REIT, InvIT Subordinate Units: Examining SEBI’s Additional Proposals

On 10 January 2024, the Securities and Exchange Board of India (“SEBI”) released a consultation paper, titled “Additional Proposals Regarding Framework for Issuance of Subordinate Units–REITs and InvITs”.[i] This paper adds on to the proposals suggested by SEBI in its consultation paper on the same subject, issued last month (“2023 Proposals”).[ii] The latest consultation paper by SEBI suggests substantial changes to the regulatory framework regarding subordinate units issued by Real Estate Investment Trusts (“REITs”) or Infrastructure Investment Trusts (“InvITs”), which have been discussed in this article.

Background

The existing framework governing REITs and InvITs provides for all unit holders to have equal rights, as regards voting rights and right of distribution. However, it is permissible to issue “subordinate units” exclusively to sponsors or their associates. Sponsors under the SEBI (REIT) Regulations, 2014, are those persons who set up the REIT.[iii] The subordinate units issued to sponsors have inferior voting rights or any other rights compared to ordinary units.[iv] The consultation paper, thereby, proposes changes to three aspects linked to the issuance of subordinate rights by REITs and InvITs. These are (i) incorporating a ceiling on subordinate units which can be issued to sponsors or their associates; (ii) bringing uniformity in the nature of rights conferred by subordinate units; and (iii) dealing with changes in terms and conditions of the subordinate units after issuance.

Additional Proposals

The first proposal deals with the specification of a ceiling (in percentage) on subordinate units issued by REITs or InvITs. The paper acknowledges that subordinate units are primarily issued to bridge the difference in the valuation of an asset, as perceived by the sponsor and the REIT or InvIT. This point is explained with an illustration, wherein the sponsor’s asset valuation and the REIT’s asset valuation have a difference of INR 100 crores. In such a case, the REIT can issue subordinate units for this amount. The terms of issuance of such REITs may also provide for the conversion of the subordinate units into ordinary units after 5 years if specific pre-decided performance benchmarks are satisfied.

The problem identified by SEBI with the existing framework is two-fold. Firstly, if the performance benchmarks are met, the units will automatically be converted into ordinary units, resulting in the benefits of capital appreciation accruing only to the sponsor. Secondly, the conversion to ordinary units would necessarily dilute the holding of the existing unit holders of the REIT or InvIT. Keeping this in mind, the proposal seeks to limit the issuance of subordinate units at the time of acquisition to 10% of the price at which the asset is acquired.

The second aspect covered in the paper deals with bringing uniformity in the nature of rights that subordinate units confer on the sponsors or their affiliates. Owing to the lack of clarity on what kind of rights the subordinate units confer on the unit holders, it is proposed that the subordinate units shall only carry inferior voting rights, inferior distribution rights, or both. In addition to this, REITs will not be permitted to issue multiple classes of subordinate units. This means that an REIT would not be able to issue one class of subordinate units with 40% distribution rights and another class with 70% distribution rights.

The third aspect revolves around the permissibility of changing terms and conditions after the issuance of the units. The 2023 Proposals envisaged a one-time extension of the entitlement date, which is the date on which the subordinate units get converted into ordinary units if the required benchmarks are satisfied. However, this one-time extension of the entitlement date was subject to stringent conditions. Recognising the importance of the terms and conditions of the issuance of the subordinate units, which include inter-alia the performance benchmark agreed upon for conversion into ordinary units, SEBI proposes to prohibit any amendment to the terms and conditions of the subordinate units after their issuance. 

Conclusion

SEBI’s consultation paper seeks to expand on the 2023 Proposals and make it even more comprehensive and detailed. The proposals aim to prioritise the interests of the individual unit holders of the REITs and InvITs, especially retail investors. This is evident from the consultation paper, with many of the proposed changes being put forth with the intention of putting investors or unit holders on the same pedestal as the sponsor, a case in point being the capped limit proposed for issuance of subordinate units so that the holding of the investors is not diluted by a sizeable margin. Additionally, the proposals concerning the nature of rights emanating out of subordinate units, and prohibition on changing vital terms and conditions after the issuance of the units, are an effort to bring in much-needed uniformity and clarity to the framework for issuance of subordinate units by REITs and InvITs.

