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Can Real Estate Certificates be an Alternative to Funds of Real Estate Funds?

With European retail investors still looking for indirect real estate investments, there are good reasons for investment managers to launch real estate certificates. These structured products have been popular vehicles for gaining exposure to hedge funds and private equity, so why not real estate?

Growing interest in indirect real estate investments European retail investors continue to show great interest in indirect real estate products. In Germany, for example, some investors are, rightly or wrongly, disappointed by the performance of some of the more traditional open-ended fund products and are looking for greener pastures.

Vehicles investing in REITs have been establishing themselves as alternatives. Funds of REITs have been launched as UCITS umbrellas out of Luxembourg and more recently also out of Germany. Additionally, REIT certificates are being issued. These structured products are intended to mirror the performance of an underlying basket of REIT portfolios.

But indirect products investing in real estate funds may be more appealing to investors, offering greater diversification. While funds of real estate funds (FoFs) have been launched, investment managers have yet to launch any real estate certificates with underlying funds. This is despite the advantages of these products in terms of tax and flexibility, as well as the popularity of similar structured products built around hedge funds.

Funds of real estate funds

The investor into the FoF can gain exposure to a great variety of different real estate asset classes: mainstream open-ended funds, opportunity funds, core plus products or even infrastructure funds. When picking the funds in which the investor desires to invest, however, the FoF manager will be bound by not only commercial, but also regulatory restrictions and tax considerations.

If the FoF vehicle is a regulated entity, the restrictions may apply at fund level. The most commonly used FoF vehicles in Europe are Channel Island trusts and Luxembourg-based Fonds Commun de Placement (FCP). These vehicles will often be subject to restrictions with respect to risk diversification and issuer limits, as well as to the legal form of the targeted property funds. In addition, there is no UCITs-type European wide harmonisation for the distribution of property funds.

As a result, a Luxembourg-registered FoF, for example, would not automatically be eligible for a European distribution passport. Instead, it would need to apply for registration in each individual jurisdiction where it is to be publicly marketed. This situation may become more relaxed in future if some of the Committee of European Securities Regulators’ suggestions are implemented.

But for the time being the greater the difference between the FoF’s asset composition and UCITs eligible assets, the harder it will be to obtain approval for public distribution. As a result, FoFs will find it particularly difficult to gain exposure to opportunity type funds.

Certificates as an alternative to FoFs?

Structured products in the form of certificates have been widely used across the investment industry. There is a great variety of different certificate types on the market, some of them offering downside protections and or return caps. Typically, a certificate would be issued by a SPV (Special Purpose Vehicle) or a bank as a structured bond with a return linked to an index of underlying assets. The subscriber to the certificate would participate in any value appreciation, but normally not be entitled to receive any dividends or other distributions until redemption of the certificate.

These certificates have several advantages. For the issuer, they are comparatively speedy to launch and, as their issuance is not regulated, have the flexibility to be linked to investments such as real estate opportunity funds. For the retail investor, there are taxation benefits. In a number of jurisdictions, including Germany, accumulating certificates, which do not make ongoing distributions, would only be subject to taxation on disposal or redemption. And then they would be subject only to a lower capital gains tax rate or even be fully exempt. This may be substantially more beneficial than taxation of a FoF investment, where income from underlying funds could be imputed or even punitive lump sum taxation could be applied.

The corollary of this is that there are a number of disadvantages to certificates. A lack of regulation obviously inspires less confidence among investors. Additionally, fee structures are complex and not transparent to the subscriber.

Certain issues encountered by FoFs cannot be resolved by certificates. The retail market is keen on liquid investments, yet the underlying lack of liquidity in real estate presents fund managers as well as the issuers of certificates with a dilemma. Solutions may involve greater cash reserves or the inclusion of some exposure to more liquid assets like listed REITs, which could be offered in a diversified fund or structured product.

It remains to be seen whether certificates will be able to become as successful a product in real estate as they have in the securities and hedge fund industries.