Prime German real estate was number one on the shopping list for institutions in 2011, but will 2012 be the year for distressed opportunities? Lynn Strongin Dodds reports

Compared with its European peers, the German real estate market is reasonably robust, but a closer look reveals that, as in many countries, most of the attention is firmly focused on core properties in top locations.

The distressed end of the market is generating a great deal of interest, but many of those assets are likely to remain on the wish list thanks to the European Central Bank's (ECB) long-term refinancing operations programme.

"The funding situation has been resolved for now and the ECB's actions have given the banks more breathing space," says Joseph De Leo, senior partner and head of portfolio management at Benson Elliot Capital Management.

"The catalyst will be the underlying real estate problems due to lease erosion and capex needs. That should force the banks to take action to preserve the value of their holdings. At the moment a lot of banks are trying to resolve their issues, but some are further ahead than others."

Phillip Burns, chief executive officer at -Corestate Capital, a Switzerland-based specialist private equity real estate firm, also points to a cultural difference between German and Anglo-Saxon banks in the way they operate.

"After Lehmans, the Anglo-Saxon banks, and in particular the US banks, addressed a lot of their loan problems, restructured and/or took write-downs, while in Europe including Germany, banks look to the sponsors to help them develop solutions rather than simply unilaterally accepting they need to take write-downs."

The other factor is the economy, which is reasonably healthy in contrast to its neighbours, particularly those on the periphery. Although GDP shrank by 0.2% in the fourth quarter last year on the back of weakening exports and private consumption, economists are predicting the beginnings of a new recovery this year.

Ernst & Young's spring euro-zone forecast, published in collaboration with Oxford Economics, predicts growth of 0.6% this year and 1.7% in 2013, with an average of 2% a year in 2014-16. This is mainly due to unemployment hitting a record 25-year low, exports rebounding and consumer demand rising.

While these indicators will feed positively into the real estate market, deal-flow is likely to be muted. In fact, Lars-Oliver Breuer, head of investment at Savills Germany, believes activity will be along the same lines as 2011, when about €22.6bn changed ownership in Germany, 20% up on 2010's €18.77bn.

"The biggest problem is that there is much greater demand than supply," he says. "There is little product and the pipeline has come down because of the lack of financing for new development. I think the interest which we saw in high-quality residential buildings will continue, while the distressed market will remain quiet because the banks are waiting for the problems to be as bad as possible before they act."

Residential had a strong following in 2011, with a recent report by CBRE showing that portfolios and complexes of more than 50 residential units enjoyed a 44% year-on-year rise to €6.12bn.

Prospects are bright thanks to cheap loans (fixed-rate mortgages are available at an average of around 3% over 10 years) as well as low unemployment, increased urbanisation and the need for investors to protect against inflation, which will drive up prices further.

"We are still seeing a handful of German mortgage lenders in the market because of the stability of the asset class," says De Leo. "Unlike the UK, Germany is primarily a rental market, with about 60% of the population renting. With little new construction, there is still strong demand for these types of properties."

The most popular sector, however, was retail, which according to Savills's research recorded a 60% increase over 2010's figures and comprised almost half (€11bn) of total transactions in 2011.

The main driver was the higher rental stability of these properties coupled with strong consumer spending, but the scarcity of high-quality supply and investors' reluctance to move down the property ladder is expected to dampen activity this year.

The state of the German economy may look healthy relative to others in the euro-zone, but institutional investors are still reluctant to take a punt on secondary and tertiary property assets. This is not exclusive to Germany, but a recurring theme that is playing out across the UK and the Continent.

Burns says: "I think the country is broadly similar to the rest of Europe in that it is split between two extremes. Just like in the UK and France, it is a barbell with the core and trophy assets at one end and the distressed at the other. There is not much appetite for the secondary performing assets in the middle, and they simply are not trading."

The main difference with the German market is that real estate investors can cast their net across a wider geographical area.

