Disrupting real estate markets

Sebi need not get into the business of regulating the platforms offering fractional ownership rights in real estate

The consultation paper “Regulatory framework for micro, small & medium REITs (MSM REITs)”, issued by the Securities and Exchange Board of India (Sebi) in May this year, makes for interesting reading. The proposal to encourage fractional ownership in real estate assets under regulatory oversight, if properly structured and implemented, is likely to provide new investment opportunities to a large number of investors, allow secondary market trading in fractional ownership rights, and improve transparency in asset pricing.

The post-Covid period has brought in many long-lasting structural changes in Indian financial markets, the most significant being the increased number of individual investors entering them. The number of demat accounts increased from 41 million at the end of March 2020 to over 115 million now, i.e. an increase of 180 per cent. Technological advancements, coupled with the ease of on-boarding, including through various apps, and e-KYC have helped in making trading in stocks almost frictionless. More and more asset classes need to be made available to investors to keep their interests going in the market. Sebi’s proposal should be seen in this context, apart from attempting to reduce illiquidity in the real estate market.

Now let’s compare the equity market with real estate. First, the size — the market capitalisation of all listed companies was about Rs 280 trillion as on May 1, 2023. As for real estate, it is impossible to come up with any credible figures, though intuitively it should be pretty significant for a large country like India. Second, as regards liquidity and transparency in pricing, the equity market is liquid and transparent; the real estate market is illiquid and opaque. Clearly, the equities and real estate markets are at two opposite extreme ends of the asset-pricing spectrum.

Fragmentation is one of the main reasons that ail the real estate market. As compared to about 5,000-odd listed companies, the number of commercial properties would be in many millions, with widely varying characteristics, thereby making credible valuation and property title verification difficult. This dampens trading in the real estate market, matching buyers with sellers for a property could prove to be painstaking, real estate agents extract meaty commissions, and an absence of transparent pricing pushes the market underground.

Building a liquid market for real estate is not easy. The Sebi (Real Estate Investment Trusts) Regulations, 2014, provide a framework to move in that direction by allowing investors to invest in real estate through units of trusts holding the properties. Activities under these regulations took off only from 2017 onwards, when some major amendments were brought in by Sebi through extensive stakeholder consultations.

As on May 1, 2023, five real estate investment trusts (REITs), with assets of about Rs 55,000 crore under management, were registered with Sebi. Of these, three were listed. The ticket size for participation and the trading lot size have been gradually reduced over the period, thereby facilitating investment by a wider set of investors. At present, the minimum amount an investor can invest at the time of public issuance of REITs is Rs 10,000-15,000. The minimum lot size for trading is one unit. Liquidity in the trading of listed REITs has improved and is even somewhat comparable to a sample of equities of similar market capitalisation and free float. That said, REITs are yet to gain due popularity among investors. The consultation paper notes that one of the impediments to the growth of REITs is the high requirement for minimum asset size and minimum offer size in the existing regulations.

The proposal to introduce a chapter in REIT regulations for MSM REITs, with relaxed thresholds and extra provisions for investor protection, makes sense. The proposals for relaxed thresholds include those relating to asset size, subscription size, and net worth requirements for the sponsor and the investment manager. The proposed higher percentage of AUM (assets under management) investment in completed and rent-generating properties; ensuring a higher proportion of distributable cash flow to unit holders; capping the total expense ratio; and frequent valuations of assets are likely to provide extra comfort to the investors.

So far, so good. What requires deeper analysis and more thinking is the proposal of Sebi regulating the “fractional ownership platforms” (FOPs). The paper acknowledges such web-based platforms have mushroomed in the past few years. Wouldn’t Sebi face an outreach problem if it takes upon itself the task of regulating them? How effective would enforcement be of the platforms that don’t register with Sebi or, worse, which don’t even come to Sebi’s notice?

In addition, what about the platforms with an SPV (special purpose vehicle) structure with less than 200 investors not agreeing to convert into the REIT structure? Sebi may not have any regulatory jurisdiction over such cases.

Remember the period of mushrooming CIS (collective investment schemes) in the country. At that time, Sebi had faced criticism because its enforcement mechanism was found wanting in checking that menace. One of the main problems was of outreach. Sebi, with its limited staff and a whole lot of other onerous responsibilities, could not effectively cope with the unregulated CIS, which were spread across states. Eventually, it was realised by the government and financial-sector regulators that such unregulated activities were best handled at local levels, i.e. state governments/districts. The enactment of the Banning of Unregulated Deposit Schemes Act, 2019, was because of this realisation. One cannot help getting a feeling of déjà vu in respect of the present proposal.

Why not use the existing stock exchange mechanism for the public issuance, listing, and trading of MSM REITs? In the past few years, the stock exchanges have gained experience in listing and trading public REITs’ units. That should be useful in their handling MSM REITs. As for improving the outreach of the stock exchanges to facilitate participation by a larger set of investors, the online broking services, which have taken off in a big way, would help.

The regulation of FOPs should be left to the Real Estate Regulatory Authorities of the states concerned or any other appropriate authority. Further, unauthorised FOPs, having characteristics of deposit schemes, would perhaps be best handled under the Banning of Unregulated Deposit Schemes Act, 2019. Anyway, Sebi need not get into the business of regulating FOPs.

The writer is a retired IAS officer and former Sebi chairman