If prices for real estate begin to grow again, real estate mutual funds could become both a good tool for investment and a solution to the housing problem. Meanwhile, they are a wonderful tool for tax evasion
 
Ekaterina Shokhina

Real estate mutual funds have become the most noticeable event on the mutual investment market over the last year. A year ago, only two real estate mutual funds operated in Russia. Today, as many as seventeen funds are operating and ten are currently being established.  The total value of the real estate funds’ assets currently amounts to about 5 billion rubles.
The first real estate mutual funds were established by developers. Construction companies used them to attract investors. Later, virtually all large management companies, which had had long had mutual funds made up of stocks and bonds, began to set up real estate mutual funds. Investments in real estate at the time when prices were growing rapidly appeared to be a wonderful way to diversify investment business and its development.

Benefits and risks of a private shareholder
  
In theory, it is most profitable and attractive for private investors with average incomes to invest funds into real estate through a specialized mutual fund. This instrument’s greater affordability (since far less money is required to buy a share than to purchase, say, an apartment) and a smaller investment risk are the main advantages of investing funds in a mutual fund rather than directly in real estate. “When dealing with a construction company directly, an investor is immediately taking on the risk of investing in a single project,” says Vladimir Kirillov, General Director of KIT Management Company. “For example, it may turn out that there are not enough funds to complete construction of a block of flats, and an investor could be left with zilch. A mutual fund has several construction projects, and even if one of them fails, it will affect a share’s value and, consequently, the investor less. In other words, developer’s risks are diversified in the fund in contrast to direct investments.”
In addition, as some representatives of management companies argue, shares in real estate funds could become a tool for Russians to solve their residential problems. A fund is specially set up to build a specific block of flats. An individual takes a bank loan to buy shares in the real estate fund. The bank keeps the shares, which provides creditors with some guarantees that funds will be returned. Natalia Plugar, Deputy General Director of UralSib Management Company, believes that this scheme is efficient when purchasing housing under construction, as banks do not take rights under investment contracts on housing construction as collateral when they issue a loan for purchasing an incomplete project. Moreover, purchase of an apartment this way costs less. “When purchasing an apartment through a mutual fund, a buyer will pay for its prime cost plus the cost of services provided by a management company and other participants in the mutual fund’s infrastructure that by law cannot be more than 10%,” says Natalia Plugar. “While buying an apartment on the market, those who wish to purchase housing overpay.”
Radiating the brightest optimism, representatives of real estate mutual funds admit, though, that there are grave risks in their business. The first and foremost is the risk of changing market conditions. The rush to set up real estate mutual funds last year was based on the expectation of the further rise in prices, when both investments in construction and operations on the secondary real estate market look very attractive. However, the market is currently at a standstill, and it is not clear what will happen to mutual funds in the context of a stagnating or declining market.
The risk concerned with market conditions is redoubled by the specifics of the domestic real estate market with its poor legal framework and frequent ties to the criminal underworld. Even professionals find it extremely hard to work on this market. For example, construction companies time and again deceive investors, requesting them to pay extra for their work and building materials. “Many investors, who set about construction projects a few years ago, calculated that construction would cost $700-1,000 per square meter. However, so many pitfalls have been discovered in the course of construction that the cost increased by 1.5-2 times in the end,” says Oleg Repchenko, Director of the Real Estate Indices Analytical Center. “A couple of years ago, such investors didn’t go bankrupt only because real estate prices were rising by 30-40% a year at the time. If prices had been at a standstill, the cost would have been higher than the selling price. While today, prices have ceased to rise and the risks have increased.”
Another risk factor is that the real estate markets in Moscow and St Petersburg are closed. “There is an established system of construction, investment, and the realtor business in these regions,” says Natalia Plugar. “Companies making up this chain don’t want to concede their markets. For example, we were told straight up by a construction company we conducted talks on investments with, ‘Why should we bother with such as a large investor – mutual fund? It will audit and control us plus demand that we fulfill the terms and conditions of a contract.” And finally, there is always the risk that the management company itself will perform poorly. As representatives of management companies say, it is most risky for investors to put funds in construction, which a management company finances only partially. “If a real estate project is built immediately on a closed fund’s balance, this reduces shareholders’ risks. However, there is a practice now when a management company invests funds under shared investment agreements, i.e. co-invests a project. In this case, nothing but some agreement promising something in the future would appear in the fund’s balance. This considerably increases shareholders’ risks,” says Vladimir Kirillov.

“An internal offshore” repays risks 

The above listed factors significantly dampen Russians’ interest in participating in real estate mutual funds. However, mutual funds themselves are mainly targeting a limited circle of large investors. At that, they are targeting not so much private individuals as companies. This has an effect, first of all, on a share’s cost which runs about $100,000 on average. There are real estate mutual funds where a share costs $8 million. Management companies justify their pricing policy by the fact that real estate mutual funds are a new instrument so far; the legislative base of their activities has not been fully developed. Therefore, they don’t want to bear responsibility to the population at large. “The issue of ownership rights registration in a mutual fund as well as taxes for shareholders and management companies has not been fully solved yet, since under the current legislation a mutual fund is not a legal entity,” says Natalia Plugar. “Therefore, we want to work over some legal and market risks with professional investors, first, and only after that deal with private individuals.”
On the face of it, the logic is somewhat strange, since market risks are the same for a small private investor and for a large company. However, there is one factor that certainly repays all the risks of legal entities’ participation in real estate mutual funds: as a result of imperfection of the legislative base, such funds give investors great opportunities to reduce taxes. “Since under the current legislation neither mutual fund’s shareholders nor management companies are owners of the property contributed to the mutual fund, and the mutual fund itself does not constitute a legal entity. So, it turns out that while the real estate is in the mutual fund, no one has to pay taxes on profits made from the use of this property, nor pay VAT and property tax,” says Natalia Plugar. “This enables large investors to invest their profits in full in construction of new projects. We have reckoned that every fifth apartment house within one fund can be built thanks to savings on profit taxes from the first four houses, i.e. in fact, it will be free for investors.”
Tax savings can be gained not only when dealing with the construction industry. “Today, an enterprise can contribute its entire property complex to a mutual fund, and the enterprise would not pay taxes on profits, property, and value added. For example, one can contribute a shopping mall to a mutual fund and be allowed not to pay taxes on all its operations,” says a representative of one of management companies. “One large trade company has established a mutual fund and contributed its real estate to it, and now it is renting floor and storage space from its own fund. Rental payments are fully included in the cost, thus reducing profit tax, and the mutual fund doesn’t pay taxes by definition.”
The fact that the name of a shareholder who has handed over his property to a fund and the value of his property are not subject to disclosure also makes real estate mutual funds attractive to companies. Furthermore, the property handed over to a mutual fund cannot be frozen. “I myself experienced what happened when the office of the public prosecutor froze part of the property fund – the stock,” Natalia Plugar tells Expert. “To release the stock frozen by mistake, we even didn’t have to go to court. Our application to the office of the public prosecutor was enough to overturn their decision.”
Tax authorities are apparently concerned in earnest with the tax loophole that has developed in the form of mutual funds, and changes concerning their tax status will likely be made before long. It is doubtful that afterwards real estate mutual funds will remain as attractive as they are now.

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