Tenant privatisation has fallen short of expectations, so how do we meet healthy demand for German residential? Rainer Schorr provides some answers

Nearly 70% of all institutional investors wish to invest in Germany and 23% plan to maintain their current level, which means that more than 90% of investors feel positive about the German real estate market. This is one of the findings of the Estavis investment barometer based on a survey carried out in January.

Some 71% of the respondents intend to invest primarily in German commercial real estate. This is not related to their view of Germany's residential real estate market, but rather their desire for risk diversification. The majority of the polled investors already have substantial commitments in German residential.

The survey shows that 13% of investors feel comfortable with an allocation to residential of up to 50%, while for 4% of respondents a 50-80% share is conceivable and a further 8% are giving some initial thought to a primarily residential allocation to real estate. Most investors focus on western Germany - in particular on prosperous cities like Hamburg, Cologne, Dusseldorf and Munich. Berlin, too, continues to be at the centre of attention, though the interest is largely attributable to the fact that real estate prices in the capital have remained low.

The interest shown in the German residential real estate market is not new. In recent years, many foreign investors acquired sizable residential portfolios in Germany. The main factors motivating investors were rental growth and the option to resell the residential portfolios to tenants individually. A survey of international institutional investors conducted by Morgan Stanley on German Property Day in London in January 2006 revealed that 85% of investors expected home ownership in Germany to increase sharply over the next five years. About half of all investors expected an increase to 50% from today's 43%; many were more optimistic still, expecting home ownership to pass the 60% mark.

In most cases, tenant privatisation has not lived up to investor expectations. Moreover, the business of housing privatisation has been, and continues to be, difficult because purchase prices for housing companies and larger residential portfolios have soared, while the selling prices that can be realised through retail privatisation to tenants have remained constant. In many cases, the book values of the residential stock of listed property companies has climbed to a level that would leave no profit margin at all if the apartments were sold to tenants after sales costs had been taken into account. The hopes of many investors have thus been dashed, and this is reflected in the quoted values of listed German property companies that focus on residential real estate which have dropped more sharply than those of listed property companies focusing on commercial property.

Yet people have ignored - and continue to ignore - the fact that condominium sales to capital investors are booming now, as before, and remain unaffected by the lull in tenant privatisations.

That hopes vested in tenant privatisation have so often failed to materialise lies in the fact that many investors acquired residential portfolios in economic backwater regions of Germany where neither the willingness nor the ability of tenants to acquire their apartments has ever been very pronounced. Many tenants in such depressed regions simply do not have the equity capital that banks require before underwriting any acquisition of residential property. Expectations that these residential portfolios would be open to large-scale tenant privatisation were less than realistic from the start.
For capital investors - who tend to have a higher net worth than the tenants of housing acquired by investors - it is rarely a problem to put forward the equity capital required for buying a let condominium. Frequently, capital investors from economically robust regions will acquire apartments in weaker regions.

Condominium sales to capital investors are also favoured by the new fiscal framework in Germany. Over the past years, the German legislature revoked all options for tax-sheltered capital investments - the one exception being the investment in listed properties and in real estate belonging to so-called redevelopment areas.

Article 15b of the German Income Tax Act, passed in late 2005, denies the option to set off fiscal losses of closed-end property funds and similar models if the loss exceeds 10%. The acquisition of listed real estate and of real estate in redevelopment areas, however, is explicitly exempt from this provision, provided such acquisitions are not subjected to any "model structuring." In such cases, the capital investor is eligible for the tax benefits defined in Articles 7h and 7i, German Income Tax Act.

The possibility to combine retirement provision with tax savings makes these apartments a very attractive capital investment for German investors. When it comes to capital investments, you are unlikely to find another country in the world where residents rely as heavily on real estate as Germans do. Last year, German investors withdrew a total of nearly €32bn from equity and bond funds while investing more than €11bn in open-ended and closed-ended property funds.

Investors about to commit themselves to a listed German property company should therefore take a critical look at the business model: The term "housing privatisation" might apply to a wide variety of business models. The business model most promising from our perspective does indeed exploit the opportunities of tenant privatisation because there are some locations where such opportunities exist.

The focus, however, is on sales of let condominiums to capital investors. This approach should exploit both the opportunities afforded by sales of tax-optimised capital investments (listed buildings, redevelopment areas), and the opportunities arising in line with the classic partitioning business of buying up tenements and reselling the individual apartments to capital investors.

Rainer Schorr is chairman of the board of directors of the Estavis real estate investment group in Berlin