Over the last three years the German real estate sector has grown closer than ever to the capital markets and the trend is set to continue, as Claudio Lagemann reports
The hypothesis that Germany's real estate and capital markets are increasingly merging is not new. While Germany is at an early stage compared with the US or UK it has been stimulated by the trend towards the growing internationalisation of the real estate markets and its real estate economy is likely to adapt successively to the structures of the international real estate and capital markets.
Note two fundamental trends: First, investors are showing increasing interest in the German real estate market. Compared with previous years, this trend has gained momentum and peaked in the record transaction volumes of 2006. According to Jones Lang LaSalle (JLL), the transactions volume in the German commercial real estate market in 2006 (€49.5bn) was more than double the previous year's figure (€20.5bn).
International investors, who contributed 62% of total investment in the Germany real estate market as early as 2005, strengthened their presence as the share jumped to 75% last year. Most of these investors are globally oriented companies, including the real estate private equity funds increasingly active in Germany. This development is expected to continue through 2007.
Second, in addition to the increased inflow of international investment capital on the German real estate market is the growing tendency to use the capital market to leverage real estate investments in Germany. This manifests itself not just in growing financing volumes, but also in a greater variety of financing models for equity financing as well as for outside capital financing.
Thus, several real estate companies launched successful IPOs in Germany in 2006, and further IPOs are imminent in 2007. Out of a total of €23bn that flowed into European property PLCs in 2006 in conjunction with initial and secondary public offerings, 20% went to Germany, according to Bankhaus Kempen & Co. When considering IPOs only, Germany actually accounted for 37%.
With the law for the inception of real estate investment trusts (REITs) in Germany having been ratified in spring 2007, another investment vehicle that is already familiar to internationally active investors from numerous other markets, and that has proven to be a success on the market, has become available in Germany.
However, the present solution can hardly be considered optimal. One drawback is that Germany became the only country worldwide to exclude residential properties from REITs. Therefore this form of equity capital financing continues to be unavailable for a large segment of the real estate market. This is all the more regrettable because the underlying reasons fail to convince. The key argument used by the political groups who opposed residential REITs was tenant protection.
Yet in Germany tenant protection is already more extensive than in most other countries, and its regulations apply regardless of ownership. Tenant protection thus cannot count as an objective argument for barring REITs from investing in residential property.
In addition, there are other reasons that speak against a conversion of existing real estate companies into REITs, such as restrictions regarding activities abroad or service activities and outside financing. Moreover, it is almost impossible for companies adopting the REIT status to carry forward their losses so that provisions they have set aside pursuant to Art. 6b, German Income Tax Act, become fully taxable. That the tax burden of a given company will be cut by the pending trade tax reduction anyway also plays a role that should not be underrated.
This is not to suggest that prospects for the G-REIT are dim. Under current legislation, the shift to the REIT status in Germany makes sense mostly for existing real estate companies that invest in domestic commercial real estate while providing no services for third parties and relying on modest outside financing. Another option, which may become far more significant in practice than the status change of existing property PLCs, is the conversion of suitable subsidiaries into G-REITs. Favoured by the exit tax regulation, group subsidiaries that invest in domestic commercial real estate will have an easier time acquiring real estate from proprietary corporate portfolios. Moreover, their clearly focused business activity is a more convincing equity story than that of their parent companies which are often difficult to analyse for the capital market. In several companies, plans of this kind have become rather specific, and the first IPOs may be expected within the next few months.
From today's perspective, the REIT Act restrictions may cause the market potential of the G-REIT to lag behind the forecasts. While considering the current legislation, HSH Nordbank nonetheless assumes that G-REITs will achieve a potential market capitalisation of €15-40bn by 2010. If you add conventional non-REIT property PLCs, whose market capitalisation is currently €21bn, the addition of G-REITs might cause the market capitalisation of property PLCs in Germany to double or triple.
Aside from share financing, other forms of equity capital financing play a significant role on the German real estate market.
For one thing, closed-end property funds, where private investors typically participate in the equity capital of partnerships, gained considerable momentum in 2006. According to calculations of market analyst Stefan Loipfinger, the placed equity capital of closed-end property funds investing in Germany rose to €2.12bn in 2006, up by 39% on the year before. The realised fund volume, including outside capital, actually increased by 58%, to reach €5.07bn.
Recent years have also seen fundamental changes in external financing. Domestic business developments suggest that classic mortgage financing is increasingly replaced by non-recourse financing. While this is the most common financing form for commercial real estate investments internationally, this financing model was still exotic in Germany a few years ago. Increasingly, financing banks resort to the capital market to refinance their activities, by securitising loans for example.
The market has undergone a massive revitalisation in recent years that is likely to accelerate. Out of a total volume of €410bn on the European securitisation market in 2005, Germany accounted for only about €35bn. One year later, in 2006, the loan securitisation volume in Germany had nearly doubled to €66.7bn. At 54, the number of transactions had more than doubled compared with the previous year when there were 26 transactions, and this is explained by the growing number of minor transactions taking place alongside major ones.
The volume of CMBS transactions developed particularly dynamically, reaching €24.2bn, 36% of the entire securitisation volume in Germany in 2006. The second-largest segment was ABS transactions (€22bn or 33%), followed by RMBS transactions (€11.4bn or 17%) and CDO transactions (€9.1bn
One reason for the sustained growth that we expect for various forms of outside financing and on the securitisation market is the skyrocketing demand for complex structured financing. It is closely connected to the high share of portfolio transactions in the real estate investment market. The seller side is dominated in particular by open-end and closed-end property funds, plus by large corporations. On the buyer side you find mostly internationally active institutional investors that prefer to acquire real estate portfolios rather than individual properties because of their high liquidity and the lower transactions costs. According to JLL, portfolio transactions already reached a share of 58% of the entire transaction volume on the German market for commercial real estate.
The German real estate market has progressed in terms of openness toward the capital market and has noticeably adapted to international structures in recent years. Not least, this has caused the industry to professionalise, and has precipitated a notable increase in market transparency - a trend that is likely to continue.
Claudio Lagemann is global head of real estate at HSH Nordbank