“Never invest in a business you don’t understand.” — Warren Buffett.
Gathering sufficient knowledge before each investment decision is crucial in efficiently building your portfolio, optimizing performance, and managing exposure.
The importance of these choices is highlighted when commercial real estate investors consider allocating capital in private funds. These real estate pooled funds fall into two categories: open-end and closed-end funds.
Closed-end funds have a fixed pool of assets and predetermined end date, along with a defined return target. Generally, no capital is added or withdrawn. In practice, most of the real estate funds are closed-ended. To exit, investors must sell their units to another investor seeking to take a position. In other words, closed-end funds offer close to no liquidity.
In contrast, open-end funds have constantly fluctuating portfolios since investors can enter and exit at any time during the fund’s existence. No termination date is set. Therefore, underlying assets constantly evolve following outflows and inflows of capital.
In this article, we will discuss the characteristics of and main differences between open-end and closed-end real estate funds, and how these investment models can support your unique financial objectives.
Closed-end funds: Profile, strengths, and limitations
A closed-end real estate fund is an investment fund with units and term predetermined. Investment in this fund is limited to the capital to be raised initially, and only open during a defined subscription period.
Upon the manager’s receipt of commitments, the fund is closed and new investors cannot be added. Most closed-end funds are either listed as REITs (Real Estate Investment Trust) or unlisted but reserved for institutional investors.
What are the exit strategies for a closed-end real estate fund?
To recover capital in a closed-end real estate fund, you will either have to sell your participations to a willing buyer (‘over-the-counter’) or wait until the fund’s assets are liquidated.
Both scenarios highlight closed-end funds’ lack of liquidity. Also, closed-end real estate funds usually have lock-up terms of 10 to 20 years.
What about the returns?
Return strategy in closed-end real estate funds primarily involves the appreciation of the underlying assets and their sale at term by optimizing them — such as construction, renovation, cost, and management structure — rather than focusing on the units’ income streams.
Therefore, returns in a closed-end real estate fund are predictable: The strategy of the fund is driven by executing a core business plan, with the expectations of profitability well known to its investors.
Open-end funds: Profile, strengths, and limitations
With no termination date, an open-end fund continually accepts subscriptions while adjusting its strategy and asset allocation. When there is a net inflow of new money, the fund manager invests it in additional underlying assets.
In case of an outflow, the fund’s portfolio is rebalanced. That said, few real estate investment funds are open-end.
What are the exit strategies for an open-end real estate fund?
Real estate funds with an open-end structure allow investors to enter and exit without restrictions. Fund managers may, however, impose an initial lock-up period so that the base assets can be allocated to the fund without disruption.
Afterward, investors who wish to exit may sell their units to the manager, who has the underlying investments to fund their redemptions. In summary, open-ended structures offer greater flexibility and liquidity.
What about the returns?
Income strategy comes mostly from the fund’s underlying unit cash flows. Managers seek assets with steady, recurring income over time.
Due to their focus on capital appreciation rather than development, open-ended real estate funds are considered to offer relatively lower total returns while carrying a lower level of risk.
Performance during market downturns: Open-end or closed-end?
Effect on open-end real estate funds
Open-end funds can suffer from a panic effect driven by the economic context where investors are eager to exit quickly. Consequently, the most liquid assets are sold to finance redemptions, often at a lower market price.
These circumstances can trigger severe losses and imbalances in the fund’s portfolio, leaving the remaining investors in a difficult position.
Effect on closed-end real estate funds
Closed-end funds are relatively immune to this problem. Investors who wish to exit will have to find buyers in a very limited secondary market. Fund managers, on the other hand, are not required to sell the underlying assets. As a result, investors willing to hold their position will not be affected by a ‘panic selling’ effect.
In general, closed-end funds have shown excellent performance during economic recovery periods.
Keep your investment objectives in mind
Both open-end and closed-end real estate funds present pros and cons. Open-end funds provide greater flexibility and liquidity, thus minimizing risk. Consequently, returns are overall lower.
Closed-end funds, in comparison, require lock-up terms acceptance and hence no liquidity, allowing their managers to focus on maximizing the fund’s objectives and performance. And in a stressed economic climate, the balance of the portfolio is protected from the risk of a forced sale.
In practice, your choice will also be highly affected by the nature of the underlying units and the manager’s allocation strategy, subject to current market conditions.
Regardless of the fund’s type, remember to conduct thorough due diligence on its manager prior to making any investment decision. It will allow you to assess the fund’s capabilities and forecast its performance.
Ultimately, your choice should reflect your objectives, after taking all factors into account, including risk tolerance, time frame, liquidity, and tax considerations.