Into the world of fractional investing

Little drops of water, little grains of sand, make the mighty ocean and the pleasant land .....these are immortal lines penned by poet Julia Carney. Yes, small things make their presence felt when they get together and as assets become expensive and go out of reach of the hoi polloi , adding up fractions is gaining traction.

Fractional investing today has made possible part-ownership of real estate, US stocks (Indian stocks can’t be bought/sold in fractions), vehicles, equipment, furniture and what not. In this article, we tell you the good, the bad, and the ugly of fractional investing.

Realty tidbits

For investors, property has always been the big kahuna of assets. Commercial real estate, be it retail, warehousing or hotels, involves thousands of square feet and billions of rupees, making it unaffordable for an individual. Even if you own some commercial realty, the key problem is sweating that asset, i.e. generating regular income, doing maintenance and active management. This is why emergence of tech-powered fractional investing platforms such as Strataprop, Assetmonk, Myre Capital, hBits, Yield Asset and Definite.re — focussing on real estate — has been timely.

Instead of crores, the minimum ticket size is drastically lower at ₹25 lakh for a share in a property of your choice. You potentially get access to top-grade commercial properties across major hubs in the country. When you own a share, you reap its proportionate rental yield (monthly/quarterly payment) and possible capital appreciation over time. All this, without being involved in day-to-day management.

Though the fractional investment offerings sound eerily similar to the teak, emu, goat, ghee-related collective investment schemes in the late nineties and early 2000s, the platforms insist they aren’t. They argue there is no guarantee of any return and real estate is a hard asset. Do note these platforms are operated by companies registered with Registrar of Companies (RoC). Only some display the RERA (Real Estate Regulatory Authority) licence on their website. For all investments, a Specific Purpose Vehicle (SPV) is created in which funds are raised to own and manage the property. The SPV can either be a limited liability partnership (LLP) or a private limited company. As an investor, you, like others, will own shares of the SPV holding the specific property.

The platforms assume responsibility for oversight, reporting, and major decisions on behalf of the investors, so that you can be a passive owner. In exchange, some platforms charge a fixed annual professional fee (1-2 per cent) on your ownership amount. Others levy a combination of fees pertaining to property management (0.5-1 per cent) and performance (10-20 per cent above a fixed hurdle rate on capital appreciation at the time of asset sale). Some platforms say rents received from the property are distributed as interest which are taxable directly in the hands of the investors. The profit on sale is considered as capital gain.

Fractional real estate investing platforms appear similar to Real Estate Investment Trusts (REITs) or a Real Estate Fund (run under Alternative Investment Fund or AIF structure) — barring some differences. First, REITs and AIFs are highly regulated while these platforms are self-regulated. Two, the decision about property choice and capital deployment rests with you in these platforms, while the REIT and AIF managers do it on your behalf. Three, concentration appears higher in case of platform investing if you have just ₹25-50 lakh to invest. Four, REITs offer the easiest entry and exit via the stock exchange. In fractional platforms, exits can be via asset sale (decided by a majority of co-owners), private sale between two parties, or a dedicated resale market/window of the platform. Some properties have an initial six-month lock-in.

Fractional owners can end up taking a highly specific bet even when they don’t know enough about the micro market. A higher return obviously compensates this risk. The return is composed of rental yield (7-9 per cent is claimed) and capital appreciation. The potential return advertised on the portals is represented as IRR, which is average annual return that accounts for rental return as well as appreciation. The IRR of properties is said to be between 15 and 18 per cent over five years.

While the platforms offer easy and online access, there is often a limited price discovery at the investment stage. Plus, there is no established market currently for selling a fraction of a commercial property, which hinders exit price discovery.

We are also unclear on where the loyalty of platforms rests because it appears they facilitate transaction pre-sales (like a broker), but post-sales, act as property manager (for the buyers).

REITs seem a better investment option here. With a lot size of 200 units, India-listed REITs give you passive commercial real estate exposure for as low as ₹60,000 to ₹80,000. AIFs are also good but the minimum investment is ₹1 crore.

Bite-sized stocks

With Indian investors wanting to diversify globally, the US stock market has emerged as the favourite hunting ground. The FAANG stocks, Dow-30 shares, Warren Buffett’s Berkshire Hathaway...the list is endless. These are well-run companies with excellent balance sheets and often offer superior growth potential.

