There are signs that German pension funds might be relenting on their fixation with core real estate. Shayla Walmsley considers the evidence

Caution bordering on aversion sums up the approach of German pension funds to real estate.

This cautious approach has its detractors, and chief among them is Thomas Beyerle, head of research at IVG, who has criticised German institutional investors' focus on getting their money back, rather than making more of it. He has labelled as "absolute nonsense" the perception of "risk-free" core investment behind this trend.

However, there are a few exceptions to the rule, which could mark the beginning of the end for the flight-to-core trend.

In March, the German banking industry pension fund BVV announced it would set up an investment vehicle to gain access to global real estate markets, including emerging markets. Although the €23bn pension fund has not yet determined the structure of the investment, it will ultimately diversify an existing portfolio that is primarily exposed to euro-zone markets.

Rainer Jakubowski, board member at BVV, recently described the euro-zone as "a tarnished region". That the region has lost its safe-haven reputation could cause more pension funds to begin looking at non-European real estate markets. In some cases, this is already happening through core-satellite strategies, with Germany and the euro-zone providing the core base of a portfolio and Asia providing a smaller growth-oriented exposure.

"In general, Asia tends to have a positive connotation as a growth region," says Marius Schöner, head of Germany at MGPA.

Yet for 18 months Ärzteversorgung Westfalen-Lippe (AeVWL) has shied away from global macro investment themes and market-driven strategies. The €9bn regional doctors pension fund has invested 19% of its 20% target allocation to real estate.

"We're not concerning ourselves with global topics, and we're trying to avoid broad investment strategies. There are simply too many uncertainties in many real estate markets," says Marian Berneburg, head of real estate investment.

"We're looking for investments that make sense from a real estate perspective, not just from a market or economic perspective - not least because the economy is so difficult to calculate."

Much the same could be said for the fund-of-funds mandate awarded by €53bn Bayerische Versorgungskammer (BVK) pension fund to UBS last November. Although the mandate could include exposure to emerging markets, the focus will be on niche strategies and sectors, including hotels, parking and developments.

It would be difficult to extrapolate a single trend from this set of examples, and more difficult still to demonstrate a particular appetite for safe havens. London, the preferred location for sovereign wealth funds, is getting mixed reviews from German pension funds. On one hand there is BVK's £124m (€148m) acquisition of a prime retail asset in the City (see photo). On the other is what Klaus Schmitt, management board member of German property firm Patrizia Immobilien, suggests is a lack of German appetite for aggressively overpriced UK assets.

Although the fund manager has opened a UK office, it has only four or five UK commercial and retail properties in its funds and, despite a three-year stint scouting UK residential, it has failed to identify significant opportunities. "The luxury end has done well in recent years and it's not what we're interested in. We're looking for good leases but we haven't found many opportunities," says Schmitt.

Patrizia opened the UK office to cover Europe's large real estate markets. It already has offices in Copenhagen and Stockholm, where the real appetite is. If there is a shift, it is to an asset class pension funds know well, residential - which comes with significantly longer leases in Germany than elsewhere in Europe - in stable nearby markets.

"The Nordics market is in good shape," says Schmitt. "There are good working residential markets in Sweden, Finland and Denmark. Prices are bottoming. The demographics are attractive, too, especially in Sweden and Norway."

According to Schmitt, the question for German pension funds is not whether to invest but when. "The institutional investors who invest in European funds are quite sophisticated. They rely on our expertise but it's necessary to convince them that now is the right moment, especially to invest in Denmark - just as it was the right moment to invest in Finland and Sweden six to 12 months ago," he says.

In some cases, there has also been a shift in appetite for residential within the domestic market. AeVWL will not touch it. "In residential we're concerned about pricing," says Berneburg. "It has moved far - probably too far for our liking. The so-called flight to safety might actually have led some investors into very unsafe territory. It is our belief that some investors are simply overpaying at the moment."

More cautiously, Nordrheinische Ärzteversorgung (NAEV) has sold off poorer-quality assets within its residential portfolio, which makes up more than 30% of the pension fund's overall real estate allocation.

According to a recent survey by EC Harris, 54% of German investors still favour domestic real estate.

"We're looking at local and micro opportunities. Real estate has returned to its very local roots," says Berneburg. "You can earn money from real estate across all parts of the cycle. Now we're investing in specific projects, targeting all sectors in many markets. It's opportunity-driven and follows a bottom-up strategy."

An alternative to global diversification is domestic diversification. How investors will access second-tier markets is a big question. One of the advantages of investing in retail in this respect is that major retailers in Germany have a presence in second-tier cities, and grocery retailers with strong covenants, such as Metro and Aldi, operate in local markets.

Even office outside the first-tier cities - Freiburg rather than Frankfurt - may have some residual value, as banks release secondary assets onto the market (and yields inevitably harden).

Consultancy EC Harris points to an ageing stock of shopping centres with a potentially attractive return. Almost 60% of the investors polled in its survey favoured retail, while less than 30% favoured office.

Infrastructure is emerging as an alternative to aggressively overpriced real estate. NAEV made no domestic real estate acquisitions last year. Instead, the pension fund's real estate and bond investment teams are looking at European infrastructure this year. CIO Hermann Aukamp is reluctant to speculate on proposed investments "before the ink is dry", but he has not ruled out longer-term additions to the real estate portfolio dominated by domestic real estate - a third of the portfolio is invested globally.

As well as geographic diversification, pension funds are diversifying the types of vehicles in which they invest - despite the emergence of Spezialfonds.

The most adventurous are abandoning funds altogether. "Given the bottom-up approach in our investment selection direct investment is the natural first choice, but we're also willing to consider partners or managers who are unique in the way they do business, for example, local firms who understand their particular market very well," says Berneburg.

"Pension funds are once again happy to invest directly rather than relying on complicated structured real estate derivatives or variants which are costly, difficult to control and quite opaque. Hence there's a tendency among larger institutional investors to look at direct investment or separate accounts."

EC Harris sees a split in the market between traditional investors favouring core and opportunistic and value-added investors looking at developments. "For the time being it seems that risk-averse investors still prefer to pay the premium for stable and secure cash flows instead of taking on slightly higher risks in secondary markets," said its recent report.

For investors looking at development, the usual route is via a joint venture. Yet joint ventures are less common in Germany than elsewhere in Europe, not least because banks are still lending and a common requirement for German investors considering joint ventures is that the development partner comes to the deal with significant equity of its own.

In any case, Schmitt believes few funds will choose development projects and will instead stick with core and core-plus strategies over the next 12 months.

"Institutions are looking to stable investments, even with lower profits of 4-4.5% cash-on-cash, especially in residential. They see high profits as combined with high risk," he says.

Of course, there are exceptions. Schmitt points to a development fund Patrizia set up back in September with an unnamed large institutional investor. That co-investment arrangement, Wohnmodul I, allows for investment in development and asset repositioning, and for the sale of assets during the investment phase.

"It's a different risk profile but also a different profit profile. There are a few investors interested in that kind of deal, but it isn't a general trend," he says.

At most, the spirit of adventure amounts to avoiding the worst. "The principal focus is on core or on income-producing investments - if not prime assets, then assets with long leases and cash flow in established locations," says Schöner.

Schöner concludes: "German investors are getting slightly more flexible in terms of some compromises, but there is no fundamental shift away from core and income."