The downturn saw German investors return to the familiarity of their home market. But their faith in international diversification remains strong, as Richard Lowe reports

In 2007, before the credit crunch struck and the wider financial crisis emerged, German pension funds and institutional investors were on a clear path to diversify their real estate investments internationally. This would reduce risk in their heavily anchored German portfolios by gaining exposure to foreign property markets with different cycles and driven by economies with distinct characteristics. The stable nature of the German real estate market, characterised by low volatility but limited capital value movements, has always been attractive to conservative German institutions looking for income driven returns. But consensus had long been reached that complementing this with foreign real estate investments was the best strategy.

One financial crisis later and the once clear path has been strewn with debris and obstacles, and fogged with uncertainty. The latest downturn, which affected nearly all real estate markets adversely, highlighted the volatility that can be experienced outside Germany. Although the domestic market suffered - it experienced negative capital growth of -2.6% in 2009, according to International Property Databank (IPD) - it did not see the same level of re-pricing as elsewhere - the UK being the most extreme example. The result has been that German investors have become much more interested in their domestic market.

At the end of 2009, Feri EuroRating Services surveyed approximately 150 institutional real estate investors in Germany. When asked to name those markets they perceived to be currently most attractive (they could name more than one), roughly two-thirds chose Germany. In one sense, this was not a massive departure from the June 2008 survey, when just under 70% investors gave the same verdict. However, in June 2008, more than 60% also selected Asia Pacific, more than 50% chose Eastern Europe and more than 40% mentioned Scandinavia, while the equivalent figures in December 2009 were all well under 40%.

Wolfgang Kabatzki, head of real estate at Feri, says that in recent years German institutional investors have shown interest in all the major international real estate markets. "Indeed, they came back to the German market," he says.

Rainer Jakubowski, member of the board at BVV, the €21bn pension fund for German banks, validates Feri's findings. "Germany has been quite stable in the last couple of years," he says. "Of course, more stable than most of the other real estate markets, and I think this will last for a while. It is obviously an interesting market for investors."

Hermann Aukamp, director of real estate at Nordrheinische Aerzteversorgung (NAEV), admits that pension funds are mostly focused on their domestic market. "They feel the home market is a safe place to be. Perhaps this is because it is actually doing better," he says, while also pointing out that recent IPD figures show that the German office market is weak and vacancy rates have increased.

He says there has been a significant rush on the part of German investors to invest in core real estate in the main German cities, such as Munich, Hamburg and Frankfurt. In addition, there has been a lot of investment in multi-family residential assets, which are seen as very secure investments.

"Everyone is focused on prime or core," Aukamp says. "The risk appetite is very low. There is a lot of appetite for multi-family in Germany. Multi-family developments are really in favour now. This is a very risk averse investment, but people feel safe."

German pension funds and institutional investors may have retreated to their domestic market, but it does not mean they are out of the game for global real estate. Indeed, they are still committed to the path mentioned earlier, it is just that the journey to international diversification may have to take longer than originally expected.

Although Feri's most recent survey showed an almost universal preference for German real estate over any other market, the second most popular market in the survey was rather telling. Asia Pacific was voted as one of the most attractive markets by close to 40% of German investors. Admittedly, this was down on June 2008 when more than 60% of respondents selected the region, but the figures suggest that the long-term Asian investment outlook is still strong.

Jakubowski reveals that BVV is likely to increase its exposure significantly to the Asian markets. It has invested in Europe, the US and Asia, and he expects the latter to become a much larger component of the overall portfolio. "To invest only in Germany is obviously not the right approach. Our approach is to diversify," he says. "For investors in real estate markets - as with bonds and equities - the developing markets will become more and more important."

Aukamp agrees that the trend to global diversification has not stopped. "For the time being it will be slower than everybody supposed it to be before Lehman's," he says. "Investors are still looking for diversification. They still see the benefits of diversification, especially in emerging markets like Asia."

Asia Pacific might be the long-term target for German pension fund investors, but a number of other markets are on the radar at least in the more short-to-medium term. Aukamp, who also advises other pension funds on the structuring of their property portfolios, says a number of pension funds are looking what he terms ‘niche markets', such as Canada, which are seen as a stable alternative to the US.

"Many German institutions are looking in Europe," Aukamp adds. "They are looking at Paris and London. Germans have been keen investors early last year. There is still some appetite to go to London - even before the election and although the real economy may be getting worse - as well as to some provincial markets in the UK. There is some appetite to invest in France, especially Paris."

