Through its recent consultation paper titled “Regulatory Framework for Micro, Small and Medium REITs (MSM REITs)” dated 12 May, 2023 (“Consultation Paper”), the Securities and Exchange Board of India (“SEBI”) proposes the regulation of all platforms that offer fractional ownership of real estate assets.
Vide the consultation paper, SEBI seeks comments/views/suggestions from the public on the proposal for regulating fractional ownership platforms (“FOPs”). The markets regulator proposes to bring in the fractional ownership of real estate assets as ‘MSM REITs’ under the existing framework of SEBI (Real Estate Investment Trusts) Regulations, 2014 (“REIT Regulations”).
The Consultation Paper has been prepared by SEBI in light of the sudden rise of FOPs over the past 2-3 years.
Purpose: Owing to the increasing value of investments in FOPs, as well as rising number of investors, SEBI seeks to examine whether it is necessary to consider registration requirements and regulations for FOPs in order to bring about, inter-alia, regulatory oversight, common uniform standard disclosure practices, ensuring liquidity by way of listing or similar such measure, investor redressal mechanism, etc. to safeguard the interest of investors.
This note will provide certain highlights of the proposed regulation of FOPs as set out in the Consultation Paper.
SEBI notes that as of 31 March, 2023, 5 REITs are registered with SEBI, out of which 3 REITs have issued units which are listed on a stock exchange and have a total unit capital of INR 54,411 crores.
It is further noted that, although there is immense potential in real estate investment in office spaces, one of the reasons for lesser number of REITs may be attributed to the requirement of minimum asset size of INR 500 crores and minimum offer size of INR 250 crores as stipulated under the REIT Regulations.
SEBI notes that there is ambiguity whether the complete list of activities undertaken by FOPs fall under the regulatory ambit of RERA. It states that RERA’s oversight may be limited to specific areas and may not encompass the extended operational aspects of the FOPs.
Further, SEBI also highlights that the SPVs established by the FOPs to own the real estate assets, are set up mainly as private limited companies and governed by the provisions of the Companies Act, 2013, as applicable to private limited companies. As per SEBI, such companies have limited governance oversight. Additionally, the Companies Act 2013 limits the number of investors in a private limited company to 200. However, considering how the FOPs obtain interest of participation from members of the public, the regulator notes that it is entirely possible that the SPV may have undertaken a deemed public issue (DPI) without attendant compliances of issuing prospectus or filing with SEBI. The FOPs may also be organizing investors interest in the same real estate into more than 1 SPV to evade the threshold requirement of DPI. Concerns have also been expressed, that fractional ownership of real estate may amount to unregistered collective investment schemes.
SEBI argues that bringing FOPs under the ambit of the existing REIT Regulations would address the concerns mentioned above and also provide the much needed impetus for the boom of such a market. Additionally, the migration of existing SPVs or similar structures established by FOPs to the REIT structure may also lead to treatment of such investment by investors as investment in ‘Business Trusts’ as provided under the Income Tax Act, 1961 wherein certain tax benefits are available to SEBI registered REITs which may not otherwise be available to the SPV and/or its investors.
Few of the concerns for the investors under the FOP structure, as highlighted by SEBI are listed below:
- The mode, manner and sanctity of transactions executed on the FOPs may be a cause of concern as the dealings are with retail investors and subject matter of transactions in real estate, with accompanying issuance of securities or as joint ownership of the real estate using untested instruments or mechanisms on a large scale among unconnected investors.
- There is a lack of uniformity of disclosures regarding:
- valuation of real estate
- disclosures made to investor at the time of soliciting investment
- property title diligence and property title documentation
- lease, rental or tenancy documents and terms arrived at with the lessees/renters/tenants
- disclosure and managing of potential, perceived or actual conflict of interest by the FOPs/developer/tenants, etc.
- Unlisted securities connoting the fractional investment in a specific real estate asset, are issued to investors. There is no clarity regarding exit or liquidation of such fractional investment and the investor is dependent on the FOP for necessary information. Such dependency on the FOP without assurance of exit, due valuations, liquidity or transparency is unfavourable for the investors and is not in their long-term interests.
