The threat to open-ended Spezialfonds has been removed, but institutions face an expensive domestic core market, says Barbara Ottawa

It was a close call in 2012 for German real estate Spezialfonds. The legislator came close to effectively throwing the institutional fund structure out of the bath with the rest of the supposedly dirty water – namely, the beleaguered German open-ended real estate funds (GOEFs).

Implementing the EU’s Alternative Investment Fund Managers Directive (AIFMD), the German government drafted a new Kapitalanlagegesetzbuch (KAGB), or investment code.
The first version proposed outlawing all open-ended real estate vehicles, which had major implications for certain insurance-based institutional investors unable to invest in closed-ended vehicles due to their own specific investment rules. For some investors, the only solution would have been to invest in open-ended Luxemburg-based fund vehicles.
Lobbying from various real estate stakeholders helped to amend the bill in late autumn last year, allowing companies to continue issuing Spezialfonds and also allowing new GOEFs to be issued under certain limitations.

So is everything back to normal? Not quite. According to the rating agency Scope, growth in Spezialfonds was at least dampened by the recent uncertainty over their future and some investors started thinking about alternatives.

It might be that this helped speed up a development already on its way since the financial crisis: German investors being more aware about risks and opportunities in their real estate portfolios and more demanding towards their asset managers.

One institutional investor told IP Real Estate off the record that he was looking into using one of the new vehicles to be created under the KAGB, a separate company in the form of a limited partnership or a listed vehicle. This could be attractive for some holders of large direct portfolios to get them off their books without having to hire a manager to set up a fund.

“It is good for the German market that the product range is widened under the KAGB to include a real estate listed vehicle apart from the real estate Spezialfonds and the GOEF,” says Alexander Tannenbaum, responsible for real estate on the board of Universal-Investment. He thinks more institutions will opt to transfer their direct holdings to different vehicles or sell them, if they think these holdings are “only binding their resources and do not allow them to add debt capital”.

But then there is always the exception to the rule, which in this case is the €2bn professional pension fund for auditors and chartered accountants, the Versorgungswerk der Wirtschaftsprüfer und der vereidigten Buchprüfer (WPV), which has added direct real estate to its portfolio for the first time.

“Up until recently I had been of the opinion that indirect investments into properties are preferable,” says WPV managing director Hans-Wilhelm Korfmacher. “But in a pooled fund you only have limited decision-making powers and you have to accept being tied to a certain manager, sometimes for a decade.”

WPV’s real estate portfolio is being organised into a master structure. “This model will allow us to either purchase properties directly ourselves or use several managers, aiming at choosing specialists for various countries and sectors,” Korfmacher explains.

As for the debt/equity ratio the WPV is also bucking the trend: “Being able to replace debt with capital is one of the reasons for us to go into individual funds rather than pooled funds.”

Pooled vehicles will remain part of the portfolio to provide liquidity but, in line with other institutional investors, WPV has grown more cautious about the organisations it invests alongside in any given fund.

The €9.2bn Versorgungswerk Ärzteversorgung Westfalen-Lippe (ÄVWL), on the other hand, has enhanced its networking and cooperations with other investors, especially smaller pension funds which “may lack the necessary knowhow and therefore access to certain investment markets”, to create economies of scale. It also formed joint ventures with real estate managers.

Tannenbaum anticipates that the “major part” of mandates signed this year will be individual funds “as investors do not want to sit on an investment board with other institutions”. However, he adds, “there might be a few club deals or pooled funds, especially when foreign investment managers are approaching the market with new ideas in regions which might require a higher equity stake”.

And going abroad might be identified as a solution to investors struggling to find value in their domestic core markets. One case in point is Germany’s largest Pensionskasse, the €23bn BVV, which is pursuing a more international objective for its real estate portfolio.

“We will be setting up global mandates to enable us to make use of every window of opportunity,” says Rainer Jakubowski, a board member at the banking pension fund. “We got rid of the concept of a detailed, long-term real estate investment strategy with fixed target allocations.” BVV wants to be able to participate in any interesting investment “no matter which region or sector”, he adds.

But of course these investments require specialists and Tannenbaum is convinced that “German institutional investors are widening the regional range in their portfolios mainly because there are asset managers on the market now which can offer the necessary expertise.”

Domestic dilemmas
The same is true for Germany itself, where thinking outside long-standing traditional categories might also find some investors opportunities.

According to Eitel Coridaß, managing director at Warburg-Henderson, there is a “strong trend towards niche products investing in residential logistics and retail warehouses, particularly in Germany”. He notices that “in new products, clients demand a further specialisation as well as a manager with the right expertise”. He is convinced “diversified products will still have their place in a portfolio but there is a clear trend towards more focused fund products”.

In its latest real estate investment trend barometer survey, Ernst & Young quoted one investor saying: “Because of the low returns for core objects in the office and retail segment, niche products like logistic or mixed-use corporate properties will be more in demand from investors.”

