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The authors are Rahul Ranjan and Ananya Dutta, second-year students at National Law University, Odisha.
The real estate sector has been witnessing phenomenal growth in recent years. With an ever-expanding middle-class population and rapid urbanisation, the demand for commercial assets is surging. A recent industry report predicts a game-changing transformation for India's real estate and economy with sales of a whopping $1 trillion by 2030. This necessitates steps to be taken to further mature the commercial real estate market. In light of this, the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations, 2014 and Securities and Exchange Board of India (Infrastructure Investment Trusts) Regulations, 2014 provide a detailed framework for setting up and managing Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”) in India, unlocking new avenues for real estate investment and market growth.
To further strengthen this framework, the Securities and Exchange Board of India (“SEBI”) recently released two consultation papers dated 9 December 2023 and 11 January 2024 respectively to provide a mechanism for the issuance of subordinate units to sponsors and set up Unit Based Benefits for the employees of the Manager. By bringing out these proposals, SEBI has opened discussion on such intricacies of REITs/InvITs which were unanswered in the 2014 regulations.
In this article, the authors delve into the key proposals set out in the two papers while analysing their potential impact on the real estate sector. Further, the authors attempt to point out the limitations in the mechanism and avenues for improvement.
Rise of REITs and InvITs in India
REITs/InvITs can be considered as investment vehicles that provide hybrid assets for the monetisation of infrastructure and real estate assets, which enables small investors to have stakes in the ownership of large commercial assets through the purchase of REIT/InvIT units on stock exchanges.
Prior to their emergence, it was almost impossible for small investors to expand their portfolios into the real estate sector due to a high minimum capital requirement. With the introduction of affordable REIT/InvIT units, the monetisation of such assets has become possible for them. However, given its nascent stage in India, this market is still undergoing major reforms to keep up with the ever-evolving landscape as it continues to interact with forces of supply and demand.
SEBI, governed by its objective of regulating securities, has taken proactive steps to nurture the REIT/InvIT market. It has done so by implementing new policy measures and, most recently, proposing a standardised framework for issuing subordinate units. This focus on strengthening governance and ensuring uniformity within the sector attempts to align the interests of stakeholders with the interests of the REIT/InvIT.
SEBI's Subordinate Unit Framework
Though the concept of subordinate units was first introduced into the REITs and InvITs regulations through amendments in 2016, a framework for its issuance has only now been proposed through the consultation paper released on 9 December 2023. Keeping in line with the underlying principle of equal rights of all unitholders, the paper has envisaged issuance of subordinate units to sponsors and their associates on a private placement basis which would carry relatively inferior voting or distribution rights. The proposed framework submitted by SEBI's Hybrid Securities Advisory Committee also provided for disclosure of terms of subordinate units in the trust deeds/offer documents, dematerialized issuance, and separate ISIN for such units.
Subordinate units have been introduced with a view to bridge the disparity in the valuation of real estate assets by sponsors on one hand, and by the investment vehicle and its investors/potential investors on the other. Such units, existing only temporarily, will be unlisted on the stock exchanges as they are created with the intention of eventual conversion into standard units. Regulation 11(3) and Regulation 12(3) of the REIT Regulations 2014 and InvIT Regulations 2014 respectively require sponsors to mandatorily hold a minimum percentage of units on a reducing scale basis for the entire life of the REIT/InvIT. The norms have clarified that subordinate units would not be counted towards the unitholding mandate applicable to sponsors. It is clear that SEBI is committed to transparency and low information asymmetry as it requires disclosure of entitlement date/event and a quantifiable and objective performance benchmark for conversion in the offer document itself, as well as prior approval from seventy-five per cent of unitholders by value excluding the sponsors and their associates, for issuance of subordinate units post initial offer.
The minimum time gap between issuance and conversion has been proposed to be a year with the possibility of a one-time extension of one year after prior approval along the same lines as issuance post initial offer. This extension is proposed to be conditioned on the due disclosure of the possibility of extension, along with specific details of such process in the trust deed or offer document at the time of initial offer and/or at the time of issuance of such units itself.