- With FOPs not being within the purview of any financial sector regulator, KYC / AML norms are not applicable to their activities. Accordingly, many of the FOPs are non-compliant with the PMLA guidelines or KYC requirements specified by financial sector regulators.
- No uniformity or common approach on investor grievances and its handling by the FOPs.
- A major concern is the possibility of investors having a false sense of comfort that their fractional investment in real estate on an FOP is fully regulated.
- Thus, in order to address such concerns and risks to investors, SEBI states that it is imperative that FOPs as providers of services, products and platforms operate in a transparent and regulated environment that balances the needs of all stakeholders.
Proposed scope of regulation
SEBI proposes to bring FOPs under its regulatory ambit by introducing a chapter under REIT Regulations and labelling the FOPs as MSM REITs. The key highlights of the proposed regulatory framework are provided below:
- Registration requirement: Any person or entity (including FOPs) which facilitate or have facilitated fractional ownership in real estate shall be mandatorily required to register with SEBI for operating as MSM REIT in the manner specified by SEBI.
- Eligibility criteria: Such persons/entities shall be required to fulfill eligibility criteria as specified by SEBI from time to time and also migrate the existing structures to MSM REITs and thereafter continue operations as MSM REIT. Persons/Entities which either do not meet the eligibility criteria as specified or do not register within the given timelines shall be required to wind-up their operations and cease to operate. Investors aggregated by such Persons/Entities in the real estate should be provided due exit option within a pre-specified period.
- Structure of MSM REIT: MSM REIT shall be set up as a Trust under the provisions of the Indian Trusts Act, 1882 with an ability to establish separate and distinct scheme/s for owning of real estate assets through wholly owned special purpose vehicles constituted as a company under the Companies Act, 2013. MSM REIT Scheme shall have full control and shall hold 100% equity share capital in all SPV(s). The SPV(s) shall be required to have full control and shall hold 100% ownership in all the underlying property(ies). MSM REIT shall have parties such as trustee, sponsor and Investment Manager with each such person being a separate and distinct entity.
- Additional registration conditions: SEBI has proposed various other conditions to be applicable to REITs that are already applicable to existing REITs under the REIT Regulations. These are quite prescriptive and have been mentioned in Annexure A.
The proposal comes as a welcome step that will give the stakeholders some form of clarity on the regulation of fractional ownership in real estate. Up until now, there was a great sense of ambiguity on the legality of fractional ownership structures and SEBI’s proposal through the Consultation Paper seems to address this concern to a certain extent. Regulating the FOPs will also benefit in addressing the risks and concerns that retail non-institutional investors are exposed to. However, with that being said the proposal is still very much at a nascent stage and SEBI has invited comments on the Consultation Paper from stakeholders till 27 May, 2023.
It remains to seen how the existing FOPs as well as experts in this industry, will react to this move. Ultimately, the goal would be to balance the interests of all stakeholders involved.
Proposed conditions for MSM REITs under the REIT Regulations
- Application for registration as MSM REIT to be made by the sponsor on behalf of the Trust in the format specified by SEBI.
- The instrument of Trust shall be in the form of a deed duly registered in India under the provisions of the Registration Act, 1908.
- Sponsor should have minimum of 5 years of experience in the real estate industry as either a developer or a fund manager.
- Minimum holding by the sponsor – [15%] of total units of MSM REIT for each scheme, for a minimum 3-year period from the date of listing of units to initial offer on a post-issue basis. Any holding in excess of the minimum holding shall be held for a minimum of 1 year from the date of listing of such units.
- Sponsor minimum net worth – INR 20 crores. 10 crores out of the said 20 crores shall be in the form of positive liquid net worth.
- The Investment Manager of MSM REIT to be a distinct entity with the primary business of managing assets and investments and undertaking operations of the MSM REIT.
- IM minimum net worth - INR 10 crores, which shall be in the form of positive liquid net worth.
