KEY TAKEAWAYS
The article explains how retail investors can invest in high-value commercial or luxury properties through fractional ownership, pooling capital with others to earn rental income and potential property appreciation.
It details out the investment mechanism, including setting up a Special Purpose Vehicle (SPV), issuing a mix of equity and compulsory convertible debentures (CCDs), and the importance of understanding the investment structure and agreements.
The benefits of fractional real estate (FRE) are also outlined, such as higher returns, better liquidity, and no maintenance issues, while also highlighting risks like lack of regulation, credit risks, and high ticket size.
The article also discusses the taxation implications for different SPV models and lists several platforms in India offering FRE opportunities, such as Strata, PropReturns, and Assetmonk.
Investors can consider FRE if they have a long investment horizon and sufficient capital.
Recently, I took a trip to Lonavala with some friends, as is our usual monsoon tradition. Just like every other trip, our goal was to find the perfect villa. We began our search on Airbnb but soon realized that prices were skyrocketing due to the peak season. After hours of unsuccessful villa hunting, my father informed me that one of our neighbors had recently purchased a villa in Lonavala near Della Adventure Resorts. Following some persuasive conversation, he kindly offered us the place on a weekday for a 50% discount. Considering the current rental rates, we didn't hesitate to accept his generous offer.
The house was a luxurious two-story, 6-bedroom property featuring a jacuzzi, swimming pool, snooker table, parking for two cars, stunning views, and a glass-ceiling covered terrace. It was an incredibly fancy and beautiful place to unwind. Owning such a piece of real estate in that location would cost at least 4-5 crore. So the question arises, how and why did this person invest in this property? Upon speaking with him, he revealed that he was only a 50% owner of the property, with the remaining 50% being split among 2-3 other individuals.
His reason for investing was to earn a substantial rental income from a highly desirable location popular among young people in and around Mumbai and also to stay in it when he wished to. He didn't possess the necessary capital to purchase the entire property, so he was pleased to find suitable partners.
As a contributor to this blog, I promptly began exploring opportunities for retail investors to invest in similar commercial or luxury properties through fractional real estate. Let's discuss this topic in the blog post.
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Decoding Fractional Real Estate!
Fractional Real Estate (FRE) refers to partial ownership, where investors pool their capital to invest in a physical property. The rental income generated from these properties is then distributed to the investors in proportion to their original investment. The asset manager or underwriter, with whom investors entrust their capital, manages the investment portfolio, legal work, tenants, and property maintenance for a fee based on the overall transaction.
So the question now is, how investing in FRE will earn you returns?
The simple answer is - Rental Yield. Rental Yield is essentially the rent you earn per year on the purchase price of the property. You see, all of these properties, where the capital is invested, are high-ticket commercial or luxury real estate projects. They provide much higher yields than a residential property in some housing complexes.
To take an example:
Let's say you buy a residential flat for ₹1 Cr, along with ₹2 Lakh in interiors and ₹3 Lakhs in Stamp Duty. The rental income on this flat will be ₹30,000 per month and let's say maintenance is ₹2,000 per month. The rental yield will be:
$$((30,000 - 2,000)*12 months)/(1Cr + 2L + 3L) = 3.20%$$
So you will earn around 3.20% of the property every year and at current levels of rent adjusting for inflation, it will take anywhere between 22-25 years to get the value of your flat back. (Note: we haven't considered the value of property appreciation if any)
Strictly, talking about Residential Real Estate, below is a good illustration by the School of Intrinsic Compounding. The data used by them comes from this Moneycontrol Report.
Now, let's compare these numbers to yields from commercial and luxury properties. Doing this would give us a picture of exactly how dismal are the residential returns. (Commercial and luxury property includes warehouses, office buildings, shops, villas, hotels, data centers, etc.)
The above data confirms that investing in commercial real estate would give you close to 3-4X rental yields and make it a good case for investment as compared to buying a house. However, as retail investors, we cannot buy a commercial property since the capital required can be huge. This is where the case of FRE as a mechanism gets justified. So how can you invest? Well, keep on reading 😊
How does the transaction work?
The investment mechanism is just like any other unregulated pooling of funds scheme. The asset management company sets up a SPV (Special Purpose Vehicle) to pool investor's funds. The SPV in this case is a private limited company (But can be LLP as well), and investors are given a combination of shares and compulsory convertible debentures (CCDs) in proportion to their investments. Let's go through the entire process of investing in a fractional real estate deal.
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If you are unaware of what CCDs are, we have written a detailed article on them which can be accessed by clicking here.
