Many of Germany's troubled open-ended real estate funds are having to explore potential exit strategies. Frank Schaich argues that the country's prohibitive REIT regime means the perfect solution is being missed

A regular debate occurs in Germany: it is one that is often met with incomprehen-
sion abroad, but was reignited in the spring of 2011. The discussion revolves around whether frozen German open-ended real estate funds (GOEFs) threatened with liquidation can be transferred into real estate investment trusts (REITs).

The bemusement outside Germany is perfectly understandable: there are, after all, a number of examples where a real estate fund's exit strategy to convert into a REIT worked just fine - indeed, many such cases can be found in the US. The origin of Europe's largest listed company Unibail-Rodamco, for instance, is rooted in non-listed fund structures. While this has been normal in many parts of the world, Germany has made little progress.

How do you explain this? For one thing, REITs have had a hard time in Germany where, having long been successful in other countries, they were finally introduced in 2007, following a lengthy and controversial debate.

Few REITs have found their way to the German stock market with initial public offerings (IPOs). The IFD Financial Centre Germany Initiative, whose remit was to boost the introduction of REITs in Germany, projected a market potential of €122bn for German REITs. The actual market capitalisation of German REITs is, however, as low as €1-1.5bn, which is equal to less than one-third of the smallest DAX listing. The optimistic forecasts made for the REIT volume in Germany at the time thus missed the mark by about 99%.

One reason for this is surely bad timing. REITs were introduced in Germany just before the stock market crashed. In addition, the German legislature chose an approach that takes exception to international standards in many ways. For example, existing residential real estate was exempt by the German REIT Act, preventing the already conservative German REITs from acquiring existing residential property built before 2007. By contrast, risk-prone foreign financial investors (and foreign REITs, too) are not subject to such a restriction when buying German apartments.

Second - and the ramifications of this flaw in the German REIT Act are at least as grave - IPOs are subject to very tight deadlines. While pre-REITs can be established, they need to make a public offering within three years - or five years at the latest if all extension options are used - otherwise the pre-REIT will become subject to retroactive taxation, since it loses its so-called exit-tax privilege, which exempts half of the profits from corporate real estate sales to a REIT from taxation).

As a result, a pre-REIT may be forced to make an IPO for purely fiscal reasons, even if the capital market or the company's situation would actually discourage such a move. Companies opting for an IPO under such circumstances are liable to suffer steep discounts.

The legal position of German REITs creates difficulties for GOEFs choosing the REIT option as an exit strategy. Conversely, the legal basis underlying real estate funds is not exactly conducive to the REIT exit option either.

Ernst & Young counts the need for legislative changes and other critical aspects among the reasons why segregated pools of real assets are not converted into German REITs in practice.

The problem is that the pool of segregated assets will cease to exist after it is transferred into a public limited company. Moreover, the management board and supervisory board need to reconstitute themselves, and the incumbent certificate holders need to be granted the powers of shareholders. This requires revising the German Investment Act which, in its present form, does not provide for the conversion of GOEFs into REITs.

A corresponding re-enactment of the law, however, is not to be expected anytime soon. Moreover, the contract terms of the companies would have to be changed, and this is unlikely to happen without the active participation of the respective investment companies.

Under existing regulations, a REIT exit would be precarious from an economic perspective. After all, the transfer of fund-held properties and buildings into a REIT structure would be subject to real estate transfer taxation. Depending on the state in which these assets are located, the tax rate could be as high as 5%.

The legal barriers in Germany are especially regrettable because GOEFs are principally characterised by similar investment qualities as REITs. Both vehicles are long-term real estate investments. German REITs are legally restricted in their real estate trading, and revenues therefore need to be generated through the portfolio management. This is comparable to the core business of GOEFs, which tend to rely on long-term investments rather short-term real estate trading.

Another aspect is the conservative financing of the real estate portfolios. Both GOEFs and German REITs are subject to statutory limits on debt financing. Moreover, both vehicles are fiscally transparent because each one is taxed at the investor level.

The European Public Real Estate Association (EPRA) is particularly active in Germany where the market capitalisation of listed real estate companies is a mere 25% of the global average. Against this background, EPRA is going to host its 2012 annual conference in Germany, the aim being to generate momentum for change to German REIT legislation. It is to be hoped that the event will breathe life back into the discussion concerning the REIT exit option for GOEFs, and get things moving a step further.

Frank Schaich is CEO of Fair Value REIT