Is the German real estate sector failing as a destination for foreign investment? Ute Geipel-Faber and Ellen Schwemmlein look at the facts
An enormous change has taken place in the German real estate investment market in recent years, predominantly due to the increased presence of international market participants in the German property market. Implicit in this perception is the view that once international capital flows have receded, the German real estate market may be characterised again by those negative aspects traditionally associated with it.
Apart from the perceived lack of liquidity, the negative aspect mostly associated with the German real estate market is the long-term value model which smoothes and, therefore, understates market volatility.
It has been suggested that German valuation methods are ‘not grounded in theory', are ‘inconsistently applied', that there are systematic differences between the approach and other international methods, and that valuers may be more vulnerable to coercion than their counterparts in other countries. These challenges have led some commentators to question the usefulness of performance measurement data based on German valuations.
We would like to put these perceptions into perspective and argue that the sizeable change the German real estate market experienced in the last years has been generated by internal, structural shifts, supported by an increased investment demand from abroad. As a consequence, the changes are unlikely to be reversed and will ensure that the German market will remain both exciting and profitable for international real estate investors for the foreseeable future.
In both the demand and the supply side, a significant permanent change in the attitude of German real estate investors has taken place over the last 20 years. Up to the 1980s, most German institutions viewed their real estate investments as a means to store liquidity rather than a source of attractive investment returns: most owner occupiers were reluctant to contemplate either outright sales or sale and leaseback activity. As a result, real estate was not viewed as an alternative asset class. Further, owner occupiers were reluctant to view their real estate as a separate business line. These characteristics help to explain the German valuation system, the high level of owner occupation as well as limited transaction volumes.
But a range of legislative and regulatory changes have started to alter the approach of German investors to their real estate assets. In 1995 an EU directive required insurance companies and pension funds to start publishing market valuations of their real estate investments from 1999 onwards. Further, in 1998 the third Financial Market Promotion Act (Finanzmarktförderungsgesetz) led to a gradual relaxation of the previously tight investment restrictions on German insurers and pension funds. In 2002, there was a further easing of controls when the fourth Financial Market Promotion Act virtually abolished the regional limits for real estate investments. Perhaps more importantly, the Financial Supervisory Authority has started to apply to real estate the type of risk measurement approaches previously reserved for equities and bonds.
These changes forced a reassessment of the role of real estate within German investment portfolios. While regulatory changes led German investors to treat their real estate holdings as investments, euro-zone convergence led to the consideration of non-domestic real estate opportunities and increased awareness of approaches to real estate investment adopted outside of Germany (eg diversification, market valuation). Consequently, there was increased demand for professionally managed real estate funds, particularly to facilitate non-domestic investment strategies.
Immobilien Spezialfonds illustrate this development best. Until 1995, there were only 10 specialist Immobilien Spezialfonds. By the end of 2006 this figure had increased to 105. Over the same period investment volumes increased from €2bn to over €20bn. More recently, increased demand from non-domestic investors for German real estate assets has enhanced this trend. This increase was not only driven by opportunity funds from abroad benefiting from comparably low German interest rates, but also from a substantial increase in US, UK and other euro-zone investment flows. German investors now account for under 40% of the total transaction volume, down from over 90% in 2000.
On the supply-side, a growing number of German corporations have included real estate disposals and leaseback activity in restructuring programmes, triggered by the extended period of economic weakness in the early 1990s. Recent DTZ Research estimated only 52% of German institutional real estate is owner occupier, down from around 80% at the start of the decade. As a result, German owner occupation rates are now below both France (69%) and Italy (79%). There are clear indications that there will be a further sale of owner-occupied real estate in 2007.
But there is still clear scope for further improvement. Total transactions in Germany during 2006, including the residential deals, represented only 4.6% of the invested stock; the comparable figure for the UK was 10.1%, even without the abnormal boost to residential investment flows. As a result, although the increasing diversity of capital targeting the German market is a clear positive, the relatively small volume of transactions suggests limited liquidity. However, now that some large and influential German occupiers have started to dispose of their occupational estates, either completely or via sale and leaseback transactions, it is likely others will follow, leading to higher liquidity in the German real estate market.
According to a study by German real estate investment consultancy FERI, the percentage of real estate investments outsourced to external fund managers is still lower for German investors than for their UK or Dutch counterparts. Interestingly, German investors appear to be more willing to outsource their equity and bond investments than their real estate portfolios. As a result, there appears to be clear scope for further growth.
Adjustments within the open-ended funds, combined with increasing cross-border investment, flows both into and out of the German market, perhaps enhanced by the introduction of G-REIT legislation, should further improve market transparency and accessibility. German real estate investors are becoming more and more international, leading to an increasing need for internationally comparable data and, therefore, pressure for reform.