In August 2019, we published the second article in a series of articles that explore the value of family offices for high-net-worth Chinese families. In this third article, we will provide an overview of different types of structures for real estate investment by family offices.
Real estate investments form an important part of a family office's investment portfolio. Depending on their structure and type, real estate investments offer family offices numerous benefits such as diversification, stability, control and consistent cash flow. However, like all investment strategies, real estate investments are accompanied by numerous risks and considerations that family offices should address before investing. Below, we examine four types of real estate investment vehicles which family offices of high-net-worth Chinese families may employ in British Columbia. For each investment vehicle, we first provide an overview of strategies that a family office may employ to generate profit. We then examine the advantages and disadvantages of such an investment vehicle.
- Direct Real Property Investments
The most direct form of real estate investment in which a family office can engage is the purchase of real property for (i) development, (ii) trading, or (iii) rental purposes. Purchasing real property for development purposes is a long-term strategy involving a significant investment of capital to redevelop property with the intention of selling such property for profit, or leasing such property for rental income. "Land assembly" investments, which are the purchase of adjacent lands to consolidate such lands into a larger parcel, are a common property development strategy employed by family offices.
Purchasing property for trading purposes (also known as "flipping" property) is a short-to-intermediate investment strategy involving a shorter and less extensive commitment of capital than development investment but with the same profit-generating motive. Finally, purchasing property for rental purposes is a medium-to-long term investment strategy that involves ongoing obligations associated with ownership (such obligations including the payment of mortgages, taxes, utilities, and maintenance costs), in exchange for a constant stream of rental income.1
Advantages
Real property investments offer family offices diversification for their investment portfolios in the form of a tangible, stable asset. Similarly, real property investments for rental purposes can provide a steady source of cash flow in the form of regular rental payments.
Disadvantages
Real property investment requires a significant commitment of capital and time. For family offices inexperienced in property development or management, real property investments may be an unsuitable form of investment unless full-time real estate professionals are employed to handle the day-to-day activities associated with such an investment. Real property investments also involve numerous considerations associated with zoning, tax, environmental, and development requirements.2 Finally, family offices should consider the liquidity risk associated with investments in large real estate projects, as the sale of such projects may require a significant amount of time to complete.
Legal Considerations
A family office interested in direct real property investments should consider using single-purpose vehicles, which are legal structures solely established for one specific real estate investment, to limit the family's exposure to the risks associated with such investments.
The family office should engage professionals to perform tax planning to make such an investment as tax-efficient as possible for the family. Further, the family office should consider finding sources of debt-financing to use leverage, while trying to minimize financing costs and to limit guarantees given by other entities owned by the family, or by family members themselves.
A family office may also consider using a bare trust in its acquisition and management of direct real property investments. If the family chooses to employ a bare trust in its real estate investment, an entity owned by the family would be the beneficial owner of the real property, while the registered owner on title to the property would be the nominee holding the property in trust for family-owned entity, i.e., the beneficial owner. 3 The beneficial owner, as the "real" owner of the property, is entitled to receive all revenue from the property and is the decision maker with respect to all aspects of the property, such as rents charged on leases, the terms of leases or tenancy agreements, and who to hire as the property manager.4 We note that although bare trusts have allowed families to invest in real property while protecting their identity from public records, anonymity in British Columbia may no longer be ensured under the new British Columbia Land Owner Transparency Act, which is expected to come into effect in the near future.
Finally, when undertaking direct real property investments, a family office should consider the terms, conditions, and obligations involved in any contracts with property managers and tenants.
- Real Estate Investment Trusts
Real Estate Investment Trusts (REITs) are investment vehicles that earn income through investment in rental properties, such as shopping malls or multi-unit residential buildings.5 REITs are similar to corporations in that investors may purchase "units" of REIT, such units being analogous to shares which a shareholder holds in a corporation. In Canada, REITs are either public or private. Public REITs are listed and traded on stock exchanges, while private REITs are traded in an exempt market.6 An exempt market is a capital market where securities are sold without the disclosure of a prospectus (which is a document that provides information about the security and the company offering the securities).7 Private REITs must be sold through an investment or exempt market dealer that is licensed to sell prospectus-exempt securities.
Advantages
REITs offer family offices a passive form of investment since the development and management of rental properties are delegated to a property management company. Public REITs offer family offices a liquid form of investment, since REIT units are traded on public stock exchanges. Comparatively, private REITs offer family offices an investment that is more stable in value, since the value of a private REIT unit is tied closely to the appraised values of the underlying properties.8 Similarly, the Income Tax Act of Canada offers tax advantages for unit holders of REITs that meet the specific requirements set out in the Act.9
Disadvantages
As public REITs are sold on stock exchanges, their unit value is closely tied to the fluctuations of the broader securities market. This makes public REITs a potentially unpredictable investment. Private REITs, despite their relative stability in value, also carry risk exposures. First, they are not subject to the same disclosure obligations as public REITs, and therefore provide less transparency on performance for investors.10 Further, since private REITS are sold on exempt markets, they can be harder for family offices to value and resell.11 Therefore, it is crucial for family offices to undertake due diligence on all aspects of a REIT before investing.
