Fractional ownership – A piece of the action

Fractional ownership is a new buzz phrase in India’s real estate market gaining popularity with retail investors looking for lucrative projects. Amit Aggarwal, a senior partner at SNG & Partners, and Devyani Dhawan, an of counsel with the firm, explain its relevance.

Presently, there is no specific regulation governing fractional ownership of real estate in India. However, in May, the Securities and Exchange Board of India (SEBI) issued a consultation paper titled Regulatory Framework for Micro, Small & Medium REITs, with a view to regulating the platforms offering fractional ownership of real estate assets to protect investors.

What is fractional ownership?

In simple terms, an investor owns a fraction of an asset along with other co-owners, thereby splitting the cost of investment among a pool of investors.

A co-owned asset can be anything from a holiday home to a private jet, a luxury yacht, collectables and, more recently, non-fungible tokens (NFTs). However, one of the most popular income-generating assets is commercial real estate. With huge investment requirements, ownership of high-end commercial real estate is usually out of reach of retail investors. However, if a group of investors pools funds and agrees to an ownership model, they can each become co-owners and enjoy the generated income.

Real estate fractional ownership platforms (FOPs) enable retail investors to invest in real estate under a fractional ownership model with the click of a button, from the comfort of their home.

Fractional ownership models

Some of the most popular models are discussed below.

Special purchase vehicles (SPVs). In India, real estate FOPs generally follow an investment model where:

An FOP identifies an asset;
A private company is set up to own the asset;
The asset is listed on the FOP’s website with diligence details, valuation, minimum investment, return on investment and any lock-in terms;
On reaching a targeted expression of interest, investors are invited to subscribe to securities in the private company. Most FOPs keep a minimum investment range from INR1 million (USD12,000) to INR2.5 million;
Investors’ funds are collected for the securities;
The private company purchases the asset with the pooled funds;
Upkeep costs are shared among the investors;
Rental and other income from the asset is distributed among the investors;
The FOP charges investors management and maintenance fees; and
After expiry of any lock-in, investors may exit by selling their securities in the private company.

This model is most popular. The interest in the real estate asset is represented through securities in the private company. The SPV remains the registered owner of the real estate and there is no transfer of actual ownership of the asset to the investors. Investors become indirect owners of a share in the asset by virtue of their shareholding in the private company.

Joint ownership. Some FOPs allow direct joint ownership of the real estate asset among a large number of individuals. In this case, investors are direct registered owners of an asset. The investors then grant the FOP powers of attorney for managing and dealing with the asset on their behalf. In such structures, even usage rights may be shared among the co-owners, if feasible. This structure is fraught with the legal and commercial risks of multiple co-owners and numerous powers of attorney, as well as stamp duty and registration challenges.

Blockchain. This model is popular in the American investment market where asset ownership is represented through tokens and the sale/purchase and ownership of tokens is traced through a blockchain network. The property is managed by a property management company on behalf of the token owners.

Structural issues

At first glance, fractional ownership appears to be a convenient and lucrative model for retail investors to access high-end real estate. Digging deeper, there are some important issues to be aware of.

While presently there are no specific regulations governing the various fractional ownership models, there are regulations attracted to:

Pooling of investments by multiple investors for a particular purpose;
FOPs acting as real estate agents; and
The stamp duty and registration requirements for ownership of immovable property.

Some implications are discussed below.

Due diligence. As potential investors will make decisions based on an FOP’s disclosures and diligences, it is extremely important for investors to understand the diligence procedure, outcomes and implications, and any title-related issues. If possible, they should conduct an independent search on the property’s title and marketability. Similarly, the property’s valuation and the adopted methodology would also be very important. As the sector is currently unregulated, there is no written standard of diligence, title and care imposed on FOPs. Investors need to proceed with caution.

Regulatory uncertainty. While the SEBI has guidelines governing collective investment schemes and real estate investment trusts, which the authors will discuss later, these regulations do not cover the nuances of fractional ownership. This is especially so where investors propose to become co-owners of properties. Even the SEBI’s consultation paper has modified the very construct of fractional ownership by equating it with mutual funds. What is needed for fractional ownership is suitable modifications to the Transfer of Property Act, 1882, state stamp laws and registration laws that recognise the concept of fractional ownership, protect co-owners’ interests, and address the logistical and procedural issues of transferring fractional ownership.