References:

[i] Available at: https://www.sebi.gov.in/reports-and-statistics/reports/jan-2024/consultation-paper-on-additional-proposals-regarding-framework-for-issuance-of-subordinate-units-reits-and-invits_80548.html.

[ii] Consultation Paper on Framework for issuance of subordinate units and Unit Based Employee Benefits –REITs and InvITs; available at: https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/dec-2023/1702062121907.pdf#page=1&zoom=120,-6,792

[iii] Regulation 2(zt) of the SEBI (REIT) Regulations, 2014; available at: https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-real-estate-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68061.html

[iv] Regulation 4(2)(g) of the SEBI (REIT) Regulations, 2014; available at:  https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-real-estate-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68061.html

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Photo by Pasqualino Capobianco on Unsplash

SEBI’s proposals aim to prioritise the interests of the individual unit holders of the REITs and InvITs, especially retail investors. This is evident from the consultation paper, with many of the proposed changes being put forth with the intention of putting investors or unit holders on the same pedestal as the sponsor, a case in point being the capped limit proposed for issuance of subordinate units so that the holding of the investors is not diluted by a sizeable margin. Additionally, the proposals concerning the nature of rights emanating out of subordinate units, and prohibition on changing vital terms and conditions after the issuance of the units, are an effort to bring in much-needed uniformity and clarity to the framework for issuance of subordinate units by REITs and InvITs.

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REIT, InvIT Subordinate Units: Insights into Proposed Framework

The Securities and Exchange Board of India (“SEBI”) recently issued a consultation paper dated December 9, 2023 (“Consultation Paper”)[1], that deals with the lacunae in the SEBI (Real Estate Investment Trusts) Regulations, 2014 (“REIT Regulations”)[2] and SEBI (Infrastructure Investment Trusts) Regulations, 2014 (“InvIT Regulations”)[3] regarding the issuance of subordinate units and employee benefits. The objective of the Consultation Paper is to propose a regulatory framework for issuing subordinate units of REITs and InvITs to sponsor(s), their associates and sponsor group. Vide this Consultation Paper, SEBI also seeks opinion on the framework for unit-based benefits for the employees of the Manager of REIT and the Investment Manager of InvIT.

Framework for Issuing Subordinate Units

Regulation 4(2)(g) of the REIT Regulations and Regulation 4(2)(h) of the InvIT Regulations provide for equality among unit holders, ensuring no superior voting or additional rights for any individual. However, the proviso to these regulations allows for the issuance of subordinate units exclusively to sponsors and their associates. These subordinate units, while maintaining an overall sense of equality, have inferior voting or other rights compared to regular units, establishing a distinct category for sponsors and associates within the regulatory framework. Nevertheless, SEBI, to date, has not prescribed a mechanism for the mode and conditions of issuing subordinate units to sponsors and their associates.

SEBI’s Hybrid Securities Advisory Committee (“HySAC”)[4] has proposed several significant norms central to the fact that subordinate units are issued only to the sponsor(s), its associates and sponsor group and these units are designed to bear inferior voting or other rights compared to regular units. Three significant aspects highlighted in the consultation paper are noteworthy. Firstly, these subordinate units can be issued during the initial or subsequent offerings, but any post-initial issuance necessitates prior approval from 75% of unitholders by value, excluding votes from sponsors, associates, and related parties. Secondly, subordinate units come with a mandatory lock-in period until conversion to ordinary units or extinguishment, with a minimum one-year gap between issuance and conversion. The regulation prescribes that converted units shall be listed and tradeable on the stock exchanges only upon approval from the stock exchanges. Finally, following the issuance of subordinate units, any proposed modifications to their terms and conditions highlighted in the REIT or InvIT Trust Deed require approval from 75% of ordinary unitholders by value and unanimous approval from subordinate unitholders. The framework also covers the recommendation and conversion process, performance benchmarks the requirement of audit, and the need for unitholder approvals in case of changes to the terms and conditions of subordinate units.

Employee Incentives for REIT or InvIT Management

Any company or LLP or body corporate incorporated in India which manages assets and investments of the REIT or InvIT and undertakes operational activities of the trust constitutes a manager of the REIT[5] or Investment manager of InvIT[6] (collectively referred to as “Management”), respectively. In its Consultation Paper[7], SEBI proposes Unit Based Employee Benefits (“UBEB”) catered toward Employees of the Manager of REIT or Investment Manager of InvIT (“REIT or InvIT Employees”), in the hope that structure would foster better alignment of REIT or InvIT Employee interests with the respective trust.