Moreover, the second consultation paper released on 11 January 2024, invites suggestions in respect of the specification of ceiling on the extent of issuance of subordinate units to address dilution of proportionate unitholding upon conversion, provide uniformity in the rights attached to them so as to align unitholding standards across REITs and InvITs, and promote better understanding among the stakeholders.
Unit-Based Perks for REIT/InvIT Employees
Additionally, the paper dated 9 December 2023, proposes perks for employees of the manager in the form of Unit Based Employee Benefits (“UBEB”) to provide scope for alignment of their interests with the interests of REIT/InvIT. Notable proposals include the creation of a separate Employee Benefit Trust (“EBT”) and outlining methods for the trust to acquire units. Further, the proposals restrict the use of such units exclusively for UBEB purposes.
Apart from this, the proposals stipulate that the approval of 75% of unit holders by value is essential for issuing units to the trust in lieu of management fees. Such a requirement will take into account the interests of a majority of unitholders and can serve as a deterrent to employees, preventing them from making decisions with an intention to rapidly increase unit values on a short-term basis which can potentially jeopardise long-term sustainability and growth.
Way Forward
The proposed voting mechanism for issuance of units is likely to favour those having a large percentage of units, i.e., amounting to more than ten per cent of the total units, who are generally the institutional investors. Such investors are usually more willing to take risks and are less susceptible to adverse impacts of potential dilution.
In countries like the USA, less than a quarter of the common stock of REITs remains under the ownership of individuals. REITs/InvITs were set up in India with the view to make ownership more accessible to small investors. Any alteration in the current regime should thus not be detrimental to them. The existing REITs and InvITs regulations allow unitholders, collectively holding not less than ten percent of the total units, to pool their votes and nominate a director on the board of the Manager/Investment Manager. As small investors hold a very small percentage of units individually, they are more likely to be adversely affected by any potential dilution. The authors propose that the pooling of votes by unitholders on similar lines should be allowed for the approval of issuance of subordinate units. Such unitholders may be subject to the Stewardship Code, provided in Schedule VIII and Schedule IX of the InvIT Regulations 2014 and REIT Regulations 2014 respectively, for all purposes resulting from that pooled voting to ensure ethical decision-making. An arrangement like this would balance the safeguarding of the interests of small investors alongside the need for transparency.
Further, we recommend establishment of an alternate mechanism with differentiated voting rights for subsequent occasions of issuance of subordinate units post creation of the first issued or ‘primary’ subordinate units. We suggest that primary subordinate unitholders, being sponsors who are mandatorily required to hold units for the entire life of the REIT/InvIT, are also vulnerable to potential dilution of their holdings and therefore, should possess at least inferior voting power in such decisions. This approach serves as a protective measure, akin to capping subordinate unit issuance.
Additionally, in relation to the existing inferior rights of the subordinate unitholders, there still remains scope for non-uniformity as the proposals provide for discretion in setting a cap on the extent of voting and distribution rights. Herein, we recommend the fixation of a cap based on the nature of different segments of the real estate market such as Industrial REITs, Residential REITs, Healthcare REITs, etc. given their risk-return profiles, enabling clarity and certainty for the stakeholders. On similar lines, InvITs should be segmented depending upon the type of infrastructure they own and operate like communications, transport & logistics, energy, etc.
Concluding Remarks
SEBI’s proposed framework is a step in the right direction in providing opportunities for growth and investment in the real estate sector. However, proposals must not lose sight of the foundational goals of the creation of the REITs and InvITs. Any regulation that lacks clarity, particularly regarding caps and inferior rights, could leave stakeholders vulnerable to volatility in the markets. Before moving forward, SEBI must consider the possibilities of expansion of voting rights to an extent and segmentation of the market for the purposes of setting caps in order to ensure better efficiency in the existing mechanism and further democratisation of the assets.
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