Further, while the Real Estate (Regulation and Development) Act, 2016, (RERA), deals with the registration of real estate agents, the legislative body should consider amendments that carve out a separate set of obligations and responsibilities for FOPs.

FOPs manage assets on behalf of real estate investors and make all decisions about asset maintenance, renovations, sale and purchase. For this work, FOPs should be regulated under RERA, not merely as brokers or agents, but more akin to promoters as defined under the act.

RERA was formulated to protect investors and retail allottees as they stay invested in a project. Similarly, in case of fractional ownership, it is the retail investor who is investing money in an asset with the intent of earning appreciation on its value.

Exiting. While FOPs may give assurances to investors that their investment is not subject to any lock-in, and they can exit at any time by transferring their fractional share or securities to a third party, it is not clear who will provide this exit, who will identify a potential buyer, the agreed valuation and the manner of
addressing investor grievances.

This may lead to an investor’s investment being stuck in illiquid securities; the investor is completely dependent on the whims of the FOP for achieving an exit, which the FOP may or may not be able to deliver in a timely manner.

REIT v fractional ownership

In simple terms, real estate investment trusts (REITs) are akin to mutual funds, where investors invest in units of the trust and get returns based on income generated from the underlying asset. REITs are registered under the SEBI (Real Estate Investment Trusts) Regulations, 2014, where a trustee holds the REIT assets for the benefit of the unit holders.

While an investment manager is responsible inter alia for making investment decisions about the assets, including conducting due diligence, valuations and title checks, the trustee has a supervisory role over the investment manager and is responsible for following due procedure.

A REIT sponsor or initiator has prescribed requirements including minimum net worth, a minimum holding in the REIT, and minimum lock-in for such units to ensure they have skin in the game.

REITs raise funds through an initial offer and subsequently through follow-on offers, rights issues, QIPs, etc. The minimum asset size of a proposed REIT is INR5 billion, and minimum offer size for initial offer is INR2.5 billion. The units of a REIT are required to be listed on a recognised stock exchange to ensure liquidity for the investors.

The minimum amount to invest in a REIT in India after the SEBI’s notification on 30 July, 2021, ranges from INR10,000 to INR15,000. Therefore, even small retail investors have access to units of a REIT.

Under REIT regulations, investment by a REIT can be only in holding company and/or SPV (holding or developing properties), or properties, or securities, or transferable development rights (TDR) in India. No investment is allowed in vacant land or agricultural land. Not less than 80% of the REIT assets’ value can be invested in completed and rent or income generating properties. REIT regulations also have detailed provisions for real estate purchases and sale by REITs, investing through SPVs, the rights of unit holders and detailed disclosure requirements, all with the objective of protecting investors’ interests.

So, while REITs are regulated structures with prescribed requirements for investment in properties and issuing units to investors, fractional ownership structures do not provide the same uniform level of risk protection and accountability. For instance, there is no requirement for an FOP to have any minimum stake in an SPV formed for fractional ownership; there is no multi-layer check and balance structure; and there is no ready liquidity as the securities of the SPV are usually unlisted. That said, some of the advantages offered under a fractional ownership structure are not available under a REIT structure.

For instance, in a fractional ownership structure: an investor can choose which specific property to invest in, depending on his/her criteria; there is no restriction on the type of property; there is no lock-in; and co-ownership of the property is achievable, whether direct or through an SPV.

SEBI consultation paper

The SEBI has now proposed to regulate FOPs to ensure a uniform level of investor protection and has issued a consultation paper. Some of the paper’s salient features are mentioned below.

