Fractional Ownership of Real Estate: Need for robust legal framework to protect investors

Fractional ownership of real estate assets is at a nascent stage and on the brink of attaining attractiveness as an investment model.

Many prospective investors are dissuaded from buying real estate as an asset class given the high-ticket size, illiquid market, fear of fraud and legal complexities. Real estate investment trusts (‘REITs’) is a possible solution to this problem, however REITs too have certain drawbacks, viz- REITs own a large portfolio of real estate assets wherein investors cannot cherry pick assets. Fractional ownership permits cherry picking real estate assets.

The concept of fractional ownership of real estate assets was introduced in the United States of America in the early 1990s and gradually gained acceptance in European countries. Fractional ownership refers to a structure wherein groups of investors pool in monies to acquire ownership of a high-value asset.

Fractional ownership of real estate offers flexibility by reducing the financial burden on a single investor of owning and maintaining a property- whether commercial, residential, industrial, and enables investors to get exposure to a high-end property with a smaller ticket size thus opening doors to owning smaller parts in multiple projects and diversifying their portfolio of investments. The investors share the incomes and expenses related to such assets in proportion to their contribution.

One of the recommended models of implementing fractional ownership is setting up a special purpose vehicle (“SPV”) which purchases the asset. The fractionally-owned asset is the SPV’s asset and contribution of each investor is reflected in the shareholding of the SPV. Investments usually have a lock-in period. Subject to the lock-in, investors may exit by private sale where investors are free to sell their fractional ownership to any party (subject to valid KYC and regulatory compliance).

Fractional ownership of real estate assets is at a nascent stage and on the brink of attaining attractiveness as an investment model. Currently no regulations exist in this space. While some platforms claim to provide a title report and make periodic disclosures, there are no distinct standards for it. Nevertheless, if regulated well, it can possibly be a great option to boost real estate sales and clear unsold inventories.

Investors require being careful about the following:

i. Quality of due diligence conducted along with selection criteria of the asset;
ii. Lock-in period and taxation of proceeds distributed to the investors;
iii. SPV structure- restrictions on transferability of shares of the SPV;
iv. Poor liquidity in the secondary market for transfer of shares of the SPV;
v. Absence of regulatory framework or regulator making such structures more susceptible to mismanagement;
vi. Fees and other costs charged by intermediaries along with costs like audit fees for the property tax and other levies.
vii. Quality of the lessee, escalation of rent, lock in period in the lease deed;
viii. Potential legal issues arising out of disputes with lessees/licensees.
ix. In case fractional ownership is also meant to confer rights to use and enjoy the property, the manner of use and occupation must be specified in the documentation.

As the concept of fractional ownership of real estate is gaining momentum, it can open up new investment opportunities to a large segment of smaller investors – thereby channelizing small household savings into the real estate sector, which in turn could aid developers in clearing up large unsold inventories. It is recommended that a robust legal framework in relation to fractional ownership of real estate is formulated for ensuring that investors are adequately protected.

(By Ashoo Gupta, Partner, Shardul Amarchand Mangaldas & Co. Views expressed are personal)