Take a step back

Germany's impressive economic outlook bodes well for investment in its real estate market, but investors need to consider the options carefully, as Jan Wagner reports

To international investors, including those dealing in real estate, Germany must seem one of the hottest opportunities on the globe these days. 
After the near stagnation and high unemployment of 2001 to 2005, the economy has rebounded spectacularly. In June, the Institute of the World Economy in Kiel adjusted its growth forecast for 2007 to 3.2% from 2.1%. For 2008, the institute sees growth at 2.7% - about last year's level - and unemployment at fewer than 3 million. Germany hasn't been in this good economic shape since the post-unification boom of the early 1990s.

Foreign investors in Germany are already doing their best to profit from the upswing. Abundant liquidity from them has fuelled a boom on Frankfurt's stock market. In residential real estate, Anglo Saxon private equity firms have acquired hundreds of thousands of apartments - cheaply they say - with the intention of floating these properties on exchanges and earning a nice return.

Amid signs of a sustained recovery of its commercial property market, Germany has also lured European pension funds. Last April, ABP, the €210bn scheme for Dutch civil servants, and ATP, a €50bn Danish labour market fund, set up a venture to invest up to €700m in commercial property. The venture's third investor, German real estate firm Patrizia, is also its asset manager. Other foreign pension funds known to be invested in German property are PGGM, the €86bn Dutch health care scheme, and KP, a €12bn scheme for local government employees in Denmark.

KP raves about how well it has done. "We started to invest indirectly two years ago. At the time, we saw clear evidence of an economic recovery. Since then, the performance of our real estate investments has been good," reports Henrik Kolind, head of real estate at Sampension, KP's asset management arm.

"We are looking for other German property possibilities both in the direct and indirect market."

KP currently has €150m invested in four German funds - two retail, one residential and one office - and one direct office property. The prospects for KP's funds also look good as the upswing is being driven not just by exports but by domestic consumption and corporate investment. Indeed, KP is so bullish on the market that, uniquely among foreign schemes in Germany, it has acquired real estate directly. In April, it paid €30m for an office building in Düsseldorf that is fully rented by a co-operative bank.

Beyond economics, experts say investment in German property by foreign pension funds will be spurred by German real estate investment trusts (G-REITs) as well as Germany's intrinsic importance. "The German exposure in the real estate portfolios of many foreign investors is relatively small considering the economic importance of the country. We therefore believe that numerous foreign investors (including pension funds) will increase that exposure," predicts Walter Klug, managing director of Morgan Stanley's property investment arm in Frankfurt.

Thomas Gütle, managing director of real estate manager Cordea Savills in Munich, wholeheartedly agrees with Klug and adds that, in his view, the exposure could reach as much as 20%. On German REITs, Gütle notes that demand for the vehicles will mainly come from foreign institutional investors for a simple reason: "G-REIT portfolios will almost completely consist of German (commercial) property. This doesn't make them very relevant to domestic investors, which are reducing their German-heavy real estate portfolios in favour of international investments."

While other experts acknowledge that Germany's property market is in much better shape than the gloomy period of 2001-05, they pour cold water on the notion that the market is a hot opportunity for pension funds. Speaking of Germany's commercial property market, Martin Lemke, managing director at Patrizia, says: "The economy may be booming but not real estate. We're seeing a slow but steady recovery from an historically low level."

Lemke is also doubtful that foreign investors will find G-REITs that attractive currently, though he stresses that this is because of overall market sentiment toward real estate shares rather than the vehicles themselves. "My feeling is that the market for G-REITs has been somewhat overstated. One of the general problems is that, currently, real estate shares are not that popular with investors," he says. "This has to do in part with expectations of a correction in overheated markets of the UK and France. Interest rates have also come up so that is working against real estate shares too."

"With respect to G-REITs, I don't see how the vehicles will be able to provide big returns for investors as that depends on being able to buy and sell property quickly. The way the legislation was crafted, however, G-REITs have to hold on to a sizeable percentage of their properties for several years," Lemke adds.

According to Klug, another strike against G-REITs is the fact that residential housing is excluded from the vehicles. "This is unfortunate, as precisely this segment of the market is what foreign investors find very attractive. We can only hope that in time the legislation will be improved," he says. A new study from German Landesbank HSH Nordbank supports the scepticism about G-REITs. In the study, the market capitalisation for G-REITs was downgraded to between €15bn and €40bn by 2010 from between €30bn and €60bn previously (see article on p34).

For pension funds looking to German property, the latest IPD statistics do not provide much encouragement either. Although the experts insist that the market began recovering in January of last year, IPD's all-property return for 2006 was just 1.3%. The IPD return for office property was even negative (-0.9%), while returns for residential, retail and industrial came in at a mediocre 5-6%.

Again refering to Germany's commercial property market Lemke says: "If you're an opportunistic investor, it's not a good idea to invest right now as undervalued objects are becoming rarer. If you're a core real estate investor, my advice would be to wait until we see upward pressure on rents. But if you're a value-added investor, it's a good time to enter Germany." According to Lemke, "value-added investors" refer to those who choose properties that are partially vacant but have the potential of becoming fully rented.