Any person, including an FOP, offering fractional ownership in real estate would be required to be registered as a micro, small or medium (MSM) REIT;
MSM REITs would be required to fulfil certain eligibility criteria as may be decided by the SEBI; and any existing FOPs that do not fulfil the given criteria would be wound up after giving exit to the investors within a particular timeframe;
MSM REITs would be set up as trusts, with the ability to establish separate schemes for owning real estate assets through wholly owned SPVs constituted as companies. The concept of sponsor, trustee and investment manager, as applicable to REITs, will apply with certain prescribed minimum net worth requirements, minimum experience in real estate, and other similar conditions evidencing genuine and experienced players;
MSM REITs would have full control and hold 100% shareholding of the MSM SPV, and the MSM SPV would have 100% ownership in all underlying properties;
The size of the asset proposed to be acquired by the MSM REIT should be at least INR250 million and not more than INR4.99 billion. This is the threshold giving it the colour of MSM REITs;
The sponsor of the MSM REIT would need to have a minimum stake in the units of the REIT and a mandatory lock-in for the holding;
MSM REITs would raise funds through the initial offer of units of scheme and such units would be mandatorily listed on a recognised stock exchange;
The nature of the real estate would be completed and rent-generating real estate properties;
Minimum subscription size to the units of an MSM REIT scheme would be INR1 million; and
Certain other conditions akin to a REIT would be prescribed including valuation norms, disclosure norms, rights of investors as unit holders and other investor protection measures.

Analysis of paper

While the SEBI has kept investor protection as paramount, the very nuances of fractional ownership of property have been diluted

Asset ownership v unit ownership. Fractional ownership, as the name suggests, allows investors to co-own a property. However, under the MSM REIT scheme, investors will only own the units of a scheme, which is akin to a mutual fund. Investors in units of an MSM REIT scheme will not have any co-ownership in the property.

No clarity on identification of asset. Again, one of the attractions of fractional ownership is that investors can choose which specific property to invest in. However, in the MSM REIT model, it is not entirely clear whether the investors will have a say in the identification of the property, or that the decision will be left to the investment manager.

Winding-up timelines. Winding up existing FOPs that do not fulfil the eligibility criteria needs to be looked at cautiously, as the investors who have invested in such schemes may not be able to get their projected returns at the time of exit.

MSM REITs. The proposed MSM REIT structure is similar to the current REIT structure, with a couple of tweaks. This is nothing but a mutual fund structure where the minimum value of the asset size is pegged. The intricacies of a fractional ownership structure are done away with, which may not make it attractive for investors who are looking at co-owning a piece of real estate.

Dilution of options. Restricting fractional ownership only to MSM REITs not only dilutes the various options for fractional ownership, but also makes it merely a security driven investment exercise. To achieve the real value for retails investors through fractional ownership of immovable assets, suitable modifications may also be introduced in the Transfer of Property Act (TOPA), RERA, stamp laws and registration laws to recognise the concept of fractional ownership of an asset and protect the interest of co-owners, as well as to address the logistical and procedural issues in case of the transfer of fractional ownership of an asset.

Suitable regulations should also be introduced to enable investors to leverage their fractional ownership of an asset for raising funds. Depending on the value of the underlying asset, the value of the fractional ownership could represent a strong security to back borrowings.

Conclusion

While the consultation paper is definitely a step in the right direction for giving recognition to the fractional ownership models, and protecting the interests of investors by thwarting the mushrooming of unregulated FOPs, it is important to retain the essence of fractional ownership to give the investors a sense of co-ownership of the underlying asset without it merely becoming another mutual fund scheme.

In the authors’ view, to protect investors without necessarily changing the underlying tenets of fractional ownership structures, it is advisable to retain the proposed net worth and minimum experience requirements of FOPs and investment managers, coupled with disclosures and valuation norms, but there should be enough flexibility to enable investors to have co-ownership in that asset, either directly or through ownership of securities of the MSM SPV.

IN DETAIL

Important regulations, issues and schemes detailed in the article are explained below

Collective investment scheme (CIS)

A collective investment is governed under the Securities and Exchange Board of India Act, 1992. Sub-section (2) of section 11AA specifies that a scheme or an arrangement that satisfies the following conditions is classified as a collective investment:

Contributions or payments made by investors are pooled and utilised for a particular purpose;
The aim is to receive profits, income, produce or property;
The scheme is managed on behalf of the investors; and
Investors do not have day-to-day control over the management and operation.

