Solvency II was one of the major talking points of this year's EXPO Real trade fair in Munich, but many important questions still remain. Richard Lowe reports
Stability is likely to be top of the Christmas gift list for most real estate investors and fund managers this year. It is a characteristic that has been absent from the markets in recent years.
The 2011 EXPO Real trade fair in Munich provided a small sense of stability, if only in terms of the number of delegates shuffling through its electronic turnstiles: at 37,000, roughly the same amount in attendance in 2010.
Certainty is another coveted, but largely elusive, quality for the real estate industry. Investors' recent behaviour - whether postponing investments outright or focusing on prime property - has been largely driven by the dearth in certainty. There was a sense that many of the 37,000 delegates were here to glean as much certainty as possible, finding out what other investors were thinking and doing - that is, rather than engaging in actual property deals, which has always been the traditional activity within EXPO Real's gargantuan trade halls.
One of the most obvious sources of uncertainty is the ongoing euro-zone debt crisis, which at the time of writing had progressed with the agreement of a new €1trn rescue package (itself far from certain in terms of structure and detail).
But there are other sources, not least the proliferation of new regulations emerging from Brussels.
Evidently, EXPO Real organisers recognised the importance of the topic, having scheduled a number of dedicated panel debates in quick succession in the main conference arena. This series of sessions included a look at Solvency II and the implications the regulations would have on insurance companies' investments and, by extension, the real estate markets.
The panel included a number of insurance and real estate investment experts, and was chaired by yours truly. Moderating such a debate was a daunting prospect, considering there are so many factors involved and that the implications for the capital markets are so significant.
The main fear is that Solvency II will cause insurance companies to reduce or abolish their real estate allocations, leading to a mass withdrawal of institutional capital from the property markets.
At first glance, it looks as though this scenario could become a reality. Under current proposals, the regulations will require insurers to incur a 25% capital charge for holding real estate. The capital charge is even higher for equities, but even so a 25% market shock charge is likely to make holding property assets unattractive.
One of the panellists, Marieke van Kamp, head of real estate investments at ING Insurance Benelux, made it clear that applying such a 25% threshold for real estate would force the insurance company to divest its real estate exposure, currently around 5% of total assets.
"As an insurance company, if we calculate our asset allocation, taking into account the Solvency II modelling as it now stands, then real estate is not really profitable - it would be better to put our money in other types of assets," she said.
Fortunately, there is an alternative solution to ING Insurance Benelux liquidating its property holdings, which comes in the form of an internal risk model. Solvency II regulators will allow insurance companies to use their own risk models, in effect enabling them to set individual capital charge thresholds for different asset classes. Importantly, by using its internal risk model, ING Insurance Benelux will be able to maintain its current allocation to property.
Michael Morgenroth, member of the board at Gothaer Asset Management, the investment arm of German insurance company Gothaer, broadly agreed with van Kamp's assessment. Under the standard 25% capital charge, "insurance companies would shift their asset allocations towards bonds," he said. "If 25% is the final number, it will be very difficult for insurance companies to maintain their real estate quota."
The use of internal models looks like the definitive answer to the problem. But not necessarily. In the first instance, it will be the preserve of large insurers with the necessary resources in-house; smaller firms are likely to have to accept the standard model.
Added to this is the uncertainty over whether regulators will ultimately accept insurance companies' internal models. Acceptance will become all the more difficult if they are inundated with internal model proposals, and they may have difficulty in authorising models that deviate significantly from the standard one.
"All these models will end up in the hands of the same regulators and it is not known, so far, to what extent regulators would feel comfortable with these data and results," said panellist Laurent Lavergne, head of fund management at AXA Real Estate Investment Managers.
The other avenue available to the real estate industry is to itself lobby Brussels to change the standard model. Efforts in this area are being led by the European Association for Investor in Non-listed Real Estate Vehicles (INREV), with support from a number of industry bodies.
The cornerstone of the campaign, which calls for regulators to reduce the 25% capital charge, is research conducted by Investment Property Databank (IPD). The regulators have relied on data from the UK real estate market, chiefly because it is the most comprehensive and detailed available in Europe. Critics, however, argue that the volatility of the UK market - generally higher than that of the continental European markets - is not representative of Europe as a whole. IPD's research suggests that a capital charge closer to 15% would better reflect the risk of holding a pan-European real estate portfolio.
Indications are that the regulators - namely, the European Insurance and Occupational Pensions Authority (EIOPA) - are listening. Morgenroth, who is also chairman of INREV and chairman of the property commission of the German Insurance Association (GDV), said he had spoken personally with EIOPA, as well the European Commission and the EU's Committee on Economic and Monetary Affairs (ECON). "They said: ‘well, we had no better data. If you can provide us with better data we will definitely recognise it'," Morgenroth recalled. "That is what we tried to provide with the IPD study."
There has been some concern that the real estate industry had been somewhat slow in recognising the need to lobby regulators. Morgenroth said GDV warned the regulators as early as 2009 that the Solvency II proposals would "really impact real estate allocations in insurance companies". But given that real estate often represents 5% of insurance company assets it was not a priority compared to other asset classes.
In late-2009 it was acknowledged that the impetus should move to the real estate industry. In early 2010, the issue was raised within INREV and the association set up its first public affairs department. "INREV has more than 350 members, comprising fund managers, investors and advisers," Morgenroth said. "We said that is the natural voice of the industry which has to be heard in Brussels."
Speaking separately to IP Real Estate, Jeff Rupp, director of public affairs and professional standards at INREV, was fairly optimistic that the regulators would heed the real estate industry's calls. They are aware of the IPD research, at least, and are paying attention to the industry's concerns.
Word on the street is that the 25% shock factor for real estate is yet to be set in stone, but this has yet to be substantiated. Certainty, it seems, remains elusive for the time being.