But as Lemke noted in passing, finding the right commercial properties to invest in is no small feat. Indeed, one of the government's main motivations in creating G-REITs was to increase the availability of commercial property for the market. German institutions - whether firms, banks, insurers or pension funds - own well over 60% of the properties they use, compared with 54% in the UK and as low as 27% in the US. The idea behind G-REITs is to give these institutions a tax-efficient way of divesting commercial holdings and create a diverse and liquid property market.

Matthias Stürmer, head of real estate investments at German power giant E.ON. says: "Finding the right properties in Germany can be very difficult for two reasons. First, the high ratio of ownership among users of office properties means that there are very few good ones to choose from. Germany is also fundamentally different in that it doesn't have just one big metropolitan city like a Paris, London or Madrid."

Along with the challenge of finding suitable properties, German law can also pose a big problem to foreign pension funds. "In the interest of protecting tenant rights, Germany's rental market is tightly regulated. Because such regulation may not exist in their home markets, this can be very difficult for foreign investors to comprehend," notes Philipp Tabert, managing partner of Winters & Hirsch, a Berlin property consultant.

Kolind adds that because of all that's needed to invest successfully in Germany - finding the right property, conducting due diligence and understanding the legal and tax issues - pension funds should pay close attention to adviser fees. "I was surprised at the huge differences in fees among advisers for real estate investment. Some were a lot higher than I would have expected."

Naturally, the challenges of finding the right properties or keeping adviser fees to a minimum can easily be overcome by taking an indirect approach to Germany - that is, investing in funds, shares or G-REITs. And while the experts differ on what type of scheme should invest in Germany now - with Lemke advocating a value-added approach and Klug and Gütle favouring a core approach - all agree that the timing is right for an engagement. Lemke also makes the valid point that by relying on the fund approach, schemes can benefit from the gearing effect. This is precisely the approach that ATP and ABP are taking in their investment venture with Patrizia.

That the asset managers Klug, Gütle and Lemke deem it the right time for foreign pension funds to consider German real estate should be taken in context. But, tellingly, pension funds engaged in Germany do not disagree with their assessment of the market. "Amid the positive prospects for the economy, it is entirely appropriate for pension funds to consider investing in German real estate. Yet because the German market is not concentrated into one city, it's probably advisable to do so via funds," says Stürmer of E.ON.

Sampension's Kolind adds that while opportunities in real estate were greater and interest rates lower when KP entered in 2005, "I wouldn't say it's too late for others to invest as we are just near the middle of Germany's real estate cycle."

There has been some discussion as to data quality and more specifically the degree to which the IPD German property index truly reflects the real situation on the ground.
Experts note that since IPD only includes data from open-ended funds and not closed ones, it is not very representative. Gütle, for example, has unveiled a table indicating that IPD covers just 23% of the properties in Germany. "An improvement of the index, moreover, is not likely, because closed funds are not obliged to regularly report their net asset values. Hence, they have no interest in giving their data to IPD," says Lemke. That said, the experts agree that barring a broader index, IPD is the best indicator for performance of Germany's real estate market (see related article on page 36).

It is also unclear that foreign investors are having difficulty finding what they regard as attractive German real estate. Consider that in this year alone, German providers of open-ended real estate funds have sold billions of euros-worth of direct holdings to foreign financial firms - some of which invest on behalf of pension funds. The more notable deals included Deka's €690m property sale to Prime Commercial Properties of the UK and Quinlan of Ireland in February; DEGI's €2.45bn sale to Whitehall, the property investment arm of Goldman Sachs, in early May; and DIFA's €2.5bn sale to ¬Morgan Stanley in late May.

Another big source of property are German pension funds themselves, even though none has yet used the G-REIT vehicle. As reported in the March/April issue, Germany's largest schemes, including the €18.6bn bank fund BVV, the €15bn doctor funds NAEV and AEVWL and the €12bn public employee scheme VBL are, to varying degrees, divesting direct holdings and investing more in international funds or real estate shares. Last month, Nestlé's German pension fund joined this group by announcing that it would reduce its €77m direct German portfolio in favour of European funds.

The motivation of the German property fund providers and the schemes is the same: Look beyond one's borders for the sake of diversification and higher returns. E.ON, which operates two corporate pension funds, is much farther along than its peers. Of the €2bn (much of it pensions money) the energy firm invests in real estate, Stürmer says only 5-10% is in German funds and another 40-45% in European ones. The remaining 50% of the total investment is split evenly between US and Asia-Pacific property funds, he adds.

Taking all these factors together - that is, bright economic prospects, a recovering property market and availability of real estate - it seems that Germany is certainly an interesting opportunity for pension funds not already engaged. But since an indirect approach is recommended, whether or not the market is hot will probably depend on the skill of the advisers and managers foreign schemes select.