10 years after Lehman: German real estate funds
Not long after the global financial crisis, Germany’s open-ended property funds experienced their own existential threat. But the industry ultimately survived, writes Steffen Sebastian
Germany’s open-ended public real estate funds are looking back on a turbulent decade. In the wake of the financial crisis, these vehicles experienced a severe crisis of their own. For the first time in their history, a number of funds were forced to suspend the redemption of their share certificates and to start winding up the funds shortly thereafter.
Collectively, investment funds with close to €20bn in real estate assets had to be dissolved. The industry’s cumulative net fund assets contracted massively as a result. According to the Bundesbank, they dropped from a peak level of €91.7bn in April 2010 to €77.8bn by January 2015. This implies a drop by more than 15%.
However, the fund wind-ups did not mark the end of the asset class as such. On the contrary, having bottomed out in 2015, the net assets of these funds have increased steadily ever since. At €91.5bn, the pre-crisis level was regained by May 2018. By no means had this stellar recovery been a foregone conclusion, and it was fuelled not just by the growth of existing funds, but also by new funds launched. But what had caused the crisis? And what were the factors helping Germany’s asset class of open-ended public real estate funds to overcome that crisis?
To understand the fund crisis of the years after 2008 and its ramifications, a brief look at the specificities of the German open-ended public real estate funds (GOEREFs) is in order. An open-ended real estate fund under German law is designed as a legally non-independent separate asset pool. The latter is managed by an alternative investment alternative investment fund manager (AIFM, or in German KVG), but is strictly segregated from that company’s assets. AIFM companies are normally subsidiaries of banks or large asset management companies.
Unlike public property companies and real estate investment trusts (REITs) in Anglo-Saxon countries, which issue a fixed number of shares, the number of share certificates issued by open-ended real estate funds varies. If investors were to return their share certificates in large numbers, the total number in circulation would drop, whereas money paid into the fund will increase it.
Until the reforms of 2013, investors had the option to withdraw their money on any trading day. The instant availability of the invested capital exposed the funds to the risk of having to perform massive maturity transformations – meaning between short-term commitments of the investors and the intrinsically long-term investments in real estate. From an investor’s point of view, paying into an open-ended real estate fund therefore implies a liquidity risk. Despite the inherent threat, no liquidity crises struck during the first 45 years following the introduction of the fund class in Germany.
Another peculiarity of the German investment fund construction is that the share price is not subject to the daily play of supply and demand, as is the case with listed stock corporations, but instead is recalculated every day. What is the underlying calculus? The value is based on the sum total of the properties’ appraised market values. Added to the sum are cash and cash equivalents, whereas borrowings are subtracted.
Next, the resulting amount is divided by the number of shares in circulation. So, the price of the share certificates reflects essentially the outcomes of the property valuations. This means that the prices are not directly exposed to the volatility of the financial markets. Due to the fact that the property valuations are conducted only once a year, market fluctuations impact the fund assets successively and with a certain time lag.
Since 1959, the year the product type was introduced, its market has seen tremendous growth. In 1960, the vehicles became subject to government regulation. A number of reforms in the 1990s opened the investment funds increasingly up for investments in other European countries (European Economic Area, EEA) and even overseas. Growth of the industry as a whole started sky-rocketing in 1990. Over the next two decades, the volume grew tenfold, from €8.4bn in 1990 to €81bn in 2014.
An important factor for the success of open-ended real estate funds is their stable and comparatively robust performance. Figure 2 shows the annual average total return of all GOEREFs plus the annual inflation rate. On the whole, the funds’ total returns not only show a high degree of stability but they also clearly outperform (in the case of the active funds) the inflation rate year after year. The inflation-hedging role is an argument that has carried and continues to carry a lot of weight with investors. With the onset of the fund crisis, active funds and funds in liquidation have shown a diverging performance. While funds in liquidation generate negative returns, active funds have continuously beat the inflation rate.
After 45 years without any serious liquidity issues, a first minor crisis struck the GOEREF sector in 2005 and 2006 from which it emerged more or less intact, retrospectively speaking.
