[Aditya is a student at Jindal Global Law School.]
With the aim of providing increased transparency, investor protection and access to redressal mechanisms for small and medium real estate investment trusts (SM REITs), the Securities and Exchange Board of India (SEBI) has recently issued a notification under the SEBI (Real Estate Investment Trusts) Regulations 2014 (REIT Regulations). This move is intended to allow fractional ownership platforms (FOPs) to offer institutional quality real estate to retail investors making commercial real estate more accessible and opening the door for new investors who were previously hesitant about fractional real estate to invest with greater confidence.
This post provides an overview of the background to the proposed amendment, outlines the necessity for regulation, analyzes its potential impact, and summarizes persisting concerns.
Brief Overview of the Existing Regulatory Landscape
The primary aim of REIT Regulations was to address the inconsistencies in the real estate sector, promote investor safety and inculcate fair trading practices. Through these regulations, SEBI aimed to establish a coherent structure for FOPs, ultimately fostering growth and stability in the real estate market. In simple words, REIT regulations offer investors an opportunity to invest in real estate assets that they might not have been able to access otherwise.
The existing REIT regulations played an imperative role in stabilizing the real estate market. First, the regulations contributed to safeguarding the protection of the interests of the investors. The regulations mandate that REITs are required to distribute a minimum of 90% of their taxable income as dividends to the investors, thereby preventing the retention of profits by REITs while simultaneously safeguarding investor's interests. Second, REIT units must be listed on the recognized stock changes in India, ensuring investors have the option to exit whenever they choose. Third, similar to mutual funds’ investments, REITs enable individuals to participate in real estate without directly purchasing properties. REIT investors do not acquire physical ownership of properties; instead, they receive units similar to the structure of mutual funds.
However, a major loophole in the existing regulations somewhat constrained SEBI's jurisdiction.
Functioning of FOPs: The Need for Further Regulation
Expanding the framework of REIT Regulations to include FOP would help stimulate the growth of the market. FOPs primarily work by attracting non-institutional investors, particularly wealthy individuals with a high net worth, for real estate investments. FOPs function by aggregating funds from investors through online platforms to invest in upscale residences. Thereafter an entity in the form of special vehicle purpose (SVP) acquires and holds ownership of the property, while investors simultaneously receive shares in the SVP. Consequently, the rental earnings that are received by the property are distributed by the SVP amongst the investors.
However, the current functioning of the FOPs raises some concerns. First, there is no proper mechanism to cross-check the authenticity and transparency of transactions conducted on FOP, particularly involving non-institutional investors and real estate assets. For example, while certain FOPs were managed by real estate agents and brokers who were subject to regulation by the Real Estate Regulation and Development Act 2016 (RERA), SEBI discovered that not all their operations, such as running the FOP, were within the scope of RERA. Second, the lack of independent review or oversight in the issuance of securities puts the interests of the investors at risk. Third, in case of any infirmities or grievances, the investors are not vested with any legal remedies.
Considering the underlying loopholes and the inherent lack of regulation, SEBI on 8 March 2024 notified certain amendments to introduce a coherent framework for working of SM REITs.
Potential Impact of the Proposed Amendment
The SEBI SM REIT (Amendment) Regulations 2024 provide a pool of funds ranging from INR 50 crore to less than INR 500 crore gathered to issue units to a minimum of 200 investors. The new framework delineates that FOPs can now offer institutional quality real estate assets to retail investors. Additionally, the acquiring and managing of these real estate assets would generate income, with ownership structured through SVPs. The author suggests that the proposed amendments would benefit retail investors who primarily invest through FOPs.
First, SEBI would now have the authority to synchronize FOPs that operate SM REITs. Under the purview of the new amendments, SEBI has introduced a separate framework for the functioning of the SM REITs. Going forward, any FOPs intending to operate SM REITs must seek registration with SEBI. Notwithstanding the same, existing FOPs currently operating unregistered REIT structures can present a mitigation plan to SEBI and apply for registration, regardless of their size or the number of investors involved.
Second, the new regulations would lead to increased accessibility of real estate for new investors. Under the past REIT regulations, only large-scale commercial properties could be a part of REITs. However, under the provisions of the proposed amendment, both residential and commercial properties with a minimum value of INR 50 Crore can be included in SM REITs. Additionally, the minimum investment threshold is established at INR 10 lakh, enhancing accessibility for individual investors in contrast to conventional REITs. This would pave the path for investments in smaller buildings, specific floors, or even well-performing residential projects.
Third, SEBI has provided regulatory oversight regarding the redressal of investor complaints. This includes the identification of shortcomings in FOPs, including the absence of a consistent and effective mechanism for resolving grievances, as well as the lack of independent assessment of current grievance resolution systems. The proposed amendment outlines a framework for the investors in SM REITs to file a complaint against SM REIT managers using the SEBI SCORES platform. This online portal has been primarily designed to handle complaints against entities regulated by SEBI.
Last, one of the common issues previously encountered in real estate investments involves investing in new projects that have not commenced construction or are still under construction. The same leads to delays in returns due to reasons such as insufficient building permits. The author argues that the new regulations will address this issue by requiring a minimum of 95% of a scheme’s assets to be invested in completed and rent-generating properties, while the remaining 5% can be allocated to investments in liquid assets.
Concerns and Conclusion
While the regulations are a step in the right direction, it has also brought out certain concerns that may affect the stakeholders in the real estate ecosystem. First, regarding the valuation of assets, clause (9) states that “For any purchase of a new property or sale of an existing property, the investment manager shall require the valuer to undertake a full comprehensive valuation of that property”. The author suggests that the regulatory notification solely focuses on valuation points concerning exits; however, it lacks information regarding how full exits will happen and the necessary steps involved. Additionally, regarding individual exits, the potential impact of frequent changes in ownership on rent pay-out mechanisms and associated costs is not addressed.
Second, concerning brokerages to channel partners, the notification delineates that “No person connected with the issue of units of the scheme of the SM REIT shall offer any incentive, whether direct or indirect, in any manner, whether in cash or kind or services or otherwise to any person for making an application in the issue, except for fees or commission for services rendered in relation to the issue”. The question of whether cashbacks or financial incentives would be offered to prospective customers remains unanswered. Furthermore, the said clause raised the question regarding whether brokerages would be offered at all for channel partners, especially considering that they have been instrumental in the upliftment of the real estate industry.
Third, while the new notification provides for adequate regulatory oversight, it does not provide for any due compliance for assets valued under INR 50 crores. The question arises whether such assets, even though not regulated, would be considered illegal. For instance, if a larger asset is divided into multiple parts to bring it below 50 crores, what occurs in that scenario remains uncertain.
The introduction of the SM REITs framework marks a crucial advancement in rejuvenating India’s real estate investment landscape. The author suggests that the amendment fills regulatory loopholes and embraces emerging investment models such as FOPs, promoting inclusivity and innovation within the industry. Overall, SEBI’s notification regarding SM REITs is a progressive step for the real estate sector as it provides investors with a fresh opportunity for diversification of real estate assets, potentially yielding higher returns, and enhancing transparency. While the final structure of the regulation is awaited, the recent regulation of fractional ownerships will afford investors the assurance of investing in a regulated asset class, including luxury properties that were previously inaccessible to certain brackets.