Investment Structure
So before starting with the actual process of investment, let's understand the structure of the deal. Investors receive a security that is packaged as a mixture of Equity and CCDs in a certain ratio. These securities are indivisible and each investor will be issued this security in proportion to their investment. Investors have to sign something called a Security Subscription Agreement (SSA). This document highlights the details of these securities.
Most of these document screenshots are taken from a sample deal of a leading FRE startup in India, but since these documents are strictly confidential and not available for distribution, we can't share them in full in the public domain.
The reason why this structure is adopted is, that the rental income from the property will be issued as interest on these CCDs. After the maturity/expiry of the deal, the CCDs will be converted to equity, and the proceeds from the sale of assets will be split amongst investors. As per law CCDs have to be converted into equity within 10 years.
Investment Model
The capital raised by the platform will be used for activities such as purchase of land, constructing commercial structures or straightaway buying an operational real estate property. The platform will furnish a detailed report about all expected future expenses and revenues.
Below is a sample document that represents the bread and butter of the model. The report will showcase all the cash inflows and outflows, along with expected IRR and overall returns. I would like to highlight that every deal can be structured differently, this is an important document to check and understand and we request you to speak to an expert to understand this in depth before investing.
Expression of Interest
The investment process begins with an expression of interest (EOI). Once you subscribe to a deal on the website of the asset management platform, you receive an EOI. This document is a kind of invitation that highlights the amount committed by you and the upfront token that is required to pay within a stipulated period.
Note: We have taken the docs of a leading FRE startup in this space but the process can be a bit different for other companies.
Another important point to note here is the penalty charged, in case you decide to terminate the agreement after paying the token amount. And the amount you will receive if the deal is not fully subscribed and the asset manager decides to shut the project down.
Article Of Association & Service Agreement
As discussed, the investment structure involves setting up a private limited company, which will have directors, shareholders and key managerial personnel. The Memorandum Of Association (MOA) lists the basic structure on which the company is setup and the Articles Of Association (AOA) highlight the operating procedure of the company, the relationship between shareholders and the company and the rights of shareholders (Investors). More than 90% of the MOA is basic and similar to all other companies, so the document you should really look at is the service agreement and AOA.
Instead of you reading 100s of pages of the document, let me just list down the important parts for you, which you should definitely go through. (These documents are provided post-investment, so there is nothing really that you can do about it, but still going through it once should help raise any concerns)
Dispute Resolution Mechanism (highlights what happens when things go wrong)
Termination clause (Withdrawing of investment before maturity)
Management fees and performance fee structure (will be different for every deal and company)
Disclosure norms for SPV (frequency and content of financial disclosures)
SPV Capital Structure
Pros of Investing in FRE
Please note that some of the points below are made in comparison to investing in traditional residential real estate and cannot be directly compared with listed or other alternative instruments.
Safe Underlying Asset: Real Estate has always been considered one of the safest options by Indians. Similarly, even in Fractional Real Estate, the investment is backed by a safe asset that will always hold a certain value, even during adverse market conditions.
Higher Returns: As we have mentioned before, if you are planning to invest in a residential property purely for investment, it's better to opt for FRE, as commercial properties have higher rental yields and IRR. In many cases, post-sale of the asset (on maturity) the IRR may be as high as 18% and this is better than taking risks on other unregulated products out there.
Better Liquidity: FRE offers higher liquidity than traditional real estate. You can exit from your investment under the terms prescribed by the asset management company. But keep in mind, that this may result in some exit load and loss of accrued returns, so please go through the necessary document (exit clause) before withdrawing the investment.
No maintenance issues: And lastly, lower responsibility for the property in general. In this case, the maintenance, rental agreements, negotiation with tenants etc., all are managed by the AMC (for which you obviously pay management fees).
Diversification: This is common in every alternative investment product, real estate exposure will have less correlation with traditional equity markets and can offer good diversification.
Cons of Investing in FRE
Regulations: One of the biggest risks is the absence of an elaborate regulatory framework. This entire sector is unregulated, and only recently SEBI has considered placing FREs under small and medium-scale REITs. Thus you should invest only if you have absolute trust in the underwriter/asset management company.
Credit Risks: It is possible that the main tenant of the commercial property you have bought defaults on their rental payments in which case the SPV will not be able to make the desired interest payments until they find someone else to replace the tenant and recover money via legal channels.
