The Risks of Investing in Real Estate Investment Funds in Canada: What You Need to Know
Real estate has traditionally been viewed as a sound and perhaps highly rewarding investment. Over the last decade, real estate investment funds REITs and private funds have become increasingly popular as one convenient way for Canadians to invest in property without the headache of direct ownership. Yet, Real estate investment funds in Canada come with their particular risks, just like all types of investments. Of course, real estate investment funds pride themselves on offering the promise of regular income and portfolio diversification, but you should be aware of the possible traps before betting your money.
How Real Estate Investment Funds Work
As a brief understanding of the risks, let’s briefly outline what real estate investment funds are. These funds pool money from multiple investors to invest in a diversified portfolio of real estate properties or real estate-related assets. It could include residential, commercial, industrial, or retail properties. There are, principally in Canada, two kinds of real estate investment funds:
- REITs: These are publicly traded on the stock market, enabling an investor to purchase shares in a pool of income-producing real estates. By convention, these funds are compelled to disburse the majority of their income as dividends to shareholders.
- Private Real Estate Investment Funds: Not publicly traded, these funds are offered to qualified investors-accredited investors or high net worth. This type of fund can invest in any real estate project from development to leasing.
Though passive income as well as diversification of a portfolio is possible with either of the two types of funds, they come with specific risks that an investor should pay critical attention to.
Market Risk
As other investments, REIFs in Canada also incur market risk. What is market risk? It is the risk due to the negative effect that unfavorable changes in the market will have on the value of the securities within its holdings. Just like the stock market, the real estate market fluctuates with economic declines, changing interest rates, and geopolitical events as well.
Economic Downturns
This demand may be few and far between in times of an unstable economy or in periods of recession, whether in commercial space, a residential home, or even retail properties. When supply outweighs demand, property values decrease, and accordingly rental income is lowered, which has a direct impact on the performance of real estate investment funds. For example, if the portfolio of a particular fund is heavily invested in office spaces, then when a recession hits, which leads to massive layoffs and downsizing of staff by companies, it may mean that there is an increase in vacancies, plummeting rental income which, in turn, affects the value of the fund and dividends paid to investors.
Interest Rate Fluctuations
The other major factor that affects real estate investment trusts is interest rate levels. In the case of Canada, when the interest rates rise, access to money becomes too expensive to afford, thus lessening demand for new properties or any refinancing opportunities. Higher interest rates also have more negative effects on REITs because they are usually highly dependent on financing in their property acquisitions. When these borrowing rates start rising, this may squeeze profit margins and decrease the returns to the investors.
Liquidity Risk
One of the most important risks in investing in any Canadian real estate investment fund, in particular, private real estate funds, pertains to liquidity risk. By its definition, liquidity is the state wherein an asset can readily be purchased or sold in the market with minimal effect on its prevailing price. By nature and subject matter, real estate is classified as a relatively illiquid asset; it takes several months, sometimes even years, to sell a piece of property.
REITs vs. Private Funds
While REITs are publicly traded and, therefore, more liquid, they also can be subject to price volatility, especially during the downward spiral of markets when a lot of investors may try to sell shares all at once. At the same time, private funds are usually less liquid. Investors in these funds often have to tie up capital for some period of time, even years, or face penalties/restrictions when exiting the fund early.
Lack of liquidity, therefore, significantly puts investors at a disadvantage if they need cash in a short period when faced with financial emergencies. You should evaluate your financial situation and tolerance for risk before investing in a less liquid fund.
Management Risk
The management risk in the investment of real estate investment funds in Canada would be another important consideration. The performance of these funds usually emanates from the expertise and decision-making capacity of the fund managers of the funds. Typically, the decision to invest in what particular property, how to manage these properties, or how and when to buy or sell certain assets are all left to the fund managers.
