Closed-end real estate funds: Real asset investment with high risks. Are there any alternatives?

Die Price development in Germany There is currently only one direction for real estate: upwards! In order to benefit from this trend as investors, alternative investment funds (AiF) are therefore becoming more and more important.

What is AiF?

Alternative investment funds (AiF) offer investors the opportunity to participate in major projects and benefit from potential returns or sales revenues. A distinction is made between open and closed AiF. Investors who invest in an open-ended AiF have the option of selling their shares at any time via an appropriate stock exchange. Closed-end funds are “closed” when enough equity has been raised. Clients who subscribe to a closed AiF therefore invest their capital for the entire, predefined term of the fund. When the property is completed, it is sold and the potential proceeds are distributed proportionally among the shareholders.

Through closed AiFs, investors can invest not only in real estate, but also in various other projects such as airplanes, cargo ships, wind and solar parks. However, real estate is still the dominant asset class in Germany: Of the 1.2 billion euros that providers were able to collect in 2020, 842 million euros (around 70%) went into real estate AIF. As a result, the equity volume placed fell by around 21% compared to the previous year, but was significantly above the 2018 level (701 million euros).

The industry has suffered from several influencing factors in recent years. These included the loss of trust due to criminal activities and insolvencies in the wake of the financial crisis, the corona related contact restrictions, which made direct sales of complex AiFs more difficult, and the implementation of stricter regulations. These new regulations apply to your implementation of AIFM guidelines, who EU regulation and also thanks to the new Fund Location Act. As a result of the new Capital Investment Code (KAGB) and the one adopted in 2021”Act to further strengthen investor protection“Although AiF has been exempted from the legal grey area, it is still subject to significant risks.

Advantages and disadvantages of alternative investment funds

Closed-end real estate funds are usually set up with the aim of selling the property at a profit after a certain period of time and paying investors a return. Ideally, this is also possible, but valid statements about profits can hardly be made due to numerous risks.

Benefits of AiF:

In times of low interest rates, closed-end real estate funds often attract visitors with high return promises. If the property, location and duration are right and the construction, rental and sale process is optimal, an attractive performance is actually possible. In addition, the legal regulations introduced in 2013 and controls by BaFin offer greater investor protection and thus an increase in transparency. This minimizes the previously even higher investment risk to a certain extent.

Disadvantages of AiF:

Despite potential return opportunities, investors should be aware of the numerous risks of AiF and closed-end real estate funds. These include:

• High investment amount: The minimum investment amount for closed AiFs is usually at least 10,000 euros — often even more.
• Long liquidity commitment: The term of closed AiFs is generally ten to 15 years. The capital contributed by investors is tied up to the end of the term.
• Complex investment product: Due to often opaque cost descriptions and texts that are difficult to understand in terms of language, private investors largely do not have the opportunity to fully understand the costs and project dimensions of an AiF. That is why, among others, the Consumer Center 2018 before closed real estate funds.
• High risk: Investors in closed-end real estate funds make an entrepreneurial investment. If the project is successful, there is a profit after the end of the term. However, if there are complications such as loss of rent or additional costs, the return is lower or complete. Should the company even go bankrupt, investors will, in the worst case scenario, be liable with all their invested equity.
• Blind pools: Many closed-end funds do not give investors any specific investment goals. This usually happens for the reason that the company itself does not yet know in which tangible asset the collected capital should ultimately be invested. This procedure, known as blind pools, is now to be banned. Mind you, the law only applies to investments. Public AIFs that are designed in accordance with the Capital Investment Act may still be set up as blind pools even after this Act has been passed.
• No investor protection on the secondary market: Investors who want to sell shares before the end of the term can only do so via the so-called secondary market. Selling early has several disadvantages for investors. On the one hand, there is no government regulation on the secondary market and there is no investor protection. In addition, shares may be subject to closing obligations on the part of the seller. This means that the new shareholder could be liable for the burdens of predecessors.

Steps out of the legal grey area reduce AiF investment risks

Due to the high risks that closed-end real estate funds can pose for consumers, the legal framework has been streamlined in recent years. Providers who want to set up alternative investment funds need, in accordance with the 2013 edition KAGB First, an operating permit from BaFin. This requires, among other things, the investment conditions, the partnership agreement, information on the depositary of the special fund, the sales prospectus and the key investor information (wAI) to be submitted and checked.

At the end of 2021, investors in closed-end real estate funds received from Constitutional Court also granted a right of withdrawal if they had received no or incomplete investor confirmation. In this case, they get back the paid-in capital, including four percent interest, for the last three years. The burden of proof lies with the providers.

Although these legal changes have minimized AiF's investment risk, they do not rule out significant losses for investors. In addition, legal requirements increase the administrative burden of creating and managing an AiF, which can drive up one-time and ongoing costs for investors.

Digitized tangible assets as a reasonable alternative

For investors who do not “accept” the risks of AiF but still want to benefit from real estate market opportunities, digitized tangible assets a good alternative. With the help of blockchain technology, shares (e.g. in real estate projects) are digitized and securely stored in the form of tokens that correspond to an authorization or share certificate. These so-called investment tokens can be stored and traded flexibly and at very low fees.

In contrast to closed-end real estate funds, have digital real estate shares There are several advantages for investors: They invest from as little as 500 euros in clearly defined projects, can offer their shares for sale via a secondary market at any time or through a purchase diversify and have an investment product supervised by regulatory authorities with attractive return opportunities. Here, too, there are risks associated with Relation to return should be considered.