Unpredictability of Cash Flows: Several factors affect the returns of FRE, during COVID-19, for example, commercial real estate returns were dismal. Similarly, during the off-season, the returns from luxury resorts can be quite low as well.
High Ticket Size: Even though the minimum investment is below normal property purchases, still the minimum investment is way too high (₹5 Lakh to ₹25 Lakh+) which can be too much exposure to a retail investor. You might be better off buying a REIT on the listed market.
Liquidity: FRE investments are for a longer time frame, and when compared to other alternate investments, they are highly illiquid. Thus, invest only if you find the returns are attractive for a longer duration, maybe 10+ years.
Taxation
For Private Limited SPV Model: The rental income (which is given as interest on CCDs) from the SPV will attract taxes based on your slab rates and any profits from the sale of assets will be taxed at 20% with indexation (if held for at least 2 years) since that will be considered as capital gains.
For LLP SPV Model: The rental income is paid out post-tax to the investor as LLPs are taxed flat at a 30% rate. Capital Appreciation can only happen when you share your stake in LLP to someone else.
Currently, only a handful of companies are offering Fractional Real Estate for retail investors but we have come across many companies building in this space and will be launching soon. There are still a few options when it comes to REITs (Regulated and market-listed versions of FRE) but trusted FREs are tough to come by. Note all these platforms are required to be registered as a broker under RERA.
Here is a list of a few platforms offering this investment for retail Investors.
Strata (Strataprop): Based out of Bangalore, Strata is an established player in FRE and one of the biggest asset managers in the market. Many investors in our community have invested money in FRE through Strata and have liked the experience. The company was established in August 2019 and the Minimum Ticket Size to invest is ₹25 Lakh. Most of the offerings are in commercial real estate.
PropReturns: Based out of Mumbai is a relatively new player in the market, started by a couple of young minds from BITS Dubai. Most of their asset offerings are in commercial real estate.
Hbits: Based out of Mumbai as well offering good property options to invest in with a minimum ticket size of ₹25 Lakhs mostly dealing in commercial real estate.
Assetmonk: Claims to have ₹260 Cr AUM offering an average 14-24% IRR in commercial real estate. The general tenure of their deals is 5+ years.
Brikitt: The company deals in holiday homes in popular tourist destinations like Goa and investment opportunity starts from ₹6 Lakhs with target rental yields of 12% - 14% IRR which in my opinion may be difficult to achieve as compared to commercial real estate. You will also be given the option to stay in the holiday home you buy for a couple of days a year during nonpeak times.
Alyf: Another company dealing in the holiday home space primarily operating in cities like Goa, Lonavala & Alibaug. They let you stay in your holiday home for a couple of days a year during non-peak times. You get all rental yields and capital appreciation from the property and ALYF manages it for you and charges an annual fee.
I am sure there are many more platforms that we haven't covered, please feel free to point them out in the comments and we will add them here.
Bottom line
Well first and foremost, you should only consider this option if you have a long investment horizon (3+ Years) with minimal liquidity needs and have sufficient capital to put upfront to purchase fractional ownership. We ran a short poll on our Whatsapp community and figured that most of the members still prefer short to medium-term alternative deals but we also are conscious that the comfort of having real estate exposure is different for Indians.
If the above applies to you, Fractional Real Estate (FRE) is a great way to invest in commercial or luxury holiday homes (where you can even stay yourself) without a very large investment and there is no headache of maintaining it as well. It gives a decent and stable cash flow for a longer duration and if the property is in a growing area, it can also offer you great capital appreciation.
If you can't afford the upfront payments and don't like the liquidity aspect of FREs, then you can consider REITs (Real Estate Investment Trusts) where you get diversified exposure to different commercial properties and have decent liquidity as the securities are traded in the listed market.
So in the end, your investment decision in FREs depends upon your liquidity preference and how conservative you want to be with your capital.
Hope you enjoyed the article, if you think there is something factually incorrect or if you know of any other platforms offering invoice discounting for retail investors, please send me a message here or message us on our Whatsapp Community which you can join here.
Please note that this is an opinion blog and not official research advice. I am not a registered RIA in India, and none of these views reflect those of my current employer. This blog aims to promote informed decision-making and does not discourage you from investing in any deals.
We plan to come up with more blogs discussing different types of instruments available in the world of startup investing, write on due diligence for some platforms, and also existing and upcoming alt investment deals in the Indian market. If you want to stay updated on the latest blogs, please subscribe to our newsletter so you get notified automatically, if you are a Tradewithpython subscriber, you know we don't spam.
Thank you for reading and hope to see you in the next one!
