Towards a Conducive Framework for REITs – Recent SEBI Amendments

[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.
Investment Conditions

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

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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