AAA Financing In Real Estate

Mutual investment funds are gaining popularity as a financial instrument on the commercial real estate market. Developers point out that of closed real estate MIFs they may save up to 25% on investment outlay by using the mechanism. In turn, regular mutual fund shareholders can count on a yield of 25-30%, which is comparable to the yield on the most successful development projects.

Closeness Pays Off

A mutual investment fund (MIF) is the pooled funds of investors entrusted to a management company for asset management. The MC must ensure efficient investment of these funds to increase the value of the shares. Open and closed MIFs exist. The open fund’s investor may buy or sell his or her share on any workday and the value of shares is updated daily. Therefore, you know the cost of shares and can buy or sell them on any workday. The funds investing in real estate can only be closed: so-called closed property mutual investment funds (CPMIF). They are created for a particular project for a period of 1 to 15 years; hence you may sell your shares and fix your profit only upon project completion.

CPMIF is the only more-or-less developed mechanism of mutual investment in real estate now available in Russia. “The advantages of mutual investments in real estate are self-evident: a considerably lower threshold for entering a project and consequently higher liquidity and reduction of investment risks,” believes vice president of MC Morskoy Fasad Lev Pukshansky. “The main CPMIF mechanism is managing a specific property, namely leasing it out,” says Natalia Sukhareva, executive director of MC Svinyin & Partners. “That is to say that real estate is in the hands of private MIF shareholders who trust its stewardship to a management company.” In her words, the current yield of such MIFs is generated from rental payments, and the growing value of shares reflects the growing value of the property itself. “The titles of shareholders are certified by an investment share regarded as a security; the shareholders are registered by a special registrar, and property inventory and supervision of business operations are exercised by a specialized depositary,” explains Alexander Strogalev, director of the Management Company Adekta. “In fact, the CPMIF is a company founded for a certain period of time, which is not registered as a legal entity,” reasons Valery Aleksandrov, head of the direct investments department for the PSB management company. The fund is most often formed from cash or real estate contributions, illumines Aleksei Ponkratyev, director of the Petersburg branch of Nomos Bank.

MIF Taxonomy

CPMIFs are graded pursuant to the goals set by their creators. In particular, a construction fund is meant to finance the process of real property construction; a rental fund accumulates regular rental payments; a development fund is formed to finance development transactions and the so-called nonpublic fund is to structure real estate assets and financial flows to pursue the owner’s interest. Closed property funds may operate as regular development companies. “In buying and developing real properties they are geared towards taking advantage of considerable tax preferences – thus, no profit tax is levied on the accretion to the fund’s capital,” emphasizes Mr. Pukshansky.

CPMIF shareholders are divided into two categories: corporate structures operating on the real estate market, which use CPMIF as a convenient cloak for their business, and private and institutional investors (banks, pension funds etc.) that consider the real estate market promising for yield on their capital. Corporate funds are generally created for some specific project or a series of projects. The number of shareholders is minimal and they independently operate their projects. Funds of this type presently dominate the market.

As for the funds attracting the money of private investors (“market” funds), a management company selects the projects where the shareholders’ cash will be invested and monitors the state of the fund’s investments. “The average price of entry to a market CPMIF on the Moscow and St. Petersburg markets is 100,000 rubles. This is a small sum for the investor planning to profit from real estate investments,” opines Ms. Ivanova.

Potential Earnings

The yield of any MIF depends on the structure of its assets. Thus, equity is part of the open MIF assets, whose yield rises or falls with the stock market. CPMIFs have a yield directly dependent on real estate management efficiency. For example, the yield of the funds invested in commercial real estate for its later lease is a function of growing real estate prices and growing rental payments.

“The return on investments in CPMIF is directly related to the general state of the real estate market and depends on the specific investment characteristics of the assets in the fund’s portfolio. In development funds, yield may near 20-30%, while rental funds bring from 10 to 15%. The general state of mutual investments and stock markets also affects the operations of CPMIF. Because a fund is steered by a specialized management company, its efficiency eventually predetermines the return on investments in CPMIF,” explains Pukshansky.

“Unfortunately current legislation prohibits MIFs to repair real properties at the expense of fund assets, so the funds cannot improve commercial properties and increase the shareholders’ earnings by upgrading the BC class,” says Ms. Sukhareva. “But we hope that this restriction will soon be lifted.”

