FSS warns overseas real estate funds can wipe out principal even with steady rental income

The Financial Supervisory Service is strengthening investor protection for high-risk funds, including overseas real estate funds.

Many overseas real estate funds are structured so that domestic investors can lose their entire investment if property prices fall, even when the building is generating normal rental income. The regulator plans to have asset managers scrutinize such risks more closely from the product design stage and disclose them more clearly to investors.

The Financial Supervisory Service held a meeting Wednesday, chaired by Deputy Governor Seo Jae-wan, with executives from eight major real estate asset management firms and the head of the asset management division at the Korea Financial Investment Association. The meeting reviewed investor protection measures taken so far and the industry's preparedness.

Speaking at the meeting, Seo said that overseas real estate funds and REITs carry a greater risk of loss than most ordinary investors realize. In typical overseas real estate investments, a local financial institution first provides a senior loan, while Korean investors' money goes in afterward as junior equity that absorbs losses first.

The problem is that even if rental income is coming in consistently, a drop in the property's appraised value below a certain threshold can trigger an "event of default" under the local loan agreement. This requires early repayment of the loan.

In such cases, the senior lender may recall the loan early or sell the mortgaged property, and fund investors holding junior positions can lose part or all of their investment.

"In some recent products, a total loss of principal has in fact occurred because of deterioration in the underlying asset combined with a junior equity investment structure," Seo said. He added that asset managers should not simply create and sell funds but must manage risk as "product manufacturers."

He said products with high potential for consumer harm — such as mezzanine and junior tranche investments — require careful review of loss potential from the design and manufacturing stage. This is especially true amid ongoing global geopolitical risk and interest rate uncertainty. Because these are publicly offered funds aimed at retail investors, he said, an "investor-first principle" of identifying risks from the investor's perspective must be established from the product-building stage onward.

The Financial Supervisory Service has strengthened its regime in three main ways. The first is stronger self-inspection by asset managers, which has already been in effect since April 1. A review of major asset managers following last year's total-loss incidents found that due diligence reports from local firms often merely listed general information about the investment region or market. They did not analyze specific risk factors such as structural defects or compliance with local regulations.

In response, the Financial Supervisory Service requires asset managers to conduct their own internal review of due diligence performed by overseas firms, with the internal control department recording its assessment. The chief executive and compliance officer must also sign off to clarify accountability. To help investors gauge worst-case scenarios, funds must now attach profit-and-loss performance graphs and stress-test scenario analyses to securities registration statements.

The second measure is clearer disclosure of key risks, set to take effect Sept. 30. This follows recommendations from a financial consumer protection forum in November 2025 that investment risks be written in more specific, investor-friendly language.

The measure applies to overseas real estate and overseas REIT funds, equity-linked funds and derivative-linked funds, leveraged and inverse funds, covered-call funds, target-conversion funds, physical gold funds and overseas fund-of-funds products. Going forward, these products must state four key investment risks on the first page of their simplified prospectus — one principal-loss risk and three special risks.

For any past case in which a similar in-house product suffered a loss exceeding 20 percent, asset managers must disclose the fund name, investment region and asset, and the date and scale of the loss. For rental-type real estate funds, managers must explicitly state that a decline in property value — regardless of rental income — can result in investors losing part or all of their principal through the senior lender's exercise of its security interest.

The third measure is stronger screening. The Financial Supervisory Service set up a special screening team within its Asset Management Supervision Department this past January and introduced a concentrated review system that assigns multiple reviewers to high-risk funds. When screening overseas real estate funds, the regulator examines whether the self-inspection report on local due diligence was thoroughly prepared and whether risks investors need to know are disclosed according to the standard format for key risks.

It will particularly focus on whether a fund's structure allows the senior lender to dispose of the property at will, against the wishes of fund investors.

Asset management executives who attended the meeting agreed that, amid heightened market uncertainty, it is necessary to identify a fund's major risks from the investor's perspective and explain them in an accessible way. They said they would treat past cases of large-scale losses as cautionary lessons and work to launch reliable products that give consumers confidence to invest.

The Financial Supervisory Service said it will continue to strengthen its monitoring of market trends and communication with the industry to protect investors and support the sound development of the capital markets.