If you have a fair idea about how mutual funds work, then you won't have a problem understanding real estate funds, because they both work towards a common cause -- maximising returns for the investor.

Like mutual funds, real estate funds (or Real Estate Investment Trusts - REITs as they are commonly referred to in the US) are founded by a group of real estate professionals/experts to 'manage' property/real estate for the investor.

Ashwin Ramesh (CIO at Primary Real Estate Advisory, a real estate management firm) elaborates, 'The real estate mutual fund industry in the US has evolved in to a concept called the REIT, the Real Estate Investment Trust. It is a publicly listed entity, which basically passes on at least 90 per cent of its profits to investors. REITs typically own large commercial office spaces, hotels and rely mainly on rental incomes. However, there are some that are more focussed on capital appreciation as well.'

REITs buy, develop and sell property and share profits with investors/unitholders from any capital appreciation on the sale of property. Apart from sale of property, real estate funds also make money from rentals on property owned by them.

Some real estate funds may not actually own property as that may involve above-average risk from volatility in property prices. Instead such funds invest in bonds/instruments that are secured by property. The coupon rate that they receive on these bonds/instruments is then distributed to investors/unitholders as dividends.

Needless to say, this expertise comes at a cost to the investor. Real estate funds like regular mutual funds charge fund management fees, brokerage fees (for buying and selling property), administration fees, marketing fees and the like. So investors clock a return on real estate fund units only after accounting for fees and charges.

Asset allocation

While real estate funds have just announced their arrival in the country, real estate as an asset class has been around for some time. Ramesh opines, "Whenever a 'new' sector comes on the screen, there is an interest, in general. Real Estate, though an old asset class, is for the first time being opened up to retail Indian and foreign participation. The fact that the last few years has seen rise in prices and volumes has helped the cause."

So what value do real estate funds add to your portfolio? According to Personalfn's Asset Allocator, real estate has the most important role to play in your portfolio and not without reason. You can survive without stocks, bonds and gold, but you can't live without property. To be sure, the role of property in the individual's portfolio is pivotal to say the least and every individual must work at ensuring he has adequate property in his portfolio.

Merits

After stocks, there is probably no asset class like property that can preserve the value of your portfolio from the eroding effect of inflation. It is widely held that gold is also a good foil to counter inflation. But over the years, gold has performed poorly on the return parameter.

Another important touch a real estate fund adds to your portfolio is that of stability. Although property prices can also be volatile, the volatility is a far cry from what investors are used to seeing in stocks for instance. When turbulence in global oil prices or economic upheavals rock your portfolio, you can expect real estate/real estate funds to be the rock in your portfolio.

Limitations

Real estate funds have the same risks that are associated with equity/debt mutual funds. For instance i.e. you could make the wrong choice while selecting a real estate fund in which case you could be saddled with a non-performer. Although this is not a limitation with real estate funds per se, it serves to highlight that there can be poorly managed real estate funds just like there can be poorly managed equity/debt funds.

If with equities three years is the minimum investment time frame, then with real estate investments you need to be even more patient. Buying property, developing it and then renting it out or selling it, is a high gestation activity. It could take some time before your real estate mutual fund actually starts making money.

Indian context

To be sure, the regulator (SEBI) has set the ball rolling for real estate funds. However, it will be some time before retail investors can begin investing in real estate funds.

As of now, the real estate window is open only to high networth individuals, institutional investors and global investors. ICICI [Get Quote] Venture, with mobilisations in the region of Rs 1,000 crores (Rs 10 billion) and HDFC [Get Quote] Property Fund Rs 750 crores (Rs 7.5 billion) are among the first off the block with their real estate products.

Pantaloon [Get Quote] Group (Kshitij Venture Capital Fund) and Kotak Group are some of the other names that plan to roll out real estate funds soon. Not surprisingly, overseas investors have also taken note of the opportunities in the Indian real estate segment. Tishman Speyer Properties, a US real estate company, has already outlined plans for the Indian property market in association with ICICI Ventures. Others are also expected to make a move towards Indian shores.

Surely such a high level of investment requires enough property to absorb it without any repercussions on the overall real estate market. Ramesh thinks this is possible. If you take real estate in a broader sense to include residential, commercial, IT development, hospitality to some extent, this amount can be absorbed. There are viable opportunities to deploy such an amount. However, it will depend, to some extent on government policies, which need to be liberalised so they do not choke the free supply and market pricing of land.

Without doubt, news of all this activity appears heady to the retail investor. The question that is still left unanswered is -- what's in it for him? Ramesh shed light on that: "We hope that the regulators do allow AMCs to offer real estate soon simply because there is need for capital on one hand and on the other there is need for the average Indian to provide shelter for his family.

"By investing in mutual funds that operate in the real estate space he will be able to periodically invest (depending on his savings) in the same asset class that he finally wants to make a lump sum investment in i.e. house.

"Also purely for investment purposes and diversification across asset classes, it makes sense for an investor to have the option of investing in real estate, along with equities and debt. The issue of matching inflows and outflows of the fund would need to be addressed at the AMC level, though."

At this stage maybe he can at best watch from the sidelines how real estate funds work, observe their performance and make notes that will prove useful at a later stage, when he will finally be permitted by the regulatory body to invest in real estate funds.

Given the potential of the real estate market and the underlying investor interest, there is every reason to believe that this will happen sooner than later.

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