[By Dhrutvi Modi & Harshit Chauhan]
The authors are students of Gujarat National Law University.
INTRODUCTION
In recent years, the Indian real estate market has grown significantly, with Real Estate Investment Trusts (REITs) playing a crucial role in attracting investments. Introduced in India in 2014 to enable small investors to access the real estate market, the market has been primarily dominated by large-scale REITs due to high investment thresholds, restricting opportunities for small and medium-sized investors.
In August 2020, SEBI proposed Micro, Small, and Medium REITs (MSM REITs) to address the limited investment opportunities for small and medium-sized investors in real estate. These REITs offer lower investment thresholds, providing capital sources for real estate developers and reducing reliance on traditional financing. Recently, in May 2023, SEBI released the regulatory framework for MSM REITs, aiming to stimulate the Indian REIT market’s growth by broadening investor participation and expanding financing options for developers.
This article provides an analysis of the regulatory framework for MSM REITs released by the SEBI. The article evaluates the proposals put forth by the regulatory framework and assesses their potential impact on the REIT market in India. The article also examines the challenges faced by the REIT market in India, including high tax rates, limited availability of quality assets, and the need for regulatory clarity. It analyses how the regulatory framework for MSM REITs aims to address these challenges.
ISSUES FACED DUE TO LACK OF PROPER REGULATION
- Lack of uniformity in disclosures – non-uniform disclosures on Fractional Ownership Platforms (FOPs) raise concerns due to involvement of non-institutional investors and untested real estate mechanisms. More transparency and oversight are needed, leaving investors with limited legal recourse for potential issues.
- Lack of assurance – FOPs issue unlisted securities for real estate investments, but they may not provide adequate exit information or liquidity options, which is unfavourable for investors’ long-term interests.
- Unclear claims of succession and inheritance after lapse of Power of Attorney (POA) – FOPs enabling joint real estate ownership through POA structures impose binding liabilities on the FOP and raise concerns about valuation, liquidity, transparency, and potential misuse of POAs. Investor’s death, insolvency, or bankruptcy may lead to POA lapses, exposing other owners to succession and inheritance claims on the stake of the deceased or insolvent investor.
- No application of Know Your Customer (KYC) and Anti-Money Laundering (AML) norms – The absence of financial sector regulation for FOPs means that they often do not adhere to KYC and AML norms. This non-alignment with Prevention of Money Laundering Act, 2002 and financial regulator’s KYC requirements leads to inconsistent customer identification practices, raising risks of identity misuse, fund source concealment, and money laundering, thereby posing a threat to the financial system.
- Absence of standardized grievance redressal mechanism – FOPs lack standardized grievance redressal mechanisms, each with its own policies that may not favour investors. Even if some FOPs are registered with state-level RERA as real estate agents, this registration does not imply comprehensive regulation of the FOP and its activities by RERA, leaving investor interests potentially unaddressed.
- Non-uniform selling practices – non-uniform selling practices and lack of independent valuation could lead to investors falling prey to mis-selling.
REGULATORY FRAMEWORK FOR FOPs IN OTHER COUNTRIES
- United Kingdom
In the UK, key regulations for fractional ownership include the Companies Act 2006, which mandates registration and reporting to Companies House, board of directors, and corporate governance standards. The Financial Services and Markets Act 2000 (FSMA) requires authorization from the Financial Conduct Authority (FCA) for public offerings, with FCA oversight and enforcement powers for non-compliance.
There is a stamp duty land tax (SDLT) payable on purchasing the fractional interest in the property. The amount of SDLT depends on the purchase price of the property and the percentage interest being acquired. The rate of SDLT is generally 0.5%, but higher rates apply to second homes and buy-to-let properties. There may be ongoing tax liabilities associated with fractional interest ownership as well. When selling the fractional interest in the property, capital gains tax (CGT) may be payable on any profit made. CGT is charged on the gain made on the sale, calculated as the difference between the sale and purchase prices, deducting any allowable expenses. The CGT rate is determined by an individual’s overall taxable income and gains for the tax year, and it can vary between 10% and 28%.
- Hong Kong
Real estate investment trusts (REITs) are collective investment schemes set up as unit trusts in Hong Kong. They are listed on the Hong Kong Stock Exchange and invest primarily (at least 75% of their gross asset value) in real estate assets that generate income. The purpose of REITs is to give investors returns resulting from ongoing rental revenue. A REIT Code and other guidelines on the authorization and management of REITs have been released by the Hong Kong Securities and Futures Commission. According to the REIT Code, REITs can only invest in vacant land if certain conditions are met, and they can only engage in property development activities if certain conditions are fulfilled. Additionally, REITs can borrow up to 50% of their gross asset value. REITs must pay their investors a dividend equal to at least 90% of their annual audited net income after taxes.