Unlike the UK, where the focus is on London, or France, where Paris dominates, almost half Germany's 2011 total transaction volume was invested in the main markets of Frankfurt, Berlin, Hamburg, Düsseldorf and Munich.

Savills's research reveals that Frankfurt, which saw several large-scale deals, was in front last year, generating a single-asset transaction volume of more than €2.3bn, accounting for over 14% of the total German market.

Munich came second, almost doubling its volume invested in single assets to €1.6bn, while Berlin and Hamburg recorded 11% and 14% respective increases. Düsseldorf did not fare as well, and volumes plunged by 40% compared with 2010.

While each of these cities has its own characteristics, the one sector that did not perform well in any market was office, which once dominated the German property scene.

Although volumes improved to €6.58bn in total in 2011, up from €4.88bn in 2010, it still trailed other real estate sectors. According to the latest IPD figures, office produced a 4.3% return, which, although better than 2010's 3.1% still lagged behind the best-performing property sector - residential at 7.8% - and retail, which was up by 6.1%.

"It all comes down to risk and security," says Breuer. "The problem with many office buildings is that you are reliant on a single tenant. The main attraction, for example, of a 50 [tenant] residential unit building is that there is limited risk of a complete vacancy."

The future, though, looks brighter over the next two years, especially in Berlin and Munich, where rents are expected to rise modestly to around 2.5 to 3% amid solid net absorption and supply constraints, according to a new report by RREEF Real Estate.

Occupier demand in Hamburg, which has been trending upward, will be hit by net additions to supply such as the HafenCity redevelopment - and this will hold rents flat in the near term, with moderate growth averaging around 2% per annum after 2013.

As for Frankfurt, a high vacancy rate coupled with moderate but steady supply and turbulence in the euro-zone is likely to keep office fundamentals destabilised in the near term.

Private equity firms that have been flocking to Germany and the rest of Europe will also have to wait for opportunities at the distressed end, even though the country's banks, along with the UK, have the greatest exposure to commercial real estate.

According to a report by Corestate Capital and German business school EBS Real Estate Management Institute, the European market for non-performing loans is estimated at €750bn, with Germany's share consisting of €250bn. In addition, non-core debt, defined as credit financing not aligned with a bank's core competency, stands at €1trn in Europe, with €500bn belonging to Germany.

As for the commercial mortgage-backed securities market, there is €10.76bn of multi-family commercial mortgage-backed securities (CMBS) loans set to mature in the second half of 2013, as well as an additional €1.55bn-worth the following year.

"There is a huge demand from private equity firms for these types of properties, but the pipeline is limited and I do not expect to see large-scale transactions," says Breuer. "I think what we will see is smaller deals sold by the special servicers to asset managers who can add value to the properties."

De Leo adds: "I think we will see the banks drip-feeding deals to the market this year. The same will be true for the CMBS market, where there will be a slow unwinding and selective deals, especially in the residential sector, such as the one we recently completed with Speymill Deutsche Immobiliens."

In March, Benson Elliot exchanged contracts with a number of subsidiaries of Speymill Deutsche Immobilien Company (SDIC) to acquire the Tor residential portfolio.

The transaction, which involved the acquisition out of receivership of more than 3,000 residential units and ancillary commercial units in 80 properties in Germany, is one of the first enforced sales of a defaulted CMBS loan in the country.

Although terms of the deal were not disclosed, the portfolio was last valued in May 2011 at €190m and the balance of the loan was €187m at the end of last year.

According to Boris Schran, founding partner at Peakside, one of the biggest challenges to doing deals in the distressed space is lenders' ability to absorb write-downs to prices to allow them to clear their portfolios.

"The German market was and still is doing relatively well, so initially there was little pressure, allowing them in a lot of cases to extend," he says.

"As a result, only a limited number of distressed transactions have occurred so far. However, with mounting pressure I think we will see more, in particular single, mid-sized transactions coming during the course of this year."