Inflows into Germany's so-called real estate Spezialfonds are slowing; the new G-REIT has been disappointing. Meanwhile changes to the investment law can't come soon enough. Barbara Ottawa reports

Over the past few years discussions on German real estate have been dominated by the long awaited arrival of the legal framework to allow the creation of real estate investment trusts, or REITs.
But when the law was finally passed in April 2007 many were disappointed because of the exclusion of residential property built before the beginning of 2007.
"Politicians did not want unscrupulous businessmen to exploit people living on social welfare," Dirk Lepelmeier, managing director of the Nordrheinische Ärzteversorgung (NAEV), says, explaining the political motivations for the decision to IPE Real Estate.
"A huge segment of real estate on the books of German companies is now unavailable for REIT investors," he notes.
At the end of 2006, Lepelmeier had told IPE Real Estate: "German REITs hold the key to unleashing institutional investment in German real estate".
However, the situation is now "completely different" as German legislation created a "key without teeth," the NAEV head says. 
"Development of REITs this year was well below expectations," Henning Klöppelt, chief executive of Warburg-Henderson, says. Only one G-REIT has so far been registered, with around 10 other companies considering seeking registration.
The Alstria Office AG in Hamburg was the first to set up a German REIT structure in October. In mid-November it announced its first transaction for the vehicle, the purchase of an office block in Essen in a €62m sale and lease-back deal.
Apart from turbulences on the real estate markets Klöppelt blames over-rigorous G-REIT regulations for the slow start.
"In my view the German REIT is laborious to administer," he says. "It takes a lot of resources to manage the shareholder structure and keep up transparency in order not to lose tax advantages."
However, when it comes to tax advantages the German legislator has privileged the REIT vehicles with the so-called "exit tax" arrangement.
When selling real estate to a REIT fund vendors only have to pay tax on half their profit on the sale while the full sum becomes taxable when selling to any other fund or individual.
Till Entzian, a Frankfurt-based lawyer who authors the Kandlbinder Report, an annual survey of Germany's real estate industry, predicts a growth in REITs which will become a competitor to the so-called real estate Spezialfonds, or ISF.
ISFs are property funds created for pension schemes, insurers and other institutional investors. In exchange for investing at least €25m, an ISF affords them considerable transparency, lower fees and good deal of control over the investment process. Traditionally they have been preferred by such investors as BVV, VBL and NAEV. To set up an ISF, the institutional investor can either work with external managers or pool money with others to acquire properties internationally.
Compared with ISFs and indeed any type of real estate fund, REITs - essentially listed property firms - are more liquid and offer greater tax advantages. The exit tax arrangement will allow REITs to purchase real estate cheaper than other vehicles, the report notes.
"This competitive edge created by discretion of the legislator can never be achieved by an ISF," Entzian points out.
The REIT market is also expected to grow with the help of the company tax reform effective from next year, which will cut taxes on profits - including those from real estate sales.
"From next year more companies are expected to sell their real estate holdings to G-REITs and I think they will become an interesting investment complementing the offering of ISFs," Klöppelt comments.
Indeed, the expectations for G-REITs seem to have slowed down asset growth in ISFs somewhat. At the end of last year assets in the 109 ISFs stood at €19.7bn, having grown 16.9% or €2.8bn over 12 months, the highest asset inflow since 2002, according to the findings of the Kandlbinder report. Providers of supplementary pensions kept their share in ISF investments at 30%, similar to last year. However, in early 2007 asset inflows stalled and investors seemed reluctant to put money into ISFs. Compared with the first five months of 2006, when investors put €1.5bn of new assets into Spezialfonds, net assets decreased by €65m in the same period in 2007.
"This investor reluctance is no reason to predict the imminent death of the ISF," Entzian stresses. "First of all it must be noted that asset inflows into ISFs are extremely volatile," he explains. "It is not unusual to see very low inflows or outflows for several months before then seeing €200m or €500m in net assets in one single month. For example, in 2006 half of net inflows were reported in May when over €1.3bn was added," he points out.
Entzian is convinced that the slow start for ISFs in 2007 does not mean investors have lost interest in this vehicle completely.
And indeed, NAEV will increase its use of this special vehicle after having been "disappointed" by the introduction of REITs.
"We had planned to create a REIT structure for some of our direct real estate holdings which is mainly residential property," Lepelmeier notes. "But we were disappointed by the final legislation."
The €8.5bn fund now aims to decrease its €675m in direct real estate holdings and convert the rest into a domestic ISF.