Legal Considerations
Family offices should carefully review prospectus disclosures of publicly traded REITs to understand risk exposures.
- Limited Partnerships
Limited Partnerships can be established to develop or manage real estate properties such as condominium buildings.12 As mentioned in our previous article, a limited partnership is typically operated by a single general partner with unlimited liability, supported by one or more limited partners with limited liabilities, similarly to the limited exposure faced by shareholders of a corporation. In the real estate context, the general partner of the limited partnership is responsible for the management and development of the property.13
Advantages
If a family chooses to invest as a limited partner in a limited partnership, the limited partnership offers the family a passive form of investment, since property development and management is left to the general partner, which is typically a developer. Limited partnerships also offer family offices liability protection, since limited partners are only responsible for the partnership's debts and obligations to the extent of such limited partners' investment. Limited partners are also taxed at their own level for income earned from a limited partnership, thereby being able to take advantage of their own losses.
Disadvantages
Limited partnerships are primarily governed by limited partnership agreements, which may restrict the ability of limited partners to sell their partnership interests.14 Even without this restriction, family offices may struggle to find a liquid market to easily sell their interests. Further, limited partnerships that invest exclusively in a single real estate project will often face risk considerations which are similar to those associated with real property investments, such as liquidity issues, vulnerability to market forces, and various legal requirements. Banking financing is often needed for projects, and limited partners, especially those owning larger interests, may be required to provide a guarantee in respect of such financing to the lender of the project.
Legal Considerations
A family office should consider using a separate entity to invest in the limited partnership where there may be a requirement to provide guarantees to the lender of the project. Such a separate entity, typically a corporation or another limited partnership, will provide an additional layer of legal protection for the family's assets in the event that the limited partnership is unable to meet its debt obligations, thereby triggering the guarantee obligation.
Further, a family office that is intending to form or join a limited partnership should consider obtaining certain protections from the general partner of the limited partnership. These protections are often obtained through a separate agreement with the general partner.
Finally, a family office should be aware that under the laws of British Columbia, a limited partner that is, or becomes, involved in the business of the limited partnership may lose its designation as a limited partner and consequently may also lose its limited exposure to the partnership's debts and obligations.
- Mortgage Investment Corporations
Mortgage Investment Corporations ("MICs") are entities that raise capital for the purposes of providing financing or mortgages to borrowers who are unable to obtain loans from traditional sources such as banks.15 Investors earn income from the interest generated from the MIC's portfolio of mortgages.16 There are also partnerships set up to operate similarly to MICs.
Advantages
MICs can be profitable ventures for family offices to undertake in British Columbia, since there is a strong need for alternative financing in British Columbia. Further, MICs offer family offices diversification since mortgages can be arranged for multiple types of real estate projects, including residential, commercial, or land developments.17
Disadvantages
MICs often lend to more high-risk borrowers than banks do.18 Therefore, it is crucial for family offices to undertake due diligence on the financing provided by an MIC before the completion of such financing. Further, MIC mortgages can also be the second or subsequent mortgage on a property, making such mortgages lower in priority during default proceedings.19 Finally, the regulatory landscape surrounding MICs have recently undergone significant changes, which family offices should consider before investing in an MIC.20
Legal Considerations
As mentioned above, regulations in respect of MICs have become stricter in recent years. For a family office contemplating setting up an MIC, increased regulation leads to additional responsibilities and costs associated with compliance with such regulation. Further, for family offices investing in MICs or similar entities, failure to comply with regulation can lead to higher costs, fines and even a forced closure of operations. Accordingly, family offices investing in MICs or similar entities should ensure that their investment targets are well-operated and that the targets have the capability to comply with the aforementioned regulations and other applicable laws.
In the past, we have seen some investors participate in management shares or profit-sharing schemes meant for real estate managers or brokers. Family offices should be careful that these arrangements do not fall under the new regulatory regime and inadvertently risk non-compliance with regulations.
Footnotes
1 "Understanding Real Estate Investments" – Ontario Securities Commission
2 Ibid.
3 Bare Trusts and Multifamily Rental Housing – Lawson Lundell (2013)
4 Ibid.
5 Ontario Securities Commission, supra note 2.
6 Ibid.
7 "What is the exempt market?" – Ontario Securities Commission
8 "Hot real-estate market fuels growth of niche investments" – The Globe And Mail (12 June 2018)
9 "REITs as a force for good" – Grant Thornton, at 7.
10 Ontario Securities Commission, supra note 7.
11 Ibid.
12 Ibid.
13 "Real Estate Limited Partnership (RELP)" – Investopedia
14 Ibid.
15 Ontario Securities Commission, supra note 2.
16 Ibid.
17 Ibid.
18 Ibid.
19 Ibid.
20 Navigating B.C.'s New Rules For Mortgage Investment Corporations" – Lawson Lundell LLP
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