Experience and Expertise
Some managers are more experienced or even sophisticated in the real estate market than others. This leads to poor decisions in management such as overpayment for property, failing to maintain the assets appropriately and poor timing of the market. It is, therefore, very important that an investor study the past performance of the management team before making any investment in the real estate investment fund. Look for different kinds of managers with a good track record in heading various market conditions while adding to the maximum return on investors.
Interest Alignment
Investors should also be aware that there could be some principal-agent conflict of interest between the investors themselves and the fund’s management. For example, some fund managers maximize their compensation through fees at the cost of the overall performance of the fund. Understand what the fee structure is and how it aligns with the long-term performance goals of the fund before investing in it.
Property Particular Risks
Everything that is an asset in a real estate investment fund comes with certain aspects of risk. It could be location-specific issues, tenant risk, or just unforeseen expenses that actually affect the value of your overall investment.
Location Risk
The success of an investment in real estate often depends on location. Properties located at the prime location with assured economic growth, good infrastructure, and high demand for housing or commercial spaces are most likely to appreciate and generate stable rental income. However, if a fund invests in properties in unpreferred or economically challenged areas, the risk of vacancies and property values reducing increases.
Investors should examine the portfolio of a particular fund and look at the geographic diversification of properties and possible risks associated with each location. This is also because those funds that are highly concentrated in just one area may be highly vulnerable to a fall if the same region faces an economic decline or other localized issues.
Tenant Risk
There are several types of risks, the most common: is tenant risk-if there is one factor of non-payment or early vacancy. This factor affects the net revenues of a real estate investment fund because, in commercial and retail property, the number of long-term leases is high. Consider this example of a commercial building; if an anchor tenant files for bankruptcy or leaves, there could be a loss in rent resulting in very low occupancy for a long period.
Properties with high tenant turnover, or those whose tenants are concentrated in industries that may be especially vulnerable to changes, such as retail during the COVID-19 e-commerce boom, will have higher levels of tenant risk. It is important to check the stability and creditworthiness of a fund’s tenants before investing in it.
Operating and Renovation Costs
Unexpected expenses for maintaining, repairing, or renovating properties are another factor that affects the returns of real estate investment funds. Indeed, older properties do require major capital expenditures to remain competitive in the marketplace. Such costs also erode the profitability of the fund and consequently reduce dividends, apart from the potential for capital appreciation.
They should also look for those funds that have a clear strategy in managing and maintaining their properties and provide enough reserves for unforeseen expenses. The funds that invest in newly developed or well-maintained properties may decrease the risk of unexpected costs.
Regulatory and Legal Risks
Regulatory and legal risks also arise when investing in Canadian real estate investment funds. Real estate markets are subject to government regulations, zoning laws, and tax policies, many of which change, often negatively impacting the performance of a real estate fund.
Shifting Regulations
It may be local zoning laws, rent control measures, or environmental regulations that may change and thereby decrease profitability. For example, increased zoning restrictions could inhibit the potential development or redevelopment of properties by the fund, while newer rent controls may reduce the total rent that could be received from the tenants of that property.
Tax Implications
Tax regulations also create a difference in real estate investments based on the type of fund and location of a property. For example, in Canada, REITs are favorably treated in terms of taxes since they are not normally taxed at the corporation level, provided they distribute a majority of their income to investors. However, tax laws change, and new policies may reduce, at least in part, the favorable tax treatment afforded to REIT investors and private real estate funds.
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Conclusion
Investment in various types of real estate investment funds in Canada can provide investors with benefits such as portfolio diversification, passive income, and, more often than not, capital appreciation. While doing this, one must be rightly informed about a variety of risks: from market volatility and liquidity concerns to management and property-specific ones.
This means that, before you commit your capital, you need to conduct some deep research into the portfolio of the fund, the management team, and the fee structure. Moreover, you need to analyze your financial goals, risk tolerance, and investment horizon concerning their correspondence to the strategy pursued by a real estate investment fund.
Thus, you’ll be able to make your decision more reasonably, taking into account all pros and cons of the real estate investment funds for your portfolio.
