What is a real estate investment fund and is it a profitable option?

REITs provide investors with profits from property market activity

The majority of realtors (81%) believe that Russian-speaking investors rarely put their money into property funds, a 2017 Tranio.com survey has shown.

However, such a mode of investment is set to become more popular. “We expect Russian nationals to learn more about collective investment (crowd funding) and real estate funds, and to gradually begin moving in this direction in 2017–2018. This format is often more convenient than buying and then managing a property individually,” George Kachmazov, managing partner at Tranio.com, says.

This guide explains how to use an investment fund as a tool for investing in projects related to property and the construction of real estate.

The fund operates in the following manner:

  1. the fund appoints a management company (fund managers);
  2. investors make a capital contribution to the fund;
  3. fund managers purchase properties with the money from investors;
  4. fund managers generate profits and direct them to the fund;
  5. profits from lease and/or resale of property are distributed among the investors in the fund proportionately to their share.

Fund investments have many advantages:

  • low entry threshold: €1,000–30,000 (when compared to the minimum price of a liquid property, which is €100,000);
  • shares are easy to buy and sell (on any working day in open-end funds);
  • professional management (saves time);
  • investment portfolio diversification;
  • greater liquidity in comparison to direct property investment.

However, there is also a significant disadvantage: foreign funds are difficult for non-residents to invest in.

Tranio expert, Alexander Chernov, comments: “It is difficult for individuals to invest in the US for a number of reasons. Most investment platforms are organised as REITs (Real Estate Investment Trusts), exempt of taxation, which move the property investment income tax burden onto their shareholders (investors). Such a structure is favourable for US residents who often invest in these types of funds using the money from their retirement investment accounts that also have tax preferences for investment purposes. However, foreign investors who put their capital into similar American funds will have to pay a significant amount of income tax and submit a tax return in the US on their own, as the funds do not act as tax agents. In addition, tax returns are laborious and expensive to prepare.”

However, according to the Head of Financial Services at Tranio, Kirill Schmidt, it is possible to invest in REITs on the stock exchange, like in securities. “In this scenario, there’s no need to submit a tax return in the USA,” he says.

Types of funds

First, it is important to know what different types of real estate investment funds are out there before looking at profit accrual models.

1) By profit use

Accumulation (Acc.) fund Income (Inc.) fund
Ways profits are used Profits are reinvested into the fund to buy other properties or shares Profits are deposited on the investor's bank account
Purpose of fund Boost and increase the property base to generate incremental income Only earn income
Most real estate investment funds combine expansion and income generation.

2) By trading on the stock exchange

Listed Non-listed
Share issuance Issuing shares Optional
Legal status — REITs;
— private equity real estate companies.
— unit trusts or mutual funds;
— pension schemes;
— limited partnerships.
“Information on non-listed funds is just as widely available for investors as information on listed funds. This is a well-regulated field. For retail investors it is even easier to put their capital into a unit investment fund than into an exchange-traded fund, and this segment of the market is more transparent,” Kirill Schmidt says.

3) By term of investment:

Open-end Close-end
Terms of sale and purchase An investor can buy units or call on a management company to purchase units on any business day. Established for a fixed term (5–10 years). Investors may not withdraw money from the fund over the term indicated. Units are repaid when the fund is liquidated.
Liquidity High Low
Most funds with development projects are close-ended but investors can sell their units to another person.

Funds financing construction projects are generally close-ended because capital is recouped during construction. Divestment is possible once the construction is finished and the building is sold. For instance, if a fund was established in 2015 and enough capital was invested in it to undertake a construction project lasting five years, it becomes close-ended. When the property is finished and sold in 2020, the profit made is paid out to the investors.

Investment strategies

There are four main real estate investment strategies: Core, Core Plus, Value Added and Opportunistic. An investor should know the strategy of the fund in order to assess the risks and returns.

Investment strategies Data by Tranio

Strategy Other
names
Meaning Risks Return
Core Buy and Hold Real estate acquisition for rental purposes without leverage. Low Low (2–3%)
Core Plus Non-central real estate acquisition for rental purposes with leverage. Medium Medium (5–7%)
Value Added Redevelopment (real estate acquisition for renovation, future repairs and resale at a higher price). Medium–high Medium–high
(7–10%)
Opportunistic Construction, purchase of undeveloped land and encumbered properties. High High (over 10%)

* In Western Europe and the US

Most funds adopt just one strategy but some choose to combine two or three concurrent strategies (e.g., pursuing Core, Core Plus and Value Added all at once). “In Europe and the US, Core and Core Plus funds prevail by capital volume, as they include a significant percentage of the largest and the most expensive institutional properties,” Alexander Chernov says.

Core funds usually choose established low-risk markets with steady demand, price growth and low rental yields (2–3%). The Core Plus funds generate higher returns (up to 7%) by investing in less central locations and using financial leverage (sometimes 75–80% of the project is leveraged). Value Added funds can earn yields of up to 10% by channelling investor capital into developing markets which are expected to gentrify and into purchasing real estate for renovation to later sell on it at a higher price.