At the same time NAEV intends to reduce its investments in foreign ISF and instead use listed property to diversify the portfolio.
"For a long time we valued ISFs because we were ‘our own boss' in the fund but the investment restrictions are too constraining," Lepelmeier explains.
By law any ISF has to include at least 10 items in order to guarantee risk diversification. In an environment of rising real estate prices smaller funds have difficulties finding enough money for each single investment.
Over the past two years the fund has already reduced the number of the ISFs created specifically for its needs from three to two, and the NAEV head "could imagine ending up with having only one fund at the end of 2008". This fund would then hold German real estate and be slightly bigger than the current ISFs, which each have around €300m.
"ISFs are replacing direct real estate holdings and are in turn replaced by listed property, especially when it comes to foreign investments," Lepelmeier sums up.
For investments in Germany the NAEV values the ISF structure which enables it to control its investments without having to hold real estate directly. Institutional investors can choose to join a pooled ISF or have one created solely for them.
Lepelmeier explains that holding real estate directly did not make sense under German accounting standards as they are less tax efficient than holdings in an ISF.
Although this has been a problem for some time NAEV wanted to wait for the introduction of REITs before changing its investment structure. As residential properties are now excluded from REITs the fund had to choose a different strategy.
Furthermore, by law REITs must have at least ten shareholders. "This means we cannot be the ‘boss of the fund'," Lepelmeier notes.
For Warburg-Henderson CEO Klöppelt, the choice of the vehicle depends on investor needs. While ISFs offer a bespoke solution and a high degree of investor participation in investment decisions, a REIT structure often provides easy access to an existing portfolio.
"Both vehicles enrich the investment market and complement each other very well. It is important for investors to find the right mix."
He sees much greater competition for ISFs from Luxembourg's special investment vehicles SIF than from REITs. "Many foreign investors do not know about the advantages an ISF structure can offer," Klöppelt stresses. "Investment companies have to make it their priority to make the vehicle known to foreign investors."
The percentage of foreign investors in German ISFs has increased substantially over the past year, growing from 2.8% to 4.1%. Nevertheless, their share of the market remains low; Entzian believes the only explanation lies in the fact that they "do not understand" ISFs. "It is often argued foreign investors are used to the vehicles in their own country and are not willing or able to look at vehicles in other countries as well," he notes. However, he says the ISF "does not seem to be unsuitable for foreign investors as a small but loyal group has invested more than €1bn since October 2000".
Changes to the investment law which also govern ISFs, which are currently in the draft stage, are expected to make the vehicle more competitive. They will be allowed to buy into real estate companies even if they themselves hold shares in other real estate companies.
If all other regulations are met ISFs will in the future also invest in REITs or listed real estate companies, Entzian explains.
This move towards greater flexibility is "a big step forward" towards making German ISFs as competitive as their counterparts in Luxembourg, Klöppelt adds.
Entzian says Luxembourg SIFs are "the new standard for the German regulator" but even the amended investment law leaves many hurdles.
"As much as the relaxation of investment restrictions for ISFs is to be welcomed, their regulation still has not reached the same level of openness and flexibility as found in Luxembourg SIFs," he writes in the Kandlbinder report.
For example, a Luxembourg fund vehicle allows investment in direct real estate, listed property and other assets in one single fund, Entzian explains.
Because of these restrictions, UK manager Henderson, whose German joint venture with private bank Warburg is specialised in ISFs, set up its latest German shopping centre fund as a Luxembourg FCP rather than via an ISF.
However, other amendments to the investment law such as increased independence of property assessment will strengthen investor trust in the vehicle, Entzian notes.
New competition from REITs and Luxembourg vehicles as well as amendments to investment restrictions "should be fitting to enliven the ISF business," Entzian concludes.
The number of companies offering ISFs has grown to 20 over the past two years. In 2006, Frankfurt-based fund manager DEGI, one of the oldest providers of mutual funds in the real estate sector, entered the ISF market. Within a short time it had attained a 5.8% market share with €1.1bn in assets.
Last spring, Patrizia Immobilien announced its first ISF offering focusing on domestic residential real estate. Within four months of its launch the fund had invested €40m.
On the other hand consolidation in the market continues in the wake of the takeover of Siemens KAG by UBS Real Estate in 2005. In spring 2006 Cologne-based Gerling Investment was purchased by German insurer Talanx and now manages €220m in ISFs under the name Ampega Gerling Investment. A few months later in December 2006 Schroders purchased the recently founded Aareal Immobilien KAG and turned it into Schroder Property KAG.