Enhancing secure engagement and returns through small and medium real estate investment trusts

Gerald Manoharan
JSA, Bengalaru, Karnataka
gerald@jsalaw.com

Real estate has long been a cornerstone of wealth creation, offering investors a tangible asset with the potential for steady income and long-term capital appreciation. In the context of India, real estate holdings constitute a significant portion of the wealth portfolio of several asset creators. However, in recent years, the real estate market in India has witnessed a significant surge in activity, propelling it to the forefront of investment options. This growth is not only confined to traditional segments such as residential properties, but also new exciting investment avenues including logistics and commercial properties. In turn, this has created a more diversified and lucrative investment landscape.

This current market presents a compelling opportunity for investors seeking to participate in the real estate sector. However, for many individuals, the high capital outlay required to acquire a property outright is an obstacle. Recognising this, the Indian government and regulatory bodies have taken proactive steps to facilitate broader public participation and ensure investor protection.

Unlike other developed economies where real estate investment trusts were set up and regulated as early as the 1960s to engage enhanced participation and investment in the real estate market and to facilitate easy liquidation to the participants, India adopted this journey very recently. The market demand for unlocking value in real estate assets by developers was found palpable and investors, in the secure framework of progressive and clear regulations, were more than ready to take the plunge. Earlier, most real estate investment schemes which were floated by developers and market intermediaries used investment vehicles and structures which were often risky with inadequate risk disclosures and limited options of liquidity.

In 2014, a landmark development took place with the introduction of the Real Estate Investment Trusts (REITs) Regulations by the Securities and Exchange Board of India (SEBI).^[1] These regulations established a comprehensive framework governing the establishment, operation and governance of REITs in India, acting as a gateway for public participation.

The regulations established several key requirements for REITs in India. Firstly, a REIT must possess a minimum asset value of INR 5bn before it can be listed on a stock exchange. This substantial asset base helps to spread risk across the portfolio. Additionally, REITs are required to invest in income-generating commercial properties like office buildings, shopping malls and warehouses. This focus on income-producing assets translates to a steady stream of rental income for investors with income being typically distributed as dividends through at least 90 per cent of the REIT’s net distributable cash flow. Finally, for complete transparency and investor liquidity, REITs are required to be listed on a recognised stock exchange, allowing unit holders to easily buy and sell their units just like trading stocks.

The success of these pioneering REITs has demonstrably broadened investor participation in the Indian real estate market.

Consequently, a unique market segment emerged, whereby several online and technology platforms facilitated the fractional ownership of real estate assets by structuring them as companies or limited liability partnerships (LLPs). These entities then issued units in the form of convertible debentures and other securities to investors, essentially granting them fractional ownership in the underlying property. This approach allowed individuals with limited capital to participate in the ownership of high-value properties. Investors essentially held ‘notional units’ representing their fractional ownership stake. The rental yields from these properties or profits upon sale of the said real estate asset was distributed to the unit holders.

While these fractional ownership platforms (FOPs) offered exciting possibilities for fractional real estate investment, it still operated outside the purview of established REIT regulations. Therefore, the government felt that these platforms were opaque, leaving investors in the dark about the details of the underlying property and its financial health. This information asymmetry could lead to unforeseen risks for the investors lacking adequate knowledge.

Recognising the potential and inherent risks associated with FOPs, SEBI recently introduced a significant amendment to the REIT Regulations in 2024. This amendment paved the way for the establishment and operation of small and medium REITs^[2] (SM REITs). The SEBI regulations for SM REITs are designed to address the key concerns raised with FOPs and ensure greater investor protection, offering a more structured and regulated alternative to traditional FOPs. An SM REIT will involve distinct entities acting as trustee, sponsor and investment manager.

Unlike traditional REITs, which have a single pool of assets and investors, the structure of an SM REIT allows for multiple schemes under one REIT, similar to mutual funds. This provides flexibility for the investment manager to create separate schemes with distinct assets and unit holders, while all schemes must adhere to the REIT Regulations. SM REITs can have schemes such as warehouse schemes, commercial property schemes, residential real estate schemes and so on. However, each scheme should have a minimum of INR 500m in assets, and the accounts, returns and balance sheets of each scheme needs to be ring-fenced to separate them from each other. These regulations require 95 per cent of each scheme's asset value to be invested in completed and revenue-generating properties, with the remaining five per cent in unencumbered liquid assets. If reserves or other investments exceed five per cent, the Investment Manager must adjust the schemes’ financial structure to maintain compliance with the 95 per cent investment threshold.

Compared to traditional REITs requiring a minimum of INR 5bn, SM REITs allow for assets ranging from INR 500m to INR 5bn. This opens the door for a wider variety of properties, including residential buildings, warehouses and smaller commercial spaces. However, the minimum investor ticket size stands at INR 1m and the minimum number of unit holders in each scheme shall not be less than 200 (other than Investment Manager, its related parties). SM REITs are also required to distribute 100 per cent of their net cash flows to investors as dividends.

Launching an SM REIT requires a minimum of two years' experience for the investment management company, or at least five years' real estate experience from a designated employee. The investment manager must also have a net worth of INR 200m. SEBI further mandates that investment managers hold a certain percentage of the SM REIT fund for several years to ensure alignment with investor interests. Managers must hold at least five per cent of units for the first five years, increasing to 15 per cent if the SM REIT uses leverage. These holding percentages gradually decrease over time, reaching one per cent by the 20th year. Finally, the assets of each individual scheme must be valued annually by a certified valuer, providing transparency to investors and facilitating better price judgement in the market.

During the initial offer, like that of an IPO or NFO, the offer document for an SM REIT must contain key details about the scheme. Units are issued in demat form and subscribed through a book-building process with ASBA (account supported by blocked amount) registration, allowing them to be traded on stock exchanges like equity shares.

This innovative structure broadens investor participation by lowering the minimum investment amount. This translates to greater financial inclusion, allowing individuals with limited capital to tap into the potential returns offered by real estate. Furthermore, SM REITs address the opacity concerns that plagued FOPs by establishing a robust regulatory framework. Investors can now expect greater transparency regarding the underlying assets, management structure and financial health of the SM REIT.

The real estate market in India is poised for continued growth, driven by factors like urbanisation, rising disposable income and a growing demand for commercial and residential spaces. The introduction of SM REITs alongside existing avenues like traditional REITs presents a compelling opportunity for investors seeking exposure to this dynamic sector.