In December 2005, Deutsche Bank announced that it would have to reappraise the portfolio of Grundbesitz Invest, its largest open-ended real estate fund, worth €6bn. Investors fearing that the reappraisal would necessitate a substantial markdown of the share price started returning their share certificates and thus caused a run on the fund. Deutsche Bank was forced to suspend the redemption of share certificates.
The panic spread to the rest of the market and in January 2006 the AIFM company KanAm Grund also had to close its funds KanAm Grundinvest and KanAm US-Grundinvest. But for the time being, the big crash was averted. All three of the funds reopened in March and April of 2006 without triggering another run. Recovery progressed swiftly, and by the end of 2006, these three funds registered net cash inflows again.
However, just two years later, the liquidity crisis returned with a vengeance. In the wake of the financial crisis, which reached its peak with the bankruptcy of Lehman Brothers in September 2008, institutional investors in particular withdrew large sums of money from the funds. Redemption requests far exceeded the liquid assets on hand, so that in late-October 2008 more than a dozen funds had to suspend their share redemptions, including major funds like the SEB ImmoInvest or the CS EUROREAL (each with about €6bn).
Although 10 funds were able to reopen during 2009, the upward trend did not last. The main reason for this was an inappropriate move by the German government. In May 2010, it published the proposal of a flat-rate adjustment of 10% for all valuations. Foreseeably, many private and institutional investors asked for redemption of their fund shares in the following months.
On 30 September 2010, KanAm announced the wind-up of its KanAm US-Grundinvest fund, making it the first liquidation of an open-ended real estate fund in Germany. A short while later, in October 2010, another two funds – DEGI Europa and Morgan Stanley P2 Value – folded and announced their liquidations. The crisis reached its peak in 2011 and 2012 when four and seven funds, respectively, were wound up. About €20bn of real estate assets came onto the market at the height of the crisis.
The proposal of a flat-rate adjustment never made its way to the parliament, but it exacerbated the crisis at a critical point in time when the funds needed support rather than additional pressure.
It is now understood that at least some investors lost substantial amounts of money. Of course, the figures varied from one investor to the next and depended on the time of investment. An investigation conducted by Drescher & Cie, which assumed 31 December 2007 as investment day for the sake of the argument (a date when the crisis was not yet foreseeable) revealed that an investor in the CS Euroreal or the KanAm Spezial Grundinvest funds, for instance, would have lost less than 20% of their paid-in capital. By contrast, an investor in TMW Immobilien Weltfonds or DEGI Europa would have lost more than 60%.
What were the factors triggering the crisis? One key aspect was certainly that institutional investors had exploited open-ended real estate funds to park excess liquidity. As they combined a relatively high rate of return with same-day availability, open-ended funds seemed to be the perfect alternative to call deposit accounts.
Another thing that became obvious is that the funds hardest hit by the wind-ups were the ones without a parent bank and thus lacking the support of a potent sales unit. Only a high-powered sales organisation can ensure the kind of cash inflow of liquidity that is so urgently required during a crisis. An excellent case in point would be the DEGI Europa fund. When Commerzbank took over Dresdner Bank in January 2009, the latter had already sold the fund to Aberdeen Asset Management (now Aberdeen Standard Investments).
Commerzbank encouraged DEGI Europa investors to jump ship and move their capital into Commerzbank’s own open-ended real estate funds. The outflow of capital put the DEGI Europa under pressure at a time when it lacked an in-house sales unit to generate an inflow of new cash.
What caused the abysmal losses from sales for the funds in liquidation despite the properties having been regularly reappraised? Again, the reasons have to do with inadequate regulation. All funds in liquidation had to sell their assets within just five years, some even within three years. As a result, the funds were compelled to sell in a crisis-ridden market, with prices crumbling in the years that followed 2008.
Additionally, the funds acted as so-called forced sellers. Prospective buyers were well-aware that the funds had no choice but to sell, an insight that severely compromised the funds’ negotiating position. The financial outcome for the investors would have been completely different if the funds had been allowed to wait until the market rebounded.
