Quote from SquadAs long as the relative path for the instance is correctly set in the func_instance it should work. At least, that's my experience with it. Never had any troubles with it.
I placed the instance's .vmf in the default SDK folder, as I remembered reading that's necessary, referenced it from the .vmf in my mapping folder and the building wasn't showing up. I simply copied the map in the SDK map folder and the building appeared as soon as I opened the map, so is not like the entity was setup wrong.
Of course a limitation like this (would) make no sense for what it is intended to achieve with the feature... it's just like including a picture in a web page basically.