Insurance firms have driven the impressive inflows into German institutional real estate funds in 2009 and early 2010, as Dietmar Fischer finds

W henever Europeans talk about indirect real estate investments for institutional investors they tend to have FCPs and SICAVs in mind - as well they might. However, another vehicle is meeting with particular success - the German institutional fund or Spezialfond.

Looking back on a banner year, German institutional real estate funds reported the third highest inflow of net capital in their history for 2009, according to the BVI (German Investment Fund and Asset Management Association). It brought net assets under management up to €28.6bn. The number of institutional real estate funds rose from 116 to 135. Better yet, the positive development spilled over into Q1 2010. So how do you explain such strong growth?

To identify and explain trends and developments in the area of institutional funds you first have to analyse the investment behaviour of Germany's insurance companies. According to BVI figures, financial institutions doubled their share of the total assets held by institutional real estate funds, and now account for 11% of the investors. Yet insurance companies remain the dominant group of investors. Together with superannuation schemes, they make up 75% of the investors. This makes the investment behaviour of insurance companies the decisive factor for issuers of institutional real estate funds.

Surveys on German insurance companies offer conspicuous evidence that the positive trend is likely to continue for the institutional fund industry. There are essentially three reasons for this.

First, German insurance companies are planning to raise their overall real estate allocations. Of the insurance companies polled for the Assekuranz 2010 survey, 69% said they intended to raise their real estate allocation, while 31% plan to keep theirs stable. None of the respondent companies is considering reducing their real estate allocation. The latter averaged 6.1% of the capital investments at the start of 2010.

Current plans will increase allocations to a 6.4% average by the end of the year. The main reason that insurance companies quote for increasing their real estate allocations is today's historically low interest level. The negligible interest income from bonds is a source of increasing concern for insurance companies, which have problems realising, at a low risk, the minimum interest return they have guaranteed to their customers. Real estate investments in institutional funds offer better prospects of earning the required returns.

Second, German insurers are increasingly turning to indirect commitments. At the beginning of the year, their real estate allocation of 6.1% consisted of 3.7% direct, and just 2.4% in indirect real estate investments. Chances are this ratio will reverse within the next five years.

Before the end of this year, 69% of all poll participants want to have divested from their direct holdings. The share of real estate investment vehicles, by contrast, is to rise to 2.6% of the entire investment capital of insurance companies. This growth by just 0.2 percentage points is about €2.8bn in net capital inflow.

So the expansion of indirect real estate investments is, on the one hand, explained by raised yield expectations. After all, indirect investment vehicles can take advantage of the leverage effect of borrowing. By contrast, if life insurance companies were to invest in real estate directly they would not be permitted to borrow for this purpose. The current low interest rate level, though, creates a powerful incentive to exploit the leverage effect.

On the other hand, being able to outsource real estate management plays a key role in addition to enhanced yield expectations that are associated with indirect investments.Insurance companies have no desire to maintain a fixed overhead for the large workforce needed to manage properties owned outright. Instead, they prefer to have their properties taken care of by external fund managers. This motive plays a particularly important role for the trend towards residential real estate. Given the small-scale nature of its tenant structure, residential real estate requires a much higher management effort than commercial real estate.

A third reason for the buoyant sentiment in Germany's institutional fund industry is the increasing significance that these funds have as indirect investment vehicles. At the moment, 19% of the real estate assets held by insurers are invested in open-ended institutional real estate funds under German law. Foreign institutional real estate funds and private equity real estate companies constitute only 5% each.

A more prominent role is played by closed-ended real estate funds and property companies, which account for 27% of the German insurance industry's commitments. This year, though, 63% of the polled insurance companies are planning to invest capital in German institutional funds, while only 38% intend to buy into closed-ended real estate funds. Indeed, only 6% of the companies favour commitments in REITs.

The Assekuranz 2010 survey also revealed factors that stand in the way of an even faster expansion of indirect real estate investments. One factor is the lack of transparency. Thus, 40% of the respondents agreed that the communication of some fund managers could be improved. Reporting is in particular need of improvement.  Secondly, innovative products are in short supply. Only 36% of the poll participants stated that fund managers had responded with new products to the demand of insurance companies.

As the needs and requirements of insurance companies are as much subject to change as those of other institutional investors, fund issuance houses are well advised to design institutional fund concepts that take new trends into account.

The ongoing evolution is exemplified by the current trend toward residential real estate. At 60.8%, office continued to dominate the overall holdings of institutional real estate funds last year. Yet within a single year, the residential share soared from 2.8% to 3.4%. There is ample evidence that the trend is here to stay.

When asked whether residential investments are as important to them as investments in office, four out of 10 insurance companies said that they were.

Dietmar Fischer is partner at Ernst & Young Real Estate GmbH in Germany