Legal Lingo: Real estate funds 101

Being an aspiring commercial lawyer often means being confronted by complex, often abstract, concepts leading to an often impenetrable wall of jargon for students and trainees. Next up in our Legal Lingo series, which we've introduced to help break down this jargon, is a 101 on real estate funds.

A real estate fund (REF) is an investment fund, often in the form of a limited partnership, that uses money invested by private / institutional investors to acquire interests in underlying real estate assets, either directly or via interests in holding entities.

There are three main forms of REF:

• Private real estate investment funds: A professionally managed fund that directly invests in real estate assets. Typically involving a significant minimum investment, such funds are generally restricted to institutional, high net-worth, qualified investors (i.e. non-retail investors).
• Real estate exchange-traded funds (ETFs): ETFs buy shares in real estate companies and REITs which then trade on major stock markets with share prices fluctuating throughout the course of trading.
• Real estate mutual funds: Similar to private real estate investment funds, these funds are professionally managed but involve pooled investments in a varied number of vehicles e.g. stocks and bonds. Like real estate ETFs, they invest predominantly in REITs and real estate companies, providing a diverse investment portfolio. However, unlike ETFs, they only trade once a day after the market closes.

REF investment strategies

REFs are usually discussed as employing one or more of four key investment strategies:

• Core: Investments in low-risk, high-quality assets with a long realisation horizon on individual assets. The low risk profile of such assets is matched by their high value and comparatively lower rate of return.
• Core-Plus: Core-Plus strategies take a similar approach to Core, but seek investments with a slightly higher risk profile and that may require inputs, such as improvements or renovations, in order to realise their full potential. As a result, Core-Plus strategies typically target higher returns than Core.
• Value Add: Value-Add strategies aim to make investments that have a higher risk profile than Core-Plus and typically require physical improvement, development or operational reorganisation with a view to achieving moderate-to-high returns.
• Opportunistic: Opportunistic strategies focus on finding even higher returning investments than Value-Add with an even higher risk profile. Examples include entirely new developments and brownfield investments in land to be developed. The level of development needed typically requires a larger amount of upfront capital to be deployed raising the risk profile of such investments.

The use of leverage in REFs varies according to the strategy employed. The majority of REF investments will use leverage. However, the more capital that is required to develop an asset and the higher the return target, the more likely greater levels of debt finance will be used. As a result, Core strategies typically represent the least leveraged position, often with 0-10% leverage, and Opportunistic strategies the most at 60%+. Core-Plus and Value Added are less easily distinguished by their leverage ratios, but typically use 30-50% and 50-60% respectively.

The ability of real estate to hold a more consistent value throughout economic periods has often been a key attraction of REFs over higher risk alternative investment models. Yet REFs were by no means immune to the effects of the pandemic, being among some of worst hit asset classes with valuations tumbling.

The historically low-risk appeal of REFs is also under threat both from within the sector, with interest rates weakening the fundraising climate for higher-risk strategies, such as Value-add and Opportunistic strategies, and as a result of the macro environment where the market for low-risk long-term investment strategies is being increasingly dominated by the infrastructure fund market.