Crisil explains how small, medium REITs will broaden realty investor base

Recent regulations issued by the Securities and Exchange Board of India (Sebi) for small and medium real estate investment trusts (SM REITs) are likely to drive investor interest towards fractional ownership of real estate assets, said Crisil Ratings in a note.

Fractional ownership allows people to invest in a portion of a larger property, making real estate investment more accessible.

Earlier this year, Sebi notified the regulations for small and medium real estate investment trusts and specified that investment managers of such REITs should have a minimum net worth of Rs 20 crore and the REITs can raise a minimum of Rs 50 crore from at least 200 unit holders.

For SM REITs, at least 95 per cent of the investments should be in revenue generating assets and they cannot invest in under-construction or non-revenue generating real estate assets. This is a big difference compared to larger REITs, for whom the threshold is 80 per cent in rent-generating assets and they can hold under-construction assets too.

To ensure long-term commitment, SEBI mandates a minimum holding period for sponsors and investment managers in the SM REIT they create.

First 3 Years:

• No Debt: For SM REITs with no debt, sponsors and investment managers must hold at least 5% of the total units for the initial three years after listing.
• Debt Financing: If the SM REIT uses debt financing (borrows money), the minimum holding requirement increases to 15% for the first three years.
• Gradual Reduction: This minimum holding requirement gradually decreases over time. After 20 years from listing, the minimum holding drops to just 1%.

"So far, fractional ownership platforms (FOPs) did not follow uniform guidelines. The SEBI move is intended to address this by bringing existing FOPs under the regulatory ambit. Some of the key regulatory guardrails are mandatory

investments in operational assets, restrictions on related party transactions, compulsory listing on the stock exchange and distribution of minimum 95% surplus from special purpose vehicles," noted Crisil.

Other regulations include the need for at least 200 retail investors which will provide liquidity. Minimum liquidity requirement at the investment manager (IM) level to provide a buffer against temporary mismatches. Further, experience-

linked eligibility criteria for the IM will foster strong governance.

"“The SM REIT regulations should inspire investor confidence by protecting them against two key risks. One, project completion and leasing risks would be mitigated as investments cannot be made in under-construction assets. Two, risk of diversion of funds will reduce due to ring-fencing of cash flows and mandatory distribution of funds on a quarterly basis. Further, the regulations should improve transparency and governance," said Mohit Makhija, Senior Director, CRISIL Ratings.

As per CRISIL Ratings' assessment, SM REITs target a distinct and differentiated market as compared to conventional REITs.

Schemes under SM REITs can target niche assets ranging from Rs 50 crore to Rs 500 crore which is an untapped opportunity as conventional REITs focus on large scale assets with consolidated asset value over Rs 500 crore. Investment in SM REITs is similar to the traditional form of ownership of real estate assets, with the difference being pooling investor money for fractional ownership under a trust structure. SM REITs will float different schemes under a trust, each of which will specify assets to be invested in. 

Investors can pick schemes that are better aligned with their philosophy of investing in a certain micro-market or asset type. Each scheme will be ring-fenced from other schemes under the SM REIT. Contrary to this, the conventional REIT structure enables investors to invest in an identified pool of assets, which may be dynamic, depending on the REIT strategy, added Crisil.

"“The regulations are more stringent for SM REITs given the smaller ticket size of schemes, higher asset or geographical concentration risks, unlike traditional REITs that tap large-scale investments. Therefore, the IM’s skills in identifying the right properties and operating them professionally will remain critical for the success of SM REITs. Additionally, lean cost structures will be essential to protect investor returns," said Anand Kulkarni, Director,Crisil.

Net-net, opportunity to invest in niche real estate assets, along with aforesaid investor protection and liquidity mechanisms, should attract a new set of investors and thus, broaden the overall base. 

To begin with, the market for SM REITs is likely to see listing and registrations of existing FOPs. Successful listing and acceptance of these instruments by investors will be critical to pave the way for entry of new players. In the milieu, strong regulatory oversight will go a long way in popularising the investment vehicle.