Fund and strategies: case studies

“Objectives differ from investor to investor: some want to preserve their capital with minimum risks and returns; others have a good appetite for risk because they are looking for higher yields on their invested capital. The Western real estate fund market has a wide range of strategies, risk levels and returns for investors,” says George Kachmazov.

Foreign real estate funds and strategies Sources: Aberdeen Property Trust, Henderson, Legal & General, PropFund, US Masters Residential Property Fund

Fund Aberdeen Property Trust Henderson Legal & General PropFund US Masters Residential Property Fund
Type of fund Open-end, listed Open-end, listed Open-end, listed Close-end, non-listed Open-end, listed
Jurisdiction UK UK UK Germany Australia
Strategy Core Core Core Core Plus Value Added
Minimum budget £5,000 £1,000 (Acc.),
£3,000,000 (Inc.)
£500 €30,000 N/A
Geography
of properties
UK (London) UK (South-East England) UK Germany (Berlin and suburbs, cities with over 50,000 inhabitants) USA (New York, New Jersey, undervalued locations)
Types of funds 50% retail,
20% office
Retail and office property 22% industrial, remainder: shops, offices, retail parks, warehouses Apartments Affordable housing for 1–4 households, blocks of flats with 20–100 units
Return, % annual 2.0–2.5 3.1 2.8 7.0–10.0 N/A
Leveraged capital (LTV, %) - - - 75–80 N/A

In a survey by the European Association for Investors in Non-Listed Real Estate Vehicles (INREV), most investors that responded chose Value Added or Core strategies in 2016. These strategies were more popular than in 2015 (rising from 82.2% of respondents in 2015 to 86.2% in 2016), compared to Opportunistic strategies (which declined from 17.8% to 13.8%), meaning that investors were more risk averse in this year. The survey also distinguishes low-risk countries (e.g., Germany, France and the UK) as the most attractive markets.

Preferred investment strateges in 2016

However, the Opportunistic strategy is more popular in certain markets. For instance, JLL reports that in Spain in 2015, 28% of investment strategies were Opportunistic whereas Core and Core Plus accounted for 35%. It is worth noting that Spain and its investors have a higher risk profile than the UK and Germany.

Mitigating risk and diversifying the portfolio

Real estate funds, as with any type of investment, entail risks: the higher the returns, the higher the risks. Return on investment (ROI) depends on: whether the fund asset value increases or decreases, rental demand; and rental rate dynamics. Returns are not guaranteed for investors.

“One of the key risks in fund investment is posed by dishonest managers. It is crucial to choose a company with a good background, reputation, transparent auditing and a clear strategy,” says George Kachmazov. Most of the funds do their best to mitigate risks by mixing various strategies and diversifying their portfolio.

Key risks and mitigation

Risks How funds insure risks
Macroeconomic risks
(crisis, inflation, etc.)
Choice of stable markets (e.g. investments
in Germany's “Big Seven”) and diversification
(e.g. 80% of the capital
can be channelled into retail or offices
and 20% into logistic hubs and retirement homes).
Market risk
(real estate price decrease, lower rentals)
Forex risk
(e.g. an Australian fund investing in the US
faces exchange rate risks if the US dollar weakens)
Regulatory risk
(changes in legislation)
Price risk
(buyer offer lower than the asking price)
Buying in neighbourhoods with expected
or ongoing gentrification or regeneration.
Credit risk
(the fund cannot get beneficial
lending terms in the future)
Fixed-rate loans, LTV of 50% max.
Tenants defaulting Reliable tenants with a good credit history
(major companies such as Sainsbury's,
public companies), several tenants.
Idle capacity risk Choice of leased properties with minimum occupancy
of 80–95% in neighbourhoods
with a mature transport network, long-term
and strict lease contracts.
Maintenance cost risk Choice of quality properties (not requiring renovation,
“green” A-class office buildings, etc.).

Many funds diversify their investment portfolio, meaning they channel capital into real estate of various types in different countries using several investment strategies. Alongside real estate, funds can retain a minor part of the funds in cash or securities. There are also such funds that invest into other funds or into real estate companies abstaining from direct real estate investments.

Debunking profit myths on real estate and securities investments

Sample fund structure with diversified portfolio

Sample fund structure with diversified portfolio

How should I invest?

Core and Core Plus projects are the most secure, but the Value Added strategy allows you to earn more.

“There is no universal recommendation. the choice depends on the investment goals and where the client's portfolio has investments. For instance, if 80% of the capital has already been invested in reliable vehicles, and a vehicle to increase the yields is needed, another 20% can be directed to Value Added projects,” Alexander Chernov says.

According to George Kachmazov, those wishing to invest in Value Added strategies should choose understandable markets and reliable funds to minimise risks.

“It would be a good idea to select funds with promising strategies, for instance, investing in a class of property that will be popular within 10–20 years,” George Kachmazov says. “In our opinion, such properties are micro-apartments and senior care homes. It is also important to choose a developing area that is being gentrified and, therefore, somewhere with properties set to become more liquid in a decade or so. The funds that invest in promising and the latest strategies are more likely to generate profits than not.”

