Will SM Reits be safe for India’s retail investors?

 Currently, fractional real estate entities are smaller and unregulated, but this is set to change. (File Photo: HT)
Currently, fractional real estate entities are smaller and unregulated, but this is set to change. (File Photo: HT)

Summary

  • A look at how Sebi's regulations could reshape the landscape for India's retail investors in the burgeoning Reit market

MUMBAI : Gazing down at Bengaluru from the top of the iconic Cafe Coffee Day building, known as the Square, one can sense the emerging power in India’s real estate market. Owned by Strata, the country's largest fractional real estate platform, the building symbolizes a major shift in property investments.

Propelled by the concept of fractional ownership, Strata has rapidly grown to a formidable 1,800 crore in assets under management in just four years. This growth reflects a significant change in how property investments are perceived and pursued in one of the world’s fastest-growing economies.

“This is the office that V.G. Siddhartha sat in," I am told by Strata founder Sudarshan Lodha.

Much like Siddhartha, who transformed the nation’s coffee-drinking habits with Cafe Coffee Day, Lodha is reshaping real estate investment in India.

Launched by the Chennai-born lawyer just before the pandemic in 2020, Strata unexpectedly flourished as India’s upper middle class, confined at home, attended his webinars extensively.

The model is straightforward: fractional real estate platforms pool funds from customers into special purpose vehicles—usually private limited companies—and invest in commercial real estate. These platforms typically require a minimum investment of 25 lakh, offering investors the benefits of rental income and potential property appreciation.

However, from a taxation standpoint, the model is inefficient.

The special purpose vehicle (SPV) pays tax on the rental income it receives. When dividends or interest on convertible debentures are distributed to investors, they face taxation again at their respective slab rates. This double taxation is partly why the industry might shift towards the small and medium real estate investment trusts (SM Reits) model.

The concept of fractional real estate also extends to listed Reits in India, which collectively boast a market capitalization of around 75,000 crore. Embassy Office Parks Reit, which launched in 2019, was India's first such Reit, and now there are four listed Reits in the country. However, significant differences exist between regular Reits and SM Reits.

While a regular listed Reit provides access to a portfolio of properties across the country, an SM Reit allows investors to specifically target properties they are bullish on. Currently, fractional real estate entities are smaller and unregulated, but this is set to change.

(Graphics: Mint)
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(Graphics: Mint)

The Securities and Exchange Board of India (Sebi) has been closely monitoring the growth of fractional real estate with increasing interest and concern. In May 2023, it released a consultation paper on regulating these entities, followed by the final regulations in March 2024. 

Sebi is pushing for these entities to convert to listed SM Reits and implement customer safeguards. Entities that choose to continue in their current form risk regulatory enforcement. Operating an unregistered stock exchange is illegal, and collecting public funds from more than 200 investors triggers rules pertaining to deemed public offers. Violations could also lead to Sebi actions under Collective Investment Scheme rules.

“Think of it like the jungle vs a playground with rules. Sebi wants the industry to shift into the playground," explained a person familiar with the regulator’s perspective, asking to remain anonymous.

Yet, the industry is not quite ready to transition. In their 'jungle' phase, platforms developed diverse models. Strata, for instance, invested in several properties under construction, which is not permissible under SM Reits. 

Some platforms also created sophisticated 'internal marketplaces' for trading Reits and large databases on their customers. These 'moats' will vanish once Reits are listed and trading moves to stock exchanges. Some platforms even explored tokenization to bypass intermediaries like exchanges and depositories.

From Sebi's viewpoint, unitization is as acceptable as tokenization, and India’s legal and tax system is better suited to the stock exchange model than to blockchain or token-based technologies. Consequently, tokenization is not an option. 

However, two major sticking points remain between Sebi and the industry. First, Sebi insists on platforms investing 5% of their own funds in SM Reits as ‘skin in the game’, and second, it prohibits related-party transactions. Unlike regular Reits, builders cannot create SM Reits to offload their inventory. Industry representatives argue that these restrictions will impede the growth of SM Reits.

Moreover, fractional platforms contend that raising capital to fund the 5% skin-in-the-game requirement is not feasible, as venture capital funds are unwilling to accept such lock-ins or the low returns (commercial real estate yields are between 8 and 9%).

Will these rules change? It's still early, and Sebi is testing its framework. However, the regulator's primary responsibility is to balance industry growth with consumer protection, and it is unlikely that it will allow platforms much leeway. Changes in regulations take time, and platforms have six months to comply and transition into SM Reits. The alternative could involve facing potential regulatory enforcement.

For India’s investors and corporates, a vast opportunity awaits.

“Think of all the properties sitting with banks, PSUs, even private companies that simply aren't valued correctly. With SM Reits so many companies can do a simple ‘sale and lease back’ transaction," said Deepak Shenoy, founder and CEO of Capital Mind and keen watcher of this space.

“Let’s say bank A sells 20 branches to a Reit and then signs a 10- or 20-year lease on the same branches. It unlocks a huge amount of cash upfront while Reit investors get 20 years of assured rental income on their investment and any future appreciation in the branches," he said.

While platforms remain wary of residential real estate, they are actively exploring opportunities in student housing and corporate housing (managed housing for employees of large companies), in addition to their traditional focus on office spaces and warehouses.

Strata is particularly bullish on healthcare, having entered a ‘build-to-suit’ deal with a large hospital chain, where the platform will own and manage the real estate while the healthcare chain operates its business from those properties and pays rent.

“You see, unlike residential real estate, there is very little churn in commercial real estate. Once a company sets up its office in a particular place, employees buy houses around it. It mentions the address in its official licences and documents. It invests money in the interiors and fit-outs. Even if you hike rents, most corporate tenants will pay up rather than leave," explained Lodha.

Once fractional real estate players transition to the 'playground,' a vast array of opportunities potentially awaits them. Currently, institutional capital in this space is minimal. Mutual funds own about 20% of the listed market cap of Reits—approximately 15,000 crore. This is a mere fraction of their assets under management (AUM) of 50 trillion and well below the 10% Sebi limit for mutual fund investments in this sector.

India’s retail investors also stand to benefit.

The distributions from listed Reits, whether as dividends, interest, or return on capital, are not taxed if they are paid into a mutual fund rather than directly to the investor. These distributions simply increase the net asset value (NAV) of the mutual fund scheme, and investors only pay tax when they redeem their mutual fund units.

Mutual funds are cautiously monitoring the Reit space, concerned about the lack of frequent disclosures and detailed data. In the case of SM Reits, asset management companies may be particularly cautious given the industry's small size. However, this situation may change as the transition to SM Reit status progresses and the industry matures.

“Think of the possibilities," says Shenoy. “You can even solve the problem of retirees. Elderly folks can sell their homes to Reits, get upfront cash and rent out the same home for the rest of their lives. This is akin to reverse mortgage, a concept that hasn’t taken off in India," he adds.

This sense of emerging possibilities has attracted significant attention from India’s financial services and real estate sectors. Over the next few years, as Sebi's regulatory 'playground' develops, a more regulated industry is expected to emerge from the ‘jungle.’

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