Sebi’s objective was to safeguard the interests of small investors exploring this alternative investment route. Fast forward to 25 November, the board of Sebi gave in-principle approval to the amendments to the SEBI Regulations 2014 for micro, small and medium (MSM) real estate investment trusts, or Reits. The final details are awaited but here is what every investor needs to know about the MSM Reits landscape
While the country already has four listed Reits, fractional ownership is fast emerging as an alternative avenue for smaller investors to collectively own physical real estate. Fractional Real Estate (FRE) enables investors to pool their resources and get rental income in proportion to their contributions.
Fractional ownership platforms (FOPs) have amassed close to ₹4,000 crore in assets under management (AUM). Strata and PropShare emerge as front-runners, each managing an impressive ₹1,200 crore. Following closely, AssetMonk and WiseX handle AUMs of ₹300 crore each. hBits maintains a substantial AUM of ₹260 crore, while Alyf and Yours have AUMs of ₹85 crore and ₹65 crore, respectively.
Transaction flow
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The transaction flow in a fractional ownership platform involves various stages. It starts with the FOP showcasing property details like entry yields that includes gross rental income on pre-leased properties, target IRR (internal rate of return) that encompasses rental income and property appreciation, property photos, tenant information, and growth estimates on their website.
Investors assess these properties and based on their risk preferences put in funds. The FOP sets up a Special Purpose Vehicle (SPV), which utilizes the funds to purchase the property. The FOP usually charges an upfront fee at the beginning of this process, typically as a percentage of the total investment. For instance, it might be 3% of the total pooled investment. Additionally, the FOP gets property management fees, around 20% of the revenue generated by the property. Upon the property’s sale, the FOP charges performance fees, usually around 20% of the gains realized, sometimes with a predetermined hurdle rate (for instance, 8%). Investors receive rental incomes after deduction of fees and any tax deducted at source. The same flow applies to capital gains.
Different structures
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Real estate investment deals are diversified across various platforms and entities. Platforms like ALYF & Brikkit offer Limited Liability Partnerships (LLPs) as structures with investment opportunities primarily centred on holiday homes, allowing investors to engage with a minimum ticket size ranging from ₹6-10 lakh.
In this set-up, investors become partners in a LLP, which owns and manages the leased assets, with returns generated through rentals and property sales. An interesting feature of this model is that it allows an investor to stay in such properties during off-peak seasons. While these platforms claim higher IRRs due to the greater potential appreciation in the value of the property, none of the platforms has currently sold and proven this. Saurabh Vohara, founder & CEO at ALYF said, “This move by Sebi holds the potential to create a dual positive impact: formalizing fractional ownership as an investment class, thereby attracting a segment of portfolios towards a larger market, and fostering the supply of hospitality assets to meet the escalating demand in the travel and hospitality sectors.”
Platforms like Strata, PropShare, hBits, and WiseX operate the Private Limited Companies (PLCs) model with a focus on office spaces and warehousing. Investors here commit a minimum of ₹25 Lakhs, obtaining a blend of 90% compulsorily convertible debentures (CCDs) and 10% equity. The PLC structure involves CCDs earning returns akin to interest, while equity stakes allow for ownership, with CCDs converting to equity upon property sale.
The proposed MSM Reits includes both residential and commercial properties. Investment in MSM Reits is set at a minimum of ₹10 lakh. Under this model, FOPs might have the option to engage as sponsors, managing and operating the trust, while investors receive units representing their stakes as the trust acquires and manages properties, yielding returns through property appreciation and periodic NAV (net asset value) calculations.
“The MSM Reit regulation has revolutionised fractional investment by bringing in regulations and a lot of stability for investors in the commercial real estate sector. By investing a fraction of the total asset, investors can now own part of a Grade A commercial real estate asset providing fixed rental yields of 8-9%, and estimated IRRs of about 15-16%; helping investors achieve their goals of diversifying their portfolio,” said Shiv Parekh, CEO & co-founder of hBits.
Pros and cons, and taxation
LLPs offer the advantage of tax deferral by factoring in property depreciation (which can be set off against rental income) and taxes are paid at the LLP level (approximately 31.2%), sparing investors from direct taxation. However, LLPs suffer from drawbacks including insufficient disclosures, potential misuse of any power of attorneys, and liquidity issues. Additionally, the methods for appraising assets might lack clarity, and there might be a lack of robust KYC/AML practices.
PLCs are known for their efficiency in management compared to LLPs, yet they may still face liquidity challenges and require market-making efforts. Taxation for PLCs involves rental/interest taxes based on the slab rates on CCDs. If investors sell their shares in the company or at the time of winding up (the CCDs are converted into equity shares), capital gains are taxed at 20% if the shares are held for more than two years. If these are held for less than two years, the tax is as per the investor’s slab rate.
Trusts, particularly MSM Reits, boast the advantage of being bankruptcy remote and possessing liquidity due to being listed and rated. Dividends become exempt only if the concessional regime is not chosen. Investors are taxed at slab rate on any interest distributed by the Reit. Repayment of capital remains untaxed until the entire capital is fully repaid —however, investors need to keep track of this, increasing the compliance burden.
Section 54F
If you sell a fractional ownership share, you’re essentially transferring shares of the SPV. After a two-year period, this is classified as long term capital gains and hence eligible for benefits under section 54F of the Income Tax Act. When selling a commercial property, restrictions apply—you’re limited to purchasing either residential property or specified capital gains bonds (as per sections 54, 54F, 54EC) to claim exemptions. Buying another commercial property from the proceeds won’t allow you to offset gains.
Inherent risks
Investors engaging in fractional ownership of properties should be mindful of several inherent risks. Firstly, default or credit risks arise when tenants fail to meet lease payments, resulting in a loss of rental income until a new tenant is secured. Additionally, delays in property handover by builders or developers pose counterparty risks, potentially impacting investment timelines. Moreover, estimations about property values may not align with actual selling prices, causing a mismatch in the expected and actual IRR.
There are also concerns involving limited recourse in disputes, especially for minority shareholders, which could restrict their ability to address conflicts within the investment entity. Illiquidity poses a significant challenge as the sale of the entire property requires consent from a substantial majority of investors, while selling even a fraction might involve lengthy processes, impacting overall returns due to associated costs. Lastly, the absence of comprehensive end-to-end regulation in fractional ownership properties means investors might face unforeseen risks post real estate registration. Being aware of these risks empowers investors to make more informed decisions and implement strategies to mitigate potential losses.