- United States of America
The United States Securities and Exchange Commission (SEC) oversees the trading of securities in the country. Fractional ownership is classified as a security based on the criteria set forth in the Howey test, which was established by the US Supreme Court in the case of SEC v. W.J. Howey Co. Fractional ownership is typically sold as a security offering, which must be registered with the SEC unless an exemption applies. One standard exemption is for private placements of securities to accredited investors or investors who meet certain income or net worth thresholds. California has specific regulations for real estate fractional ownership, including disclosure requirements and provisions for escrow accounts to hold funds from investors. The state also requires fractional ownership interests to be sold through a licensed broker.
- Singapore
The Monetary Authority of Singapore (MAS), the country’s financial regulator, has laid out specific provisions and regulations to govern the operations of fractional ownership programs (FOPs) to protect investors and ensure market integrity. One of the primary requirements for FOPs is to obtain a Capital Markets Services (CMS) license from the MAS to operate legally. To obtain the license, REITs manager must meet stringent requirements, including maintaining a minimum paid-up capital of S$ 1 million and having qualified personnel with relevant experience and qualifications. FOPs must also adhere to ongoing regulatory requirements, including regular reporting and disclosures to the MAS, ensuring compliance with Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) regulations, and conducting annual audits of their operations.
COMPARATIVE ANALYSIS
India’s MSM REIT regulatory framework is evolving, offering room for a comprehensive investor-focused approach. Established REIT regulations in other countries can serve as guiding principles for India’s framework. Here are key differences between SEBI’s proposed regulations and those of other countries.
- Minimum number of investors: In India, no prescribed minimum number of investors is required for fractional real estate ownership. However, the Securities and Exchange Board of India (SEBI) has recommended a minimum of 20 investors in its REIT guidelines. In the US, the minimum number of investors required for a real estate syndication is 35, according to the Securities Act of 1933. Singapore and Dubai do not have any prescribed minimum number of investors.
- Restrictions on advertisement and solicitation: In India, there are no specific regulations on advertisement and solicitation of fractional ownership in real estate. However, the SEBI has laid down guidelines on advertising and disclosure requirements for REITs. The US has strict regulations on advertising and soliciting real estate syndications under the Securities Act of 1933.
- Tax implications: In India, fractional real estate ownership is taxed as capital gains or rental income, depending on the nature of the transaction. There are also stamp duty and registration charges, according to the Registration Act 1908, applicable to the transfer of ownership. In the US, fractional ownership is also subject to capital gains and other taxes like property and income taxes. Singapore and Dubai have similar tax implications for fractional ownership of real estate.
- Dispute resolution mechanisms: There is no specific dispute resolution mechanism for fractional real estate ownership in India. However, SEBI has recommended the formation of an independent dispute resolution mechanism in its REIT guidelines. In the US, various dispute resolution mechanisms are available for real estate syndications, including arbitration and mediation. Singapore, Hong Kong, UK, and Dubai also have similar dispute-resolution mechanisms.
Thus by, implementing a minimum number of investors, stricter advertising and solicitation restrictions, clear tax guidelines, and a robust dispute resolution mechanism would significantly improve the regulatory environment for MSM REITs. These measures would enhance investor protection, attract more participants, and contribute to the overall growth of the fractional real estate investment market in India.
CONCLUSION
The establishment of regulatory guidelines for MSM REITs in India is a significant step towards developing a robust real estate investment market, offering clarity and transparency to potential investors while safeguarding stakeholders’ interests. The guidelines cover key aspects like investor eligibility, asset composition, and valuation methods, ensuring professional management and investor protection.
However, the success of MSM REITs will hinge on factors such as demand from small and medium-sized investors and the performance of underlying assets. For instance, the demand for real estate investments among small and medium-sized investors and the performance of the underlying assets in the REIT portfolio will play a crucial role in determining the success of the investment vehicle. Continuous monitoring and compliance with the regulatory framework, including audits and inspections, are essential to ensure adherence to guidelines.
In conclusion, the regulatory framework for MSM REITs is a positive development for India’s real estate investment market, providing a secure investment option and new financing avenues. Vigilant monitoring and prompt issue resolution are crucial for maintaining investor confidence and fostering market growth, potentially attracting significant investment and contributing to economic development.