Everything you need to know about SEBI's regulations on small and medium REITs ( SM REITs)

[Meher_Smaran]

To promote investing in high-quality residential projects for retail investors via fractional investment route, SEBI recently issued a gazette notification announcing new regulations for small and medium REITs (SM REITs)

These regulations provide investors with a new option to invest and own large real estate projects with smaller amounts while safeguarding their interests as fractional real estate investment at present is still largely unregulated.

You can learn more about SEBI’s thought process regarding MSM REITs by reading last year’s consultation paper in the below thread

SEBI's Consulation paper on MSM REITs

SEBI recently published a consultation paper seeking suggestions from the public on the regulatory framework for Micro, Small & Medium Real Estate Investment Trusts (MSM REITs). Some highlights from the SEBI consultation paper How does ownership of fractional real estate work? In the past 2-3 years, lot of web based platforms started offering fractional ownership of real estate assets like warehouses, shopping centres, conference centres for an amount as low as 10-25 lakhs. For …

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What is a REIT?

Real Estate Investment Trust (REIT) is a company that typically buys and owns income-producing real estate or related assets like office buildings, malls, apartments, hotels, resorts, warehouses, etc., and operates them as a part of its investment portfolio.

It is like a mutual fund company that owns a pool of real estate properties, collects rental income, and distributes it as dividends to its unitholders who can also enjoy the price appreciation of the properties that the company owns.

One of our community members did a couple of nice posts on this topic long ago

All about REITs/InVITs : A Reckoner

Real Estate Investment Trusts (REIT) is basically a pool consisting of income-generating real estate assets that are held similarly to a Mutual fund. Just the way in Mutual funds, with REITs, the investor’s funds are deployed in commercial real estate spaces/assets. Through REITs, retail investors get an opportunity to invest in commercial properties which otherwise, would have just been a distant dream. Units under this portfolio are sold to investors through a public offer. Once these list on…

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Let’s now talk about SM REITs

What is the definition of SM REIT?

“Small and Medium REIT” or “SM REIT” means a REIT that pools money from investors under one or more schemes as per the sub-regulation (2) of regulation 26P

What’s the sub-regulation (2) of regulation 26P?

SM REITs can raise funds by offering units to their investors if they satisfy the following two main conditions:

• The size of assets that the REITs wishes to acquire should be at least 50 crores and less than 500 crores.

• the minimum number of unitholders of the scheme of the SM REIT other than the investment manager, its related parties, and associates of the SM REIT should be at least 200.

Who operates the SM REITs?

Investment manager

“investment manager” here refers to the company incorporated in India, which sets up SM REIT and manages assets and investments of the SM REIT and undertakes operational activities of the SM REIT

Eligibility criteria:

The investment manager should have:

• A net worth of at least 20 crores out of which at least 10 crores should be in the form of liquid assets

• at least two years experience in real estate industry or real estate fund management.

Skin in the game

The minimum stake that the company is:

• 5% of the units for the first five years; if there is debt – 15% of the units.

• The skin in the game limits come down gradually from the 5th year.

These units shall be unencumbered and locked in.

Lending restrictions:

• The scheme of SM REIT shall not be permitted to lend to any entity other than lending to its own SPV.

• The SPV shall not be permitted to lend to any entity.

Distribution

• The Investor manager should ensure that at least 95% of the net distributable cash flows of the SPV are distributed to the scheme of SM REIT and 100% of it shall be distributed to the unitholders.

• Quarterly distribution declaration is mandatory and the payment should be made within 7 days of such announcement and 15 working days of the end of the quarter.

Comparison between REITs and SM REITs

Particulars	REITs	SM REITs
Investment route	Directly or through SPV	SPV
Size	500 crore and above	50 - 500 crore
Type of property	Generally in Commercial RE	both residential and Commercial RE
Allocation rules	80% of assets in completed projects and maximum 20% in under-construction projects	Can only invest in completed projects
Minimum unitholders	100	200
Minimum public unitholding	25% of the issue within 3 years of listing	25% of the issue
Minimum investment	10000 - 15000 Rs	10 lakhs
Leverage by REITs	Maximum 49% of their total assets	Maximum 49% of the scheme value
Distribution of net cash flows	Atleast 90%	Atleast 95%
Duration	Half yearly	Quarterly

What are your thoughts on this potentially game-changing concept of SM-REITs?

[ndeshm]

Thank you for the post. I was interested in the SM REIT amendment. Some thoughts:

(1) Leverage: If I remember correctly, in the consulation paper, and also the public feeback document, SEBI had said no to leverage. Looks like they gave in to lobbying by the fractional platforms. This is probably useful for the SM REITs but unclear how much value it will generate for the investors (at least based on the current model on which they currently run).

(2) Minimum investors: I don’t have a good understanding of this, but are there enough number of people investing in fractional platforms to guarantee the 200 mark on a regular basis?

(3) Investment model of the fractional platforms: It is unclear to me how this will impact the existing investment model. From what I understand, the current investment model is as follows: (a) Identify and list rent generating properties on the website; (b) pool investor money and complete the deal by setting up an SPV. Make investors shearholders of SPV and also give them some convertible debentures; (c) pay regular rental income to investors after subtracting management fees (d) hold for ~5 years and exit once the property generates decent capital appreciation (some performance fees are charged above a hurdle rate).
A representative of a fractional platform told me that point (d) is what makes the fractional real estate investment truly lucrative (so basically like flipping houses). Of course, I think very few exits have actually happened till date, but there is intention to exit in the investment models. In this respect, fractional platforms have been operating similar to Cat 2 AIFs, i.e, the investment is close-ended, and the fee structure is similar (in fact, I think there was a suggestion in the public comments to treat SM REITs as AIFs, but I think this was not accepted to keep the ticket size low). REITs on the other hand are open ended and operate on a real estate development and management model, and while they can also sell properties if they want, that does not seem to be a primary objective in the investment.
The new regulations do speak about SM REIT schemes and SPVs. But it is not entirely clear to me how this will affect the existing structures.

(4) The additional regulatory requirements will probably add to the management costs and I am curious to see by how much. For instance, the current yields for fractional platforms are in the range to 7-9% (after 1% management fees). At the same time, the current yields of REITs (excluding nexus trust) are between 5.8-6.8%. I guess the added costs will even out the yield advantage that fractional platforms had. Then the “exit opportunity”, if it still exists under the new regulations, will be the only significant consideration. Thus, punting on the real estate potential of the particular property is what will produce differential returns. This also makes SM REITs riskier, but this was always true.

(4) The last thing I am curious about is how this will affect the tax treatment for fractional real estate investments. I would assume the REIT taxation should apply.