Ten funds are frozen and three are to be liquidated, while the government has sought to bring stability via rules that favour private investors. Richard Lowe considers whether the German open-ended fund sector will remain viable
The German open-ended property fund (GOEF) sector has experienced a number of liquidity crises over its 50-year lifetime, where large investor outflows have forced fund managers to suspend redemption requests. The situation today, where several funds are frozen, is therefore not without precedent. But there are some indications that the latest debacle is part of a significant shift within the sector.
For the first time ever funds are being forced into liquidation: Degi Europa; KanAM US-Grundinvest, and Morgan Stanley P2 Value. Each fund has its own reasons for being closed, but what they have in common with those funds frozen to redemptions is they relied on raising capital from institutional investors. By contrast, those funds with long-established distribution networks for attracting capital from retail or ‘private' investors have avoided the liquidity crisis and have had strong inflows.
Meanwhile, the German government is reforming the rules that govern GOEFs, including the establishment of minimum holding periods and redemption penalties. The new rules will favour private investors and render GOEFs less attractive to many institutional investors, particularly those that have used the funds for short-term trading purposes.
The upshot of these developments is that the GOEF sector is effectively returning to its roots: a long-term savings solution for the -German population that offers steady, risk-averse returns. The practice of building up GOEFs quickly by attracting ‘big-ticket' institutional capital - often enticed by dropping upfront entrance fees - is a trend that increased during much of the past decade, but has proved to be an unsustainable business model and will not be repeated. The new legislation only serves to compound this trend reversal.
The question is: will it be a smooth, orderly transition or will the situation take a long time to be resolved, possibly leading to further fund closures and resulting in further damage to the GOEF industry?
The story so far
The latest crisis affecting GOEFs did not start with the onset of the credit crunch in 2007. While open-ended real estate funds in the UK were experiencing strong outflows in the latter half of 2007, forcing many managers to freeze redemptions, GOEFS were still experiencing strong net inflows and continued to do so during the first half of 2008, as investors searched for low-risk investments. According to Germany's asset management association BVI, net inflows were more than €12bn between January 2007 and August 2008. This enabled GOEFs to continue deploying capital, acquiring real estate assets worth some €8bn in 2008.
However, the collapse of Lehman Brothers and the ensuing financial crisis caused a sharp reversal so that GOEFs experienced €5bn in net outflows in October 2008 alone as institutional investors sought liquidity. It is important to point out that these ostensibly institutional investors were those managing funds on behalf of other investors and in many cases using GOEFs as higher-yielding alternative to money market funds, rather than long-term investors such as pension funds and insurance companies.
Since then a number of funds have closed to redemption, reopened and, in many cases, been frozen again. This proved too much for the three aforementioned funds that are to be liquidated. At the time of writing there are 10 GOEFs closed to redemption, according to CB Richard Ellis. The majority of frozen funds are unlikely to reopen in the near term. It is not until November 2011 that three of these funds will see the mandatory maximum two-year closure period lapse and will have to decide whether to reopen.
Crucially, a select number of GOEFs have managed to pass through this difficult period without having to resort to closures and have continued to register strong inflows. These include funds managed by Deka Immobilien Investment and RREEF (Deutsche Bank), which according to BVI had net inflows in 2010 of €1.38bn and €1.02bn, respectively. Union Investment Real Estate also fell into this bracket until the earthquake-induced crisis in Japan caused the company to suspend redemptions in its UniImmo: Global fund because of its significant Japanese weighting. This development should be viewed somewhat separately to the other fund closures, since it was a direct result of a natural disaster in Japan.
Leaving aside UniImmo: Global, the principal reason for the divergence of fortunes between funds is the degree to which they rely on institutional capital and have strong private investor distribution networks. The three companies above are very much in line with the latter.
"The shape of the German open-ended fund sector is changing and will revert to its original idea of a vehicle designed for private investors," says Iryna Pylypchuk, associate director at CB Richard Ellis, who has been monitoring the GOEF sector. "If we look back at what has happened over the past two years, it has become apparent that those funds that are having a difficult time tend to be the ones that are newer, less firmly established in the German market, with no distribution networks and thus more heavily reliant on institutional capital."
Morgan Stanley's P2 Value fund, which is one of the three to be liquidated, is a good example. It was launched by the US investment bank in 2005 and embarked on an aggressive acquisition programme in the years leading up to the financial crisis. Degi Europa, on the other hand, is one of the industry's longest-running funds, having been established in 1972. However, its transfer away from Dresdner Bank to Allianz and subsequently to Aberdeen Asset Management caused it to lose its private investor distribution network.
Reform compounds the situation
Over the past few years the German Parliament has introduced a significant number of changes to the German Investment Act, resulting in a minimum holding period of 24 months and withdrawal penalties for the subsequent two years. These reforms are designed to make GOEFs less attractive to short-term investors and intended to make the sector more stable, especially given that investors redeeming less than €30,000 per half calendar year are exempt from the rules.