To prevent adverse scenarios for investors in the future, the German legislature responded to the crisis by re-regulating the vehicle of open-ended public real estate funds and subjected it to tighter constraints. On the first day of 2013, the Investor Protection and Functionality Improvement Act (AnsFuG) was passed into law, whose purpose was to defuse the maturity transformation issue. Six months later, in July 2013, the German Capital Investment Act (KAGB) went into force, which absorbed the majority of the new regulations that had been enacted in the AnsFuG (see KAGB ushers in new rules).
The centrepiece of the reform of 2013 is the abolition of the availability of deposits on any trading day. There is one exemption: a grandfather clause permits investors who had been invested in a fund prior to the reform to withdraw up to €30,000 per calendar half-year on any trading day. It would have been legally difficult to introduce retroactive deadlines for legacy investors. As time passes, the share of legacy investors will steadily diminish and the risk of a liquidity crisis should be substantially reduced accordingly.
Despite a certain residual risk arising from the special status of legacy investors, the reform can be rated as a success. Two indicators suggest as much: the active funds have continued to attract large sums of money in the years since the fund crisis. In 2017 alone, open-ended real estate funds registered a net cash inflow of about €5.5bn, according to the Federal Association for Investment and Asset Management.
Meanwhile, the original issue of short liquidity has almost reversed itself. The active investment funds have such high liquidity ratios today that many of them have stopped accepting additional contributions. In June 2018, Scope Ratings quoted an average liquidity ratio of 21%. The main reason being that AIFM companies have a hard time investing the cash inflows in real estate on short notice because the current market cycle of peak prices makes it difficult to find properties that will generate adequate returns on investment.
Another indicator of a comeback of GOEREFs is the fact that new funds have been set up since the crisis. All things considered, about 10 GOEREFs have been launched or announced since 2015.
Perhaps the greatest challenge for the new investment funds at this time is not liquidity but buying real estate. These funds have to build up their portfolios during a market cycle that is defined by severely pent-up demand and high property prices. The risk is that those funds that pay peak prices now will suffer devaluations in slower market cycles going forward. As new funds can only build up market volume slowly in this market situation, the four largest fund families – Commerzbank, DEKA, Deutsche Bank and Union – each with a strong distribution network, currently form a sort of oligopoly.
GOEREFs are more popular than ever. With the new rules from 2013, the product has stabilised. The way in which these funds operate and the mechanisms they use have been adapted to the intrinsically illiquid nature of the underlying real estate investments. While the liquidity risk will always be a natural part of any such vehicle, they are now in a better position to cope with it.
Steffen Sebastian is chair of real estate finance at the International Real Estate Business School at the University of Regensburg
KAGB ushers in new rules
1. At the core of the 2013 KAGB reforms was the re-introduction of minimum holding periods and notice periods. The availability of deposits on any trading day was also abolished. Fund investors now have to keep their shares for at least two years. They also must announce their intention to return fund shares at least one year in advance.
2. Fund closures were re-regulated. It is now mandatory for AIFM companies to suspend the redemption of share certificates as soon as a liquidity bottleneck looms. If fund providers fail to comply with this rule, the German Supervisory Authority for Financial Services (BaFin) has the right to decree the suspension of share redemptions.
3. To compensate for the minimum holding periods and the redemption charges, an obligatory, regular minimum distribution was introduced. Funds are obliged to disburse 50% of their income unless the money is needed for the maintenance and reinstatement of the properties.
4. The valuation regime was also amended. Assets must be revalued by independent appraisers every three months, rather than once a year. If a fund redeems share certificates more often than once a quarter, the valuation must take place within three months of the next redemption date.
5. The new law makes it easier for funds to sell their real estate. If the redemption of share certificates has been suspended for more than one year, properties may be sold at discounts of up to 10% below the values determined by the most recent valuation for the purpose of generating liquidity. After a fund has been closed for two years, sales at a discount of up to 20% will be tolerated. After three years, at the latest, investors wishing to redeem their shares must be repaid their capital. If this proves impossible, the AIFM company loses the right to manage the fund. This means the fund will have to be wound up.
Steffen Sebastian says this part of the regulation proved to be inadequate and needs revising.