An effective period of investment in real estate MIF is 3-4 years. Investments in real estate MIFs are long-term by nature and they are not fit for any speculative games. Aleksei Lazutin, director of the investment sales department at Becar Realty Group, believes that, in order to get a stable return with minimum risk, a property needs to be bought first and then a mutual investment fund is to be established. This is a well-known strategy for hedging investments in real estate, he says.

Mr. Aleksandrov believes that because supply is still far behind demand in all segments of the real estate market, investors may count on the return of 15-30% on their investments.

Pros and Cons

“The main advantage of a commercial real estate MIF is stable earnings and immunity to sharp fluctuations occurring on the stock market,” says Ms. Sukhareva. “One of the CMIF benefits is ensuring the property liquidity, thanks to its conversion to fund shares and their fragmentation,” says Mr. Ponkratyev. In addition, VAT is not levied on deals with shares, and the shares themselves are exempt from the property tax, while the operating margin of CPMIF in the form of rental payments property sale proceeds are immune from income tax. “Therefore, CPMIF allows tax-free profit reinvestment in other projects. In addition, the funds are protected from raider attacks and real beneficiaries of the fund assets are not disclosed,” lists Ponkratyev. Among the other pros of CPMIF he mentions a high degree of property control, stable return on investments, the possibility to float the shares on the stock market, diversification of risks and profitability regulation due to management of the fund structure. MIF transparency strengthens the confidence of investors in the safe keeping of their funds, so MIFs attract cautious investors, Ms. Ivanova adds.

“One of the main pros is the reliability of investments in the real estate market, which is traditionally considered less volatile than the stock market,” says Sergei Vasin, director of the real estate funds management department at Troika Dialog. He also points to the fact that, in rental CMIFs, investments are secured by rental payments. “The withdrawal of a big investor from a construction project inevitably entails project failure. On the other hand, CMIFs can be closed down ahead of time only by the decision of 75% of its shareholders,” says Vasin. This imparts additional stability to a closed investment fund.

In spite of indisputable advantages, CPMIFs also have some cons. In the opinion of Mr. Ponkratyev, they are, first of all, an extensive period of fund formation – from 3 to 9 months, and high fund service costs – from 1% to 4% of its assets value per year. Among the other disadvantages is the need to create and upkeep the fund infrastructure, given that it is accountable to shareholders, the FSFR, and the specialized depositary, and obliged to disclose information on its operation on a monthly basis. In the words of Ms. Ivanova, minimal CPMIF upkeep costs amount to $100,000-150,000 per year, so the establishment of a management company may prove unprofitable. Ms. Sukhareva believes the main shortcoming of SPMIFs is that the current legislation forbids them to modernize and upgrade properties or to attract loans on the security of its assets. Ms. Ivanova also laments the fact that similar legislation regulates such absolutely different types of business as investment in income-generating real estate, development and housing construction. “Almost all relevant operations (lease, construction, renovation, etc.) must be conciliated with the specialized depositary; but not all government agencies have experience in dealing with properties in asset management,” she adds.

Investments in CPMIF imply certain risks. The share value falls with real estate prices, and while such securities as bonds and equity can be quickly sold, it will take at least two weeks to sell CPMIF shares. However, real estate prices have been steadily growing in recent years, so the risks of the shares depreciation are minimal, unlike the shares of investment funds floating on the stock market, opines Mr. Aleksandrov.

What’s next?

About 40% of CPMIFs specialize in commercial real estate investments. “Most often the investment fund is used for the development of some specific property with the purpose of tax burden optimization. In the future, MIF can become one of the most widespread instruments of civilized investment strategy,” reasons Nikolai Kazansky, director of the investment consulting department at Colliers International. “CPMIFs are not duly developed in Russia because of certain limitations on the investment process imposed by current legislation. Meanwhile, the REIT mechanism (real estate investment trusts), devoid of CPMIFs’ shortcomings, is used almost in all developed economies. Hopefully, respective amendments to the Russian legislation will bring about considerable growth of both the real estate market and the national economy as a whole. I believe this will happen sooner or later,” Mr. Pukshansky recapitulates.

Market participants agree that this year the number of commercial real estate investment funds will keep growing. “Retail funds for the middle and upper-middle classes will be formed, although the yield of the funds will be going down,” opines Ponkratyev. “In general, the forecast is positive because Russian real estate is expected to further increase in price after presidential elections,” Mr. Lazutin concludes.