Real estate funds are one of the hottest trends on the investment landscape. Real estate funds are primarily limited partnerships which pool a number of properties within a portfolio in order to generate returns for investors. Given the intensity of the Canadian market and increased competition, there are many niche fund offerings such as those focused on home building, development, mortgage funds or those focused on specific asset classes such as hotels, and seniors residences. In addition, traditional models with broader based portfolios of commercial and corporate properties remain attractive for investors.
Types of Real Estate Funds
There are different types of real estate funds. Real estate funds are usually classified by the type of assets comprising the fund, including:
- Core Funds– These funds generally invest in stabilized, fully leased, income-producing assets in strong metropolitan areas. Core funds are typically unleveraged, meaning they carry less risk. The tradeoff is that there is less potential return for investors.
- Core Plus Funds – These funds invest in core properties as noted above, but usually require some type of improvement or enhancement in order to increase the properties’ value. For example, a Core Plus fund may acquire an under-leased, multi-tenant office building in a large financial centre, with the goal of re-leasing the building to generate a higher rate of return. Core Plus funds typically have a moderate risk/return strategy.
- Value Add Funds – Value Add funds purchase properties with the goal of improving them in some way and selling when the market is high. Properties selected for a value-add portfolio typically would have either operational or management issues or require some type of physical improvement. These funds have a medium to high risk and return strategy.
- Opportunistic Funds – Opportunistic funds purchase properties requiring a high degree of improvement or are development/raw land properties which have a high-risk and high-return. There are now many of these funds operating in urban areas, such as Toronto and Montreal focusing on development and infill.
A fund may further refine its focus by specializing in residential, industrial, rental, or office properties.
Funds can be open or closed ended which relates to the timeline and investment horizon of the fund and there will be various considerations to take under advisement when structuring either a closed-end or open-ended fund.
There are various items to consider when structuring a real estate fund and the most appropriate structure will depend on the purpose of the fund, tax considerations, liability concerns, privacy issues, the life cycle of the fund, the nature of the investors, and the amount of capital raised, amongst other things.
It is most common for a limited partnership to be used as the preferred structure for implementation of a real estate fund as it allows for flow through of profits and losses from an income tax perspective and also serves to protect the investors by offering limited liability. A limited partnership structure has the additional benefit of protecting the investment asset from the insolvency of other investors, since the investor only has a limited interest and not a direct interest in the assets of the limited partnership. There can also be securities considerations, regulatory considerations, and pension benefits law considerations depending on the nature of the fund and its investors.
Pension funds are subject to a number of restrictions and rules under the Pensions Benefit Act and Income Tax Act that they must follow when investing in real estate. Often there are unique considerations to focus on and negotiate when pension fund investors are involved, given that they are only permitted limited exposure to real estate under the legislative framework and also depending on the nature of the particular real estate fund they are investing in. Some funds allow for employee participation as a performance incentive, which creates additional structuring considerations.
In terms of governance, a general partner will manage the fund on behalf of the limited partners. It is often a heavily negotiated point as to what level of authority will be delegated to the general partner and what decisions will require the approval of the limited partners (and at what threshold of approval, i.e. unanimous, 66 2/3, majority). In some funds, an affiliate of the general partner also acts as asset and/or development manager, which raises a whole host of other considerations and points to be negotiated.
The Real Estate funds market continues to be an active sector for investment in Canada, with many different types of funds and many different fund strategies. It is important to remember that even though they are popular, real estate funds remain complex investment vehicles which carry significant legal risks in their formation and operations. As a result, experienced counsel should be sought out when forming or investing in a new fund.