"The main aim behind the amendments to the German Investment Act is to give greater protection to retail investor in order to improve the overall ‘health' of the funds," says Pylypchuk. "It is designed to help shape up the GOEF vehicle into what it was always designed to be - a long-term, stable-return, saving/investment plan for private investors. Overall, the implications for the sector remain unchanged: institutional investors are expected steadily to withdraw from the sector, while stronger protection of smaller private investors should help to maintain the sector."
Fabian Hellbusch, head of real estate marketing and communication at Union Investment, says the new legislation will make GOEFs "an even more conservative product without making it unattractive for private investors". He adds: "Although it doesn't go far enough in separating private and institutional investors as we proposed, the new legislation will, from our point of view, reduce the likelihood that funds are frozen in the future - of course, the new legislation cannot totally eliminate the likelihood."
‘Homeless' institutional capital
Some market commenters have concluded that a large volume of institutional capital will be left without a home as a direct result of the government reforms and that fund managers will respond by setting up swathes of new Spezialfonds - dedicated institutional vehicles - to capture it. In some instances this is very likely, but it is crucial to differentiate between the different types of institutional capital. Investors that were treating GOEFs as a substitute for money market funds will leave the German real estate fund sector entirely; large institutional investors, such as pension funds and insurance companies are likely to focus on Spezialfonds, although a number are already doing this.
"One very significant change that we expect to see is that much of the institutional capital will leave the public GOEF sector, and be invested via other vehicles instead - and the Spezialfonds in particular," says Pylypchuk. "Spezialfonds offer similar - if not slightly higher - levels of returns, specifically target institutional capital, tend to be smaller in size and most importantly offer much greater control to individual investors in terms of investment strategies. Thus, they are overall a much better suited investment option for institutional capital."
Simon Mallinson, director of European research at Invesco Real Estate, says he expects to see some institutional capital flow out of the GOEF sector once those funds currently frozen reopen, but it is not clear what proportion this will be. "It will give an indication of how much of the institutional money in those funds was in there for real estate exposure and how much was treating them as money market funds," he says. "Once those funds reopen we will get a sense of what the institutional money is doing."
But Mallinson believes the Spezialfonds sector stands to benefit from the exodus and the new rules limits placed on GOEFs. "Once those funds reopen, we are also expecting to see the special funds business increase as well; they do become more attractive to institutional investors, because there are less limits on withdrawals and more control."
There is a third group of institutional investors that is likely to remain in GOEFs, according to Steffan Sebastian, professor for real estate finance at International Real Estate Business School in Germany. Spezialfonds require significantly large volumes of capital and so are the preserve of the largest pension fund and insurance companies. "If you have €25m to invest, you can't open a Spezialfond on your own," he says. Even if an investor has €100m in capital to invest, it is common practice to diversify by investing it in a number of different GOEFs. "It is quite attractive for an institutional investor to be in [GOEFs] because you have huge diversification in them and they have good pieces of real estate." Sebastian says a lot of the short-term institutional capital has already left the market, and capital from smaller pension funds and insurance companies are already flowing back into the sector.
Union Investment saw record institutional inflows of €11.3bn in 2010. This was driven predominantly by the company's Spezialfonds offerings, highlighting the vehicle's growing appeal among institutional investors. But the fact that Union Investment was seeing institutional inflows across its fund offerings suggests that institutions will not be vacating the GOEF sector entirely.
Smooth transition or drawn-out affair
If industry predictions are correct, the future of the GOEF sector looks more stable. Traditional funds will grow stronger and the sector will revert to serving private investors and small institutions; special funds, or ‘Spezialfonds', which are already popular with large institutions, are likely to benefit from the legislative reforms and grow in number; short-term money will leave for good.
Unfortunately, the industry has to make the transition and it is not clear how smooth or fractured - or how quick - the transition will be. The first test will come in the next few months as the nine funds frozen to redemption reopen. There are reasons for optimism: real estate capital values have improved and funds may be in a better position to manage redemptions and begin operating again.
Matthias Naumann, research analyst at Invesco Real Estate in Germany, says that those funds closed to redemptions are "at least entering a favourable environment" to sell assets. "There is a chance they can actually gather the amount of liquidity they need," he says. The prospects certainly look good for the German real estate market, which is seeing increasing interest from international investors. "It could have been a much worse timing," Naumann says. "Most funds might be able to survive in this context."
However, Sebastian believes we are likely to see more fund closures. He is aware that some GOEFs are not certain how much institutional capital will leave and how much will remain.
"I still see quite a substantial withdrawal from the industry, so I feel that some funds might come under pressure," he says.
Pylypchuk says: "This shift away from the public GOEFs and into Spezialfonds will stretch over a prolonged period of time. Much of the remaining existing institutional investment locked in those GOEF vehicles that are either liquidating or temporarily closed to redemption will remain locked in for a few more years. Only three of the ‘frozen' funds will see the legally permitted two-year closure period lapse in late 2010, with the timeline stretching beyond 2012 for the remaining temporarily closed vehicles.
"Unless investor sentiment changes radically and funds reopen sooner than expected, it will take at least a couple more years before the previously committed institutional capital will be back into the market."