In the fractional ownership models discussed in the article, funds are collected by an FOP from an identified set of people for a common purpose – purchasing a property. Further, because the property is pre-identified by the FOP and posted on its platform for inviting investment, it can be argued that the FOP is collecting/pooling money under a defined plan.

The other ingredients of a CIS – the aim of receiving income and profits, the property being managed by the FOP on behalf of the investors who are not involved in the day-to-day management of the property – are also satisfied in the fractional ownership models. This view was also observed in Alchemist Infra Realty Ltd v Security Exchange Board of India (2013).

Therefore, for an entity to be able to undertake the activities as a CIS, it is mandatory for it to obtain a certificate of registration from the SEBI under section 12(1B) of the SEBI Act, and regulation 3 of the SEBI (Collective Investment Schemes) Regulations, 1999. Under the CIS regulations, a collective investment scheme can only be constituted in the form of a trust, where a collective investment management company appoints a trustee to hold the assets of the collective investment scheme for the benefit of unit holders. This is contrary to the current popular model of working through SPVs or direct joint ownership.

Stamp duty and registration

There is no specific law in India that governs and regulates blockchain technology and its various applications. Creating and implementing a blockchain registering land ownership would require a complete governing procedure.

The authors understand that in the blockchain model of fractional ownership, records of all the beneficiaries (in terms of tokens) are maintained and a trail is created for every token transfer. However, since the owner of the property is a separate entity – say a trust or an SPV – this blockchain would be nothing but a constantly changing list of beneficiaries. One could not claim that the transfer of rights, title or interest in an immovable property is valid or registered as per Indian law.

A private blockchain can’t be equal to the existing legal mechanism of valid transfer of property prevalent in India. Therefore, the real owner of an immovable property would be the separate legal entity. To establish that token holders are the co-owners, their names would have to be registered as owners in the records of the concerned sub-registrar.

Real Estate (Regulation and Development) Act, 2016 (RERA)

In view of services provided by FOPs, it is important to ascertain whether they would be classed as real estate agents under the RERA, requiring registration.

Section 2(zm) of the RERA defines a real estate agent as “any person who negotiates or acts on behalf of one person in a transaction of transfer of his plot, apartment or building, as the case may be, in a real estate project, by way of sale, with another person or transfer of plot, apartment or building, as the case may be, of any other person to him and receives remuneration or fees or any other charges for his services whether as commission or otherwise and includes a person who introduces, through any medium, prospective buyers and sellers to each other for negotiation for sale or purchase of plot, apartment or building, as the case may be and includes property dealers, brokers, middlemen by whatever name called.”

A real estate agent is required to obtain registration under section 9 of the RERA. Section 10 of the act prescribes the duties of a real estate agent. It can be argued that FOPs require registration under the RERA as real estate agents, and need to comply with the act.

Information Technology Act, 2000

The Information Technology Act, 2000, and the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011, set a legal framework for privacy and data protection in India. The IT rules regulate the collection, use, handling and transfer of sensitive data.

As per section 43-A of the IT act, a body corporate may be held liable for damages in the event of negligence in implementing and maintaining “reasonable security practices and procedures” for “sensitive personal data or information”.

The IT rules also require body corporates that possess, deal with or handle sensitive data through a computer resource to implement and maintain prescribed “reasonable security practices and procedures” to safeguard it from unauthorised access, use, alteration, disclosure or damage.

An FOP would need to implement and maintain prescribed standards of “reasonable security practices and procedures” identified by IT laws, especially while dealing with sensitive personal data or information of investors.

The Prevention of Money Laundering Act, 2002

As FOPs are currently not regulated by any financial sector regulator, they may not be strictly following the KYC and anti-money laundering compliance prescribed for other financial institutions.

Absence of any regulatory check and streamlining leaves FOPs to adopt their own measures of KYC, which may not be as strong as the regulatory requirement, leaving room for unscrupulous investors to invest through their platform with no sight of the source of funds.