- IM entity structure - Company incorporated under The Companies Act, 2013.
- IM experience requirement – IM or its associate to have a minimum of 5 years’ experience in fund management in the real estate industry or advisory services in the real estate industry or property management or in the development of real estate.
- Further, at least 2 key personnel of IM shall have 5 years of experience in the activities mentioned above.
- Independent director requirement – At least half of the directors of IM shall be independent not directors of the IM or IM of another MSM REIT.
- IM shall enter into an Investment Management Agreement with the trustee.
- Trustee registration requirement – Should be a SEBI registered debenture trustee and not an associate of sponsor or IM.
- There shall be no superior voting rights or any other rights provided to any unit holder of an MSM REIT scheme.
- No multiple classes of units of REIT in each scheme.
- MSM REIT and its parties to fulfill the fit and proper person criteria as prescribed by SEBI in SEBI (Intermediaries) Regulations, 2008.
- Certificate of registration will be granted by SEBI, upon fulfillment of the said eligibility conditions.
- Post issuance of registration certificate, Sponsor shall set up a trust and appoint SEBI registered Debenture Trustee as a Trustee and identify an IM for launching and administering MSM REIT and its schemes.
- Each scheme of MSM REIT shall be identified by a separate name.
- MSM REIT shall raise funds initially through an initial offer of units of a scheme, post registration.
- Mandatory listing of units of MSM REIT scheme on a stock exchange and units to be in dematerialized form,
- For initial offer – The minimum size of the asset proposed to be acquired should be INR 25 crores and the maximum size shall be INR 499 crores.
- Minimum 95% of the scheme’s AUM to be invested in completed and rent generating real estate properties. The balance 5% can be deployed in liquid assets which are unencumbered.
- Distributions: (a) minimum 95% of net distributable cash flows of the SPV to be distributed to the scheme of MSM REIT subject to the Companies Act, 2013; (b) 100% of net distributable cash flows of the MSM REIT shall be distributed to the scheme wise unit holders.
- Minimum 20 investors of the MSM REIT Scheme shall be unrelated to sponsor and its associates.
- Funds may be raised from non-residents as well.
- MSM REIT schemes are not permitted to raise debt.
- Minimum subscription size of a scheme - INR 10 lakhs. Further, the unit size shall be INR 10 lakhs.
- Maximum subscription size – 25% of the total unit capital (excluding sponsor and its associates).
- RPTs are not permitted (other than payment of fees to IM and trustee).
Valuation of assets
- Valuation of assets to be undertaken by a valuer prescribed under REIT Regulations or any other intermediary as SEBI may specify.
- To ensure accurate valuation, a full valuation including a physical inspection of the properties shall be carried out on a quarterly basis for each scheme. Consequently, the NAV of each scheme shall be required to be declared on a quarterly basis.
- Disclosure & reporting requirements (for initial offer as well as on a continuous basis to the stock exchange and unitholders) to be complied with as specified by SEBI.
- The investors shall have the right to remove the IM, auditor, principal valuer, seek winding up of the scheme, etc.
- Mandatory requirement of the annual meeting (to be convened by Trustee) to discuss items such as annual accounts, valuation, the performance of the scheme, etc.
- In case of a change in IM/sponsor, change in investment strategy, etc. investor approval is mandatory.
- Minimum disclosure requirements in the offer document will be specified.
- Minimum disclosures will be specified for the annual and half-yearly reports to be sent to the investors.
- Further, the MSM REIT Schemes shall additionally be bound by periodical disclosure requirements required under the listing agreement with the exchanges.
- Property-wise disclosure of lease rental income along with comparable lease rental income of other similar properties should be disclosed in the offer document. The above comparable disclosures shall be certified by an independent registered valuer.
 In brief, FOPs provide retail investors the opportunity to invest in commercial real estate (which was earlier primarily restricted to institutional investors) such as buildings and office spaces including warehouses, shopping centres, conference centres, etc. SEBI has observed that the underlying real estate assets offered on FOPs are similar to the real estate or property defined under the REIT Regulations.