Key elements of this framework include the creation of a distinct Employee Benefit Trust (“EBT“) at the discretion of the Management of the respective trusts. EBTs are designed to acquire units of REIT or InvIT from the shareholders of the Management or via subscription in lieu of management fees. If units are allotted to the EBT in exchange for management fees, specific conditions come into play, including the requirement for approval by 75% of unitholders and considerations for pricing based on factors like net asset value and market price. Importantly, units of such nature cannot be sold or transferred for purposes other than that of employee benefit. The framework additionally ensures regulatory compliance by imposing SEBI restrictions[8] on the Manager, Investment Manager, and associated businesses. The Nomination and Remuneration Committee is responsible for creating guidelines that guarantee conformity to securities regulations, with a focus on legal compliance and transparency.

Analysis

The proposed framework under the consultation paper appears to be comprehensive and addresses several important aspects such as eligibility, voting rights, approval processes, and disclosure requirements, providing a robust structure for market participants.  Also, the proposal regarding the creation of a separate EBT and mechanisms for it to receive REIT or InvIT units is aimed at balancing overall trust interest with employee incentives, emphasising transparency and accountability of management. While the framework aligns interests and emphasises transparency, it allows for the issuance of units to be done only once a year, within sixty days after the completion of the annual valuation exercise, which seems excessive in light of the rapid real estate market fluctuations, potentially leading to the EBT acquiring the unit at a price higher than market value. 

References:

[1] Consultation paper on Framework for issuance of subordinate units and Unit Based Employee Benefits – REITs and InvITs, available at https://www.sebi.gov.in/reports-and-statistics/reports/dec-2023/consultation-paper-on-framework-for-issuance-of-subordinate-units-and-unit-based-employee-benefits-reits-and-invits_79760.html

[2] Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations 2014 [Last amended on February 14, 2023], available at https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-real-estate-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68061.html

[3] Securities and Exchange Board of India (Infrastructure Investment Trusts) Regulations, 2014 [Last amended on February 14, 2023], available at https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-infrastructure-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68062.html

[4] SEBI’s Hybrid Securities Advisory Committee (“HySAC”) deliberated on November 15, 2022

[5] Reg. 2(1)(w) of the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations 2014 [Last amended on February 14, 2023], available at https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-real-estate-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68061.html

[6] Reg. 2(1)(zf) of the Securities and Exchange Board of India (Infrastructure Investment Trusts) Regulations, 2014 [Last amended on February 14, 2023], available at https://www.sebi.gov.in/legal/regulations/feb-2023/securities-and-exchange-board-of-india-infrastructure-investment-trusts-regulations-2014-last-amended-on-february-14-2023-_68062.html

[7] Decided on the basis of deliberations of SEBI’s Hybrid Securities Advisory Committee (“HySAC”) on February 28, 2023 and June 1, 2023

[8] Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 [Last amended on November 24, 2022], available at https://www.sebi.gov.in/legal/regulations/nov-2022/securities-and-exchange-board-of-india-prohibition-of-insider-trading-regulations-2015-last-amended-on-november-24-2022_65864.html and the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 [Last amended on January 25, 2022], available at https://sebi.gov.in/legal/regulations/jan-2022/securities-and-exchange-board-of-india-prohibition-of-fraudulent-and-unfair-trade-practices-relating-to-securities-market-regulations-2003-last-amended-on-january-25-2022-_55604.html

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Photo by Christian Wiediger on Unsplash

The proposed framework under the consultation paper appears to be comprehensive and addresses several important aspects such as eligibility, voting rights, approval processes, and disclosure requirements, providing a robust structure for market participants.  Also, the proposal regarding the creation of a separate EBT and mechanisms for it to receive REIT or InvIT units is aimed at balancing overall trust interest with employee incentives, emphasising transparency and accountability of management. While the framework aligns interests and emphasises transparency, it allows for the issuance of units to be done only once a year, within sixty days after the completion of the annual valuation exercise, which seems excessive in light of the rapid real estate market fluctuations, potentially leading to the EBT acquiring the unit at a price higher than market value. 