Annex: Specifics of European real estate funds

Annex: Specifics of European real estate funds Data by PwC

Country Legal status Requirements for fund Pros Cons
Austria Immobilien-Sondervermögen are open-ended funds, not legal entities; managed by an Austrian management company Kapitalanlagegesellschaft, KAG, that is either an LLC (GmbH) or a JSC (AG). At least 10 investments in four years. For any investor;
No taxes at fund level;
Well-regulated;
The fund buys units upon investor request.
Restrictions on types of real estate;
Capital gains are taxed whether the property is sold or not.
Immobilien-Spezialsondervermögen are close-ended funds, not legal entities; managed by an Austrian management company (KAG), which is either a company with LLC (GmbH) or a JSC (AG). At least 5 investments in four years. Flexible tool for institutional investors. Restrictions on certain types of real estate;
Only accepts investments from legal entities;
Usually long-term investments;
Capital gains are taxed whether the property is sold or not.
UK Limited Partnership (LP). None No taxes at fund level;
Lower tax rates for non-resident investors.
The structure is more suited to close-end funds.
Tax Transparent Funds, TTFs: authorised and regulated limited partnership vehicle (ALP) and contractual co-ownership arrangement (CCA). None No taxes at fund level;
Lower tax rates for non-resident investors;
Non-residents may be exempt from capital gains tax.
TTF is a new functional type of real estate fund;
Uncertainty in terms of its recognition by international organisations.
Property Authorised Investment Fund (PAIF), Open-Ended Investment Company (OEIC). Conditions are determined on a case-by-case basis. Most of the fund's income is not subject to corporate tax (yet investor’s income is taxed). Strict regulation of the fund's activities (Financial Conduct Authority).
Germany Immobilien-Sondervermögen is an open-end fund, not a legal entity; managed by a German management company (KAG): either an LLC (GmbH), a JSC (AG), or a limited liability company and a kommandit partnership (GmbH & Co. KG). Bank leverage of no more than 30% of the total real estate value. Common and reliable tool for any investor;
No taxes at fund level.
Minimum two-year holding term and one-year notice on withdrawal before unit repayment.
Spezial-Sondervermögen is a special open-end fund, managed by a German management company (KAG): either an LLC (GmbH), a JSC (AG), or a limited liability company and a kommandit partnership (GmbH & Co. KG). Bank leverage of no more than 50% of the total real estate value. No taxes at fund level. Only for professional or semi-professional investors.
Geschlossene Investmentkommanditgesellschaft, Investment-KG is a limited liability partnership.
The principal partner is usually a GmbH. Investors are partners with limited property liability.
Bank leverage of no more than 60% of the total real estate value. No tax on profit distribution for any investor. Double tax treaties and EU directives not applicable;
The fund may be subject to German trade tax.
Spezial-Investment-KG, Investmentaktiengesellschaft or a limited liability partnership.
The principal partner is usually a GmbH. Investors are partners with limited property liability.
None No taxes at fund level. Double tax treaties and EU directives not applicable;
Only for professional or semi-professional investors.
Luxembourg Undertakings for Collective Investments, UCIs:

- Fonds Commun de Placement, FCP;
- Société d’Investissement à Capital Variable, SICAV;
- Société d’Investissement à Capital Fixe, SICAF. Managed by a Luxembourg management company (Alternative Investment Fund Manager, AIFM).
Maximum 20% can be invested into one investment property;
Bank leverage of no more than 50% of the total real estate value;
Minimum asset value €1.25M.
Flexible investment tool;
Popular among foreign investors;
No taxes at fund level.
Taxation of investors depends on their country of residence.
Specialised Investment Funds, SIF (FCP, SICAV, SICAF). Maximum 30% invested into one property;
Minimum asset value is €1.25M.
No taxes at fund level. Investors can only be companies, professional investors or individuals investing at least €125,000 or those willing to provide documentary proof of investment experience;
Taxation of investors depends on their country of residence.
Société d’Investissement en Capital à Risque, SICAR, can be in various legal organisation forms (LLC, LLP, etc.). None (Opportunistic investment strategy) No taxes at fund level. Only for professional investors;
Taxation of investors depends on their country of residence.
France Fonds de Placement Immobilier, FPI;
Société de Placement à Prépondérance Immobilière, SPPICAV. Managed by a French management company or a company registered in another EU country.
€500,000 capital during the first three years after establishment;
Minimum 60% should be property;
Minimum 85% of rental income (for SPPICAV) and 100% capital gains are distributed among investors.
No taxes at fund level;
Public funds can be exempt from the 3% tax.
Double tax treaties not applicable;
Few FPIs available.

The material contained within this article is for informational purposes only. Real estate investments come with risk, which can extend to the loss of capital invested. Tranio strongly recommends discussing plans with a professional investment advisor before making any investment.

Yulia Kozhevnikova, Tranio
 
 
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