BVV made some select investments through its existing vehicles but did not make any new commitments to fund managers. "We were not very active," Jakubowski admits. He says that all the talk in the market of unprecedented investment opportunities resulting from forced sellers never came to pass. "We had the idea to invest in London, because yields and prices were quite attractive. We had the idea to invest in Paris, but there were hardly any opportunities," he explains.

But Aukamp expects pension fund investment activity to pick up significantly later this year, and markets like France and UK will be among the main targets. Much of this, he says, will be driven by the fact that most pension funds are looking to increase their real estate allocations.

Indeed, the financial crisis and market volatility may have caused German institutional investors to slow down or pause their real estate investment programmes, but the asset class has not fallen out of favour with their asset allocators. Evidence points to German pension funds continuing to increase their allocations to property.

This is certainly true of BVV. The pension fund currently has an 8% strategic allocation. It has reached this target in terms of real estate commitments (it is not fully invested), and this level is set to remain the same for the next 12 months. But Jakubowski expects this to rise further. "Due to the limited risk budget it is not possible right now, but with a long-term view, I hope it will be around 10%," he says.

Kubatzki says that Feri research suggests that most German institutional investors are not allocating to real estate at the moment at the moment, but will increase their exposure later. "Most of them are not that bullish for real estate at the moment," he says. "This means, especially when you talk about pension funds, that they will leave it as it is; they are not that keen to increase the ratio of real estate in comparison to other asset classes."

The financial crisis has not swayed German institutional investors from their long-term goal of investing in global real estate markets. That is not to say that the way they want to achieve this has not changed. Another trend appears to be emerging: investors want less risk, more certainty and greater control in relation to their indirect foreign investments.

BVV invests in foreign markets mainly through German-regulated Spezialfonds where the pension fund is the only investor - a luxury only the largest investors can enjoy. However, it also invests in a number of pooled funds with other investors. In future Jakubowski will try to stick with Spezialfonds.

"We learned that the best way for BVV to invest is in single funds," Jakubowski says. "We will be very careful with pooled investments as we are not very happy with the existing ones."

Jakubowski has also come to the conclusion that it would be desirable to have more control over its Spezialfonds. These vehicles, which already afford investors a measure of control of the management of their assets, are traditionally established through a contract with the end-investor and the Kapitalanlagegesellschaft (KAG), or investment manager.

"We have learned to be careful with long-term commitments with our partners," Jakubowski says. "The funds we construct should be more open to the idea to change partners. So we try to create structures that put our real estate partners more in the role of adviser than of KAG."

Neil Turner, managing director of Schroder Property in Germany, says that a growing number of German institutional investors were turning to local regulated vehicles such as the Spezialfonds, as well as the open-ended Publikumsfonds. The Luxembourg-domiciled and regulated FCP structure has been popular for cross-border investments, but Turner believes pension funds and insurance companies in Germany largely favour vehicles that are regulated by their domestic authorities.

"Investors want to see a regulated German entity, which the German regulators like and want to see them using," he says. "Spezialfonds and Publikumsfonds, two vehicles regulated by the German regulator, are becoming ever more important to a large number of pension funds, insurance companies and institutional investors."

Turner says this new trend is related to the move towards core investments, away from riskier strategies, as well as some of the recent difficulties experienced by highly geared, offshore vehicles. "They are looking for low-geared, core or core-plus products," he says. "The investment strategy is less risky than it has possibly been in the past, and the capital structure being used is less risky than it has in the past - ie, less leverage.
Turner continues: "I am not saying that the FCP structure in Luxembourg is not interesting for them. I think some investors will choose to invest in FCPs - they have a role to play as well - but I do find it interesting that we are seeing this switch across to these types of funds."

Publikumsfonds - open-ended vehicles that include institutional capital - hit the headline in 2009 due to many of them having to freeze redemptions. This was driven by large redemption requests on the part of multi-asset class fund of funds managers, although it has been suggested that redemptions from private investors exacerbated the situation. Legislators in Germany have responded to the crisis by proposing two-year holding periods before redeeming their shares, as well as variable cancellation periods.

Benedikt Kutschera, senior consultant at Towers Watson in Germany, says the whole debacle has been a "big issue" for a number of pension funds invested in publikumsfonds that have had to close to redemptions. The move to change the regulation is supported by Towers Watson and many of their pension fund clients. "We very much welcome it because it is a clarification," he says. "Investors will have a better understanding of what they are investing in."