[The following guest post is contributed by Sumit Agrawal, Partner, Suvan Law Advisors and Arka Saha, a final year law Student from National Law University, Orissa. Views are personal]
Although the capital and commodities market regulator, the Securities and Exchange Board of India (SEBI), had introduced Real Estate Investment Trusts (REITs) Regulations on September 26, 2014, REITs are yet to gain momentum similar to developed markets such as the U.S., Singapore and Australia. The objective of introducing REITs was to mitigate the slump in the real estate sector mired by decreased cash flows and an ever-growing leverage crisis among the top real estate companies. It was also aimed at providing retail investors with access to a new asset class, traditionally the prerogative of a few large players due to high acquisition and maintenance costs. For real estate companies, REITs were to accord an alternative mode of financing and of stripping debt, while providing small investors an asset class to hedge against inflation.
Akin to mutual funds where one can invest in stocks without the difficulty of daily management responsibilities, REITs allow investment in income-generating real estate assets such as offices, residential apartments, shopping centres, hotels, garages, car-parks, warehouses etc. REITs are structured as Trusts managed by trustees, that raise funds (through an IPO, FPO etc.) from investors, in order to invest in income-generating real estate assets. Beneficial interest of the REITs in the form of units are listed in stock exchanges so that investors can trade those units. The investment objective of REITs is to provide unit holders with yields through dividends.
Due to concerns regarding double taxation and various infirmities in the law, the objectives so far remained unfulfilled. Recently, after public feedback, SEBI amended the REIT Regulations to provide a workable framework for the launching of REITs.
Structuring of Investments
A step that can change the landscape of REITs pertains to the structuring of investments. Earlier, a REIT could either hold assets by itself, or hold assets through a special purpose vehicle (SPV), in which it held both a controlling interest and at least 50% (now 51%) of the equity share capital or interest. Thus, investments were permitted to be structured through a single vertical layer. This impeded the formation of REITs due to huge expenses incurred in re-structuring of extant assets, as the real estate sector is characterised by confluence of multiple parties specific to a project, including joint development partners, land owners, and investors, resulting in investments being structured through various layers. Consolidation of assets into one SPV or multiple SPVs in the same horizontal level is expensive due to stamp duty payable on transfers. The amendments allow REITs to invest via a two-level structure through a holding company, subject to sufficient shareholding in the holding company and the underlying SPV. This substantially reduces costs of consolidation, further allowing for added capitalisation at the holding company level through the primary markets. Notably, the Companies Act 2013 permits a company to invest through two layers of investment companies, and now REITs have been brought on a similar footing.
Real estate assets jointly held under joint development arrangements by developers and land owners who come together to develop property, along with those held by different schemes of a Private Equity fund or different funds under common control, and those held by group companies of a developer, form a large constituent of assets in the sector. Until now, up to three sponsors were permitted in a REIT Owing to this limit, multiple co-owned assets were precluded from being transferred to a REIT as each party to it could not be identified as a sponsor. This has been done away with, and the concept of a 'sponsor group' introduced, thus paving way for large scale participation.
Issue and Listing of Units
Recent changes do away with the minimum requirement of 200 public unit holders at all times, non-compliance of which could lead to de-listing of units. This was a grave impediment to the setting up of the investment vehicle as REITs had to keep a check on trading of its units post issue, a process beyond their control and oversight, due to inter-se transfer between unit holders and transfers to non-holders in the secondary markets being conducted on the basis of price time priority on the exchanges. Under the amended regulations, REITs are only mandated to ensure the presence of 200 unit holders at the time of offer of units to the public, and that the minimum public float requirements are met.
The requirements pertaining to minimum public shareholding and minimum size of initial offer to public have also been revamped to do away with the earlier requirement of an offer-size and minimum public holding of at least 25% for all REITs. This has been done to make it less onerous to market a product which is at its conception stage in the Indian markets, and to find takers for an extremely large number of units that REITs with immensely large valuations were obligated to issue to comply with such requirement. The amended regulations distinguish between REITs on the basis of their post issue valuation to set out different requirements. Large REITs, with a post issue valuation of over Rs. 4000 crores, have been permitted to make an initial offering of a lesser issue size of 10% of all outstanding units and units proposed to be offered, subject to them fulfilling the 25% minimum public float requirement within three years from the date of listing of such units. Another change of significance is the enumeration of responsibilities of merchant bankers in the public issue process of REIT units and mandating appropriate due-diligence. This move is likely to increase transparency and accountability, boosting investor confidence.
The recent changes permit up to 20% of investments (earlier 10%) in under-construction projects. This will provide greater flexibility to REITs to invest a higher amount in projects being constructed in stages. Though this may improve the returns for REITs in the long run; the risk involved in such investment product may also substantially increase.
The Way Forward
While the recent amendments have potential to revitalise the real estate sector, certain issues continue to hamper the attractiveness of REITs.
Despite permitting REITs to hold assets through two vertical layers, establishment of a REIT structure may still take sufficient restructuring of assets because of section 186 of the Companies Act. To bring the REIT regulations in concurrence with the Companies Act, the holding company which currently is permitted to make investments in an SPV holding assets, should be allowed to make investments through two vertical layers. In effect, this will entail the REIT making investments through three such layers, reducing costs by diluting the need of restructuring as equity in companies that currently invest through two layers of investment companies can be transferred to the REIT. From a tax perspective, exemption from stamp duty on properties being transferred to a REIT, in line with the Singapore experience, will incentivise the establishment of the conduit. REITs in Singapore (S-REITs), at their inception in 2002, were exempted from paying stamp duty charged at 3% when acquiring properties - a benefit that was extended till 2015, resulting in the SGX S-REIT 20 Index crossing the fifty billion dollar mark.
Globally, REITs are sold as a retail product for wealth creation. In Indian context, REITs have been designed in a way that keeps small investors out, given the application and minimum lot size of Rs. 2 lakh and Rs. 1 lakh respectively, raising doubts about there being sufficient takers of units. Perhaps the object is to protect smaller investors, due to the lack of transparency in the real estate sector. However, SEBI may have to revisit such position due to the recent enactment of the Real Estate (Regulation and Development) Act, 2016 which is bound to be a game changer, bringing in much needed credibility and accountability to the sector and boosting investor confidence. Other economic reforms such as Goods and Services Tax (GST), and relaxed foreign investment norms in the real estate sector are going to be additional catalysts in the development of the Indian real estate sector and consequently of REITs.
According to industry estimates, REITs in India will have investment opportunities up to $77 billion by the year 2020. However, there is a view that unless the returns from REITs are higher than FD rates, takers of REIT units may be few, hampering its success. With several real estate players evaluating how policies pan out in the times to come, the challenge for SEBI remains in creating a framework that assists in active participation of real estate companies while facilitating the marketing of this novel product as a viable alternative for investors.
- Sumit Agrawal & Arka Saha