But affordability is a problem. Take the example of Amazon Inc — each share of the company costs $3,500. Google parent Alphabet’s stock is priced at $2,450, which is over ₹1.8 lakh a share. We are not even talking about Berskhire Hathaway shares which cost ₹3 crore apiece, the same price tag as an Aston Martin Vantage car! This is where fractional shares offer a pocket-friendly route to own such equity investments.

Most of the brokers/investing platforms that enable Indians to buy US stocks offer the facility to transact in fractional shares. So, instead of buying one share of Amazon costing ₹2.6 lakh, you can buy 0.1 share. Fractional shares are usually a result of the dividend reinvestment plans, reverse stock splits, or similar corporate activities. With fractional shares, you do not get voting rights but dividends are distributed proportionally. Most stocks worth over $1/share with a market capitalisation over $25 million are eligible for fractional share orders.

Fractional shares are fully regulated. They offer more convenience for investors with limited capital. Ordinarily, it will be well-nigh impossible to build a top-quality portfolio with $100. But if you dabble in fractional shares, you can. In this way, limited capital no longer acts as a hindrance, which is why fractional share investing is also popularly known as dollar-based investing. Typically, the minimum investment amount for buying fractional shares is $1.

However, there are a few drawbacks of fractional shares. Firstly, prices of fractional shares may not exactly be proportionate to the price of the whole share due to supply-demand. Secondly, the time required to buy fractional shares can be more due to settlement issues. Thirdly, US brokers can, at their discretion, remove any stock from the list of stocks eligible for fractional trading. Here, no new positions can be opened and the broker will close existing positions in stocks not eligible for fractional trading. Fourthly, if you want to shift from one broker to another, your fractional shares will be sold and you’ll only receive the resulting cash back and this could come with tax implications and other fees.

Besides real estate and US equities, fractional investing approach is used for other non-traditional asset classes.

Physical asset investing

If you fancy owning a slice of vehicles, equipment and furniture, there are a few India-based investment platforms that offer curated investment opportunities in lease finance area. The hook remains the same: low minimum investment amount and promise of stable, regular income. Basically, you pool your money with other investors to invest in capital equipment that can be leased to businesses. The goods will be given directly to the lessee as part of a lease-to-own programme.

Fractional ownership of such physical assets can be yours for as low as ₹20,000. The investment structuring is similar to real estate with an SPV model using LLP structure.

Platforms such as Grip Invest charge a management fee of 2 per cent on every repayment an investor gets. The investment tenures are shorter, between 18 and 48 months and depend on the lease asset. Some platforms do not allow premature exit.

Platforms claim that all payments an investor receives are made post-tax and hence there are no additional tax implications. The argument is that return of capital or distribution of profits from a LLP is tax exempt at the hands of the partner of the LLP. Since your investment and income will be from the leasing arrangement, it is important to understand how well-drafted the lease agreement actually is. The advertised IRRs for recent deals are in excess of 20 per cent.

Covered bonds

Covered bonds also offer an indirect fractional ownership route. Covered bonds are instruments of refinancing. A loan pool is formed from the loans given to businesses/individuals by a financial institution. This loan pool is the asset against which the covered bond is issued to investors. The bond is ‘covered’ as it is protected by collateral such as property and business assets, etc. Such covered bonds assure a fixed interest rate and may have a kicker if there is a ‘credit event’ to adjust for the higher risk. Some bond issuers, in a bid to make the product more tax efficient, have attempted to link bond returns to a reference index such as equity benchmark. So, if the index drops to a certain low level below, you will only get your principal back. But if it stays above the stated level, you will get your principal and stated return. By market-linking the bond, your interest income will no longer be taxed at your slab rate and, instead, will attract tax equivalent to holding equities.

Covered bonds are complex structures, meant for people with very high risk appetite who are attracted to 9-11 per cent return. Often the covered bond route is tapped by very low-rated (read high-risk) issuers. Essentially, by buying a covered bond you become a lender to bond issuing NBFCs. Hence, do your due diligence. Read the bond information memorandum, figure out the business state of the actual issuer behind the bonds and don’t be swayed by the ease of online investing or minimum investment amount of ₹10,000. These bonds are often sold by investment platforms who charge a fee of 1-2 per cent to the NBFCs for each asset.

Summing up

Avoid becoming enamoured with online investing convenience

Invest in assets that you understand and are well-regulated by entities such as SEBI, RBI

Find out how your investor interest is protected if the worse of outcomes happens

Do your due diligence to enter the asset at the right price

Go for assets that provide reasonable exit routes

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