Others are changing locations within Germany in search of core investments. “2013 will be a very exciting year for Germany, mainly because some second-tier cities we call ‘Oberzentren’ are pushing the big seven out of investors’ focus,” says Christoph Schumacher, board member at Union Investment Institutional Property. “Cities like Nürnberg, Hannover or Münster are reporting higher room prices in hotels than, for example, Berlin or Hamburg, but all other sectors are also becoming more interesting in these second-tier cities.”

He says those are cities where the main investors are fa mily offices, smaller Versorgungswerke and local Pensionskassen, while in German top locations sovereign wealth funds and other foreign investors are buying or at least seeking core investments.

And this might drive up prices: “Bubbles could be generated where foreigners enter the market paying prices we would never pay”, warns Schumacher. He stresses: “there is no real estate bubble in Germany yet and the market remains very stable, but investors should be cautious in the residential sector where certain areas show exaggerations.”

One investor told Ernst & Young something similar: “Prices in the various asset classes and regions have grown considerably compared to the years before. But I am currently not seeing the threat of a bubble.”

Schumacher adds: “A lot of money is going into Germany but less so in those second-tier cities which foreign investors usually do not have on their radar – at least not yet. This is both because they often enter the market via international advisors which are not covering these cities and because these cities often do not have large enough objects for large foreign investors to put their money in.”

But some analysts predict that the current focus on metropolitan areas will remain strong and peripheral properties will become even more difficult to sell or let.

The ÄVWL decided “not to participate in price bidding to increase valuations” of standard core assets in good locations with long lease terms as those have “not been correctly priced” since 2011. Instead, the fund has tried to “act outside the trend by focusing more on forward deals and developments”, and this way it managed to “obtain very interesting entry prices”.

Coridaß agrees that “in all of western Europe” properties with issues like slightly higher vacancy rates or shorter rental agreements “are seen as a major risk which disproportionately affects their prices”. But in principle Warburg-Henderson still believes in the top locations: “Investments in these locations is sustainable as they have the highest liquidity and transparency and other than in B locations it is much easier to calculate an exit strategy,” he explains.

Coridaß also predicts the majority of growth in the office sector will take place in those top locations. But while the real estate company wants to stick to Hamburg, Berlin, Düsseldorf, Frankfurt and Munich for investments, it has opened the scope to core-plus assets, defined as those with rental agreements well under 10 years or a vacancy rate of up to 15%.

Tannenbaum adds: “Of course, everybody would like to have core real estate, but there is not enough on the market, so the range of investments will have to broaden to core-plus or value-add where yields of around 5-6% can be expected.”

Schumacher also points out that “investors will stay focused on core property and it will become even harder to sell properties with problems like rental issues.” And he sees institutions taking yet another route to get to core real estate. “As access to core properties has become harder, investors are going more into funds in order to get access to objects they could not otherwise invest in.”

Schumacher questions whether there will be a headlong rush into new real estate debt funds, as has been predicted by some. “You need to have the right approach, find the right partner with contacts to banks and you should not take too much risk,” he says. “Banks are queuing to finance good portfolios and core properties, but as soon as there is an issue in a portfolio it is almost impossible to get it financed. And I would also dissuade any insurer or Pensionskasse from taking this risk.”

This is in line with Korfmacher’s concerns: “We are also talking about real estate debt. However, senior debt conditions are so meagre that it is not attractive. I do need a certain spread to a covered mortgage bond to warrant the additional risk.”

Similarly, BVV is preparing itself to be able to enter the real estate debt market “at the opportune moment”. Jakubowski says: “This is a topic that fits our core business because of its long-term character and the quality of financing has improved during the market consolidation.” But he stresses it is “not clear yet when we can start with these investments” as the current market environment makes it difficult to reach target returns. For him debt real estate financing is one way to “replace the unfortunately vanished government bond theme”.

A final theme that has gained importance in German institutions’ real estate portfolios is infrastructure as, according to Schumacher, “in many institutional portfolios we are seeing slots for infrastructure investments such as renewable energies”.

But the wind has changed, according to rating agency Scope as investors are turning away from solar power towards wind investments: Solar investments had become “less attractive” in Germany and other European markets due to shrinking subsidies and a drop in prices for this kind of renewable energy. Additionally, increasing competition in the sector is “putting pressure on returns”, while “uncertainties” surrounding investments in southern Europe also have an impact, Scope says. Instead, wind investments are “quickly establishing themselves as an alternative”.

So the search for core will be one of the major challenges for investors again this year. And sell-offs by dissolving GOEFs will not be of much help, Tannenbaum says. “I do not think that the sales from the GOEFs will lead to major market distortions. Because most of the now closed funds have more properties outside Germany than within and second, the around €22bn to be sold off over the next years will not get on the market within one year.”