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An Overview of Real Estate Investment Trusts (REITs)

The concept of REITs is steadily gaining significance and investors are increasingly opting for REITs as a way to tap into the growing real estate market and diversify their portfolios. With time, REITs have become considerably popular, particularly among investors having large capital who make use of REITs to invest in high-value real estate projects. Having a wide range of investment options to select from, investors need to consider the implications involved along with their preferences and requirements before making an REIT investment.

Introduction

Real Estate Investment Trusts (REITs) refer to companies that hold ownership and/or operations in real estate. To be considered a REIT, the company must invest a minimum of 75% of its assets in real estate and derive at least 75% of its revenues from real estate-related activities. India saw its first REIT in the year 2019. As of now, there are three REITs in India – Embassy Office Parks REIT, Mindspace Business Park REIT and Brookfield India Real Estate Trust. REIT investments make it possible to have exposure and invest in real estate without having direct ownership over the property. 

Categories of REITs

When it comes to types of REITs, equity REIT is one of the most popular ones wherein rent collected through the leased-out property and proceeds received from the sale of properties is distributed to shareholders. On the other hand, mortgage REITs (also called mREITs) though don’t own real estate, advance loans to finance real estate and make profits through interests. In the case of hybrid REITs, investors have the option of diversifying their portfolios by parking their funds in both mortgage REITs and equity REITs. Accordingly, both rent and interest constitute sources of income for this type of REIT.

Private REITs function as private placements, which cater to only a selective list of investors. These are not traded on National Securities Exchanges (NSE) and are not registered with the Securities and Exchange Board of India (SEBI).

Public non-traded REITs are non-listed REITs which are registered with SEBI to carry out activities under SEBI (Real Estate Investment Trusts) Regulations, 2014. However, they are not traded on NSE. They are comparatively more stable as they are not subjected to market fluctuations. Publicly traded REITs extend shares enlisted on NSE and are regulated by SEBI. Individual investors can sell and purchase such shares through the NSE. REIT companies listed on the Indian stock exchanges are monitored and regulated by SEBI to safeguard the interest of the investors and ensure adherence to industry practices.

Risks Involved

Non-traded and publicly traded REITs pose risks, and these are not necessarily categorised as disadvantages as the cost-benefit analysis and the choices made therein are based on the discretion of the investors.

Having said that, non-traded REITs carry a higher risk than public REITs since there is no information available in the public domain to enable investors to carry out research and determine their values. In this context, the element of trust is integral. They are illiquid and the potential of having a lock-in period for the same is high, meaning thereby that investors may not be able to access their funds for a predetermined period, sometimes up to seven years. Furthermore, non-traded REITs are known for incurring high upfront fees. In the case of publicly traded REITs, the biggest challenge is the high-interest rate risk.

Tax Implications

As mentioned above, shareholders receive dividends and capital gains by virtue of REIT investments and are accordingly required to pay tax on such gains. It is necessary to mention that the dividends received in this manner are not eligible for a lower tax rate and the shareholders are liable to pay the tax as applicable to ordinary income. This is from a shareholder’s perspective. REITs are also legally bound to pay tax and cannot claim any exception available to pass-through entities such as sole proprietorships, partnerships, etc.

Benefits and Limitations

Shares in REITs are affordable for investment, and it poses a good option for small investors. The publicly traded REITs are listed on the stock exchanges which means that potential investors will have access to detailed information and make choices accordingly. Another added advantage of choosing REITs over directly purchasing commercial properties is the prospect of receiving steady dividend income.

Although REITs pose a good investing option, some challenges cannot be overlooked. First, investors are required to pay high up-front fees. The extent of risks, in the long run, is also proportional to the number of investments made and the volatile nature of the real estate market could pose a challenge to earning dividends. REITs as asset classes can lead to investors having restrictions on selling shares for a period of time.

Conclusion

REITs can prove to be a suitable retirement investment considering the steady dividend income that arises out of such an investment and on account of their growth potential. Such an investment will also help in portfolio diversification. Hence, one can connote that REITs could be a good starting point for investors to include real estate in their investment portfolio provided that the risks involved are duly assessed and the applicable tax provisions are borne in mind.

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REITs can prove to be a suitable retirement investment considering the steady dividend income that arises out of such an investment and on account of their growth potential. Such an investment will also help in portfolio diversification. Hence, one can connote that REITs could be a good starting point for investors to include real estate in their investment portfolio provided that the risks involved are duly assessed and the applicable tax provisions are borne in mind.

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