres and insolvency, protecting investor interests but they also pose a substantial financial constraint on small-scale FOPs. It may even lead to the implication that the Real Estate investments are only for businesses with deep pockets.

• Investment Managers:

MSM REITs would also require a dedicated Investment Manager solely focused on managing their assets and operations. The Investment Manager, a registered entity with at least INR 10 crores in liquid assets and five years of real estate experience, plays a crucial role. Two key personnel with similar expertise and a board with at least 50% independent directors ensure focused stewardship while minimizing conflicts of interest. To streamline operations, the proposal allows combining Sponsor and Investment Manager roles, creating a self-sponsored entity.

• Trustees:

Fourthly, the proposed regulations deal with the impartiality of a trustee, by ensuring that it would compulsorily be unrelated to the Sponsor(s) and the Investment Manager. Such a responsibility would come with the necessary resources with respect to infrastructure, personnel, etc. to the satisfaction of the Board and in accordance with circulars or guidelines as may be specified by the Board.

• Allocation of the REIT’s funds

Fifthly, upon the successful issuance of a certificate of registration, the REIT would be permitted to launch schemes with distinguishing names and shall also raise funds at the initial stage through an initial offer of the units of a scheme which must be mandatorily done in a dematerialized form and on a stock exchange. The minimum size of the asset proposed to be acquired shall at least amount up to Rs. 25 crores and must not exceed Rs. 499 crores. Moreover, 95% of its assets must be anchored in completed real estate generating consistent rental income, ensuring a steady stream of returns for investors. This unwavering focus on stability is further reinforced by the remaining 5% being reserved for readily convertible “liquid assets.”

This particular provision does seem to be one of an overreaching nature as the rigid 95/5 allocation might restrict the REIT’s ability to adapt to changing market conditions. Unexpected events like economic downturns could leave the REIT with an insufficient liquidity buffer if it’s locked into income-generating assets that cannot be easily liquidated. Focusing heavily on stable, income-generating assets may also severely hamper the REIT’s potential for high returns. While it offers consistent income, it might miss out on opportunities for capital appreciation associated with development projects or emerging real estate markets.

• Miscellaneous Provisions:

To diversify its investor base, an MSM REIT must attract at least 20 independent participants (minimum Rs. 10 lakhs each) from both domestic and international markets. Unlike traditional REITs, debt is prohibited, promoting equity-based growth. Investor concentration is limited (max 25% per individual) to ensure a balanced landscape.

Pre-existing SPVs formed by participants must be transferred to the scheme, with investors receiving units in exchange for their holdings. Those wishing to exit will have their units or SPV securities bought back at fair value by the Sponsor. To uphold transparency, the REIT is barred from transactions with related parties, except for authorized fees to the manager and trustee.

• Valuation of Assets:

The Valuation of Assets needs to be carried out by the valuer through the compliance of Regulation 2(1)(zz) of the REIT Regulations  or by intermediaries specified by SEBI as well. To accurately determine the value of properties, a physical inspection needs to be carried out on a timely basis and their detailed disclosures must be made, for the sake of the investors. Various rights have been vested in the investors regarding the appointment of auditors, principal valuers and to regulate annual meetings of the investors of Trust, which majorly deal with annual accounts, valuation reports and the performance of MSM REIT Scheme, amongst other things. Various disclosure requirements have also been laid out in the framework to ensure that the transparency in operation will strengthen the investors’ protection of interests and encourage greater indulgence by the investors.

Concluding Analysis

The proposed scheme of regulation is certainly a bold move on the part of India’s securities regulator, given that they have been rather quick to recognize the growth and success of FOPs in the realm of real estate investment. As an initial attempt, the consultation paper provides enough clarity for the stakeholders to understand what they may be required to comply with and what benefits it may provide to investors. However, it does seem to be the case that SEBI has put forth extremely high thresholds that may not be practicable in the growing industry of FOPs, which actually function as technology based market-makers. Furthermore, barring investment in under-construction projects, tying up 95% of the REIT’s income in rent-generating properties, and the discounting debt-financing may also be viewed as questionable decisions that go beyond protecting investors by restraining them and their options considerably.

Nevertheless, the invitation of public comments does prove that SEBI’s final blueprint on this issue could very well take these considerations into account and provide a more balanced scheme that does not virtually ‘handcuff’ investors attempting to indulge in this industry through FOPs. Several of the questions provided in the consultation paper do hint at the regulator’s open mindedness regarding its authority over MSM REITs.