Investment activity by insurance companies has been hit hard by uncertainty over Solvency II, but many pension funds are showing a healthy risk appetite and are enjoying more choice and better terms, as Gail Moss reports

German pension funds and insurance companies have traditionally taken a conservative approach to real estate investing. But over the past few years, declining returns from bonds and stock market-based assets have forced them to be more adventurous.

"In general, real estate allocations are increasing," says Robert Stolfo, senior director of business development at Invesco's Munich office. He acknowledges that very recently, insurance companies have become inhibited by the Solvency II discussions and have frozen plans to increase risk.

"But pension funds are still very active, especially the funds for doctors, lawyers and other professionals," he says. "These already have quite a high allocation to real estate, but are still looking to increase it. Corporate funds are also active, with some building up an allocation from scratch."

But the effects of regulation on the market cannot be overestimated, according to other managers.

Mark Wolter, managing director, WestInvest, says: "The biggest issue for insurance companies at present is Solvency II. The legislation suggests insurance companies should use higher levels of equity by investing in real estate. This will affect real estate as a whole, because it will inhibit investment."

Wolter says that at present, German institutions generally hold up to 6-7% of their assets in real estate investments.

"The new regulations envisage that real estate investments should be underpinned by at least 25% capital reserves and up to 39% if debt is used with the investment," he says. "Institutions would like to invest more in real estate, but this will make it difficult."

Nevertheless, institutional involvement in the property market - particularly by pension funds - does appear to be increasing, whatever the long-term future may hold.

Traditionally, the main focus has always been Germany itself, where pension funds with direct real estate investments can benefit from their tax-exempt status; for this type of investing in most other countries, tax-exempt status cannot be claimed.

Germany remains an attractive investment market. One reason is the strong growth of the German economy. "German institutions look for an average total return of 5%-plus over the long term," says Wolter. "And they can still acquire property in cities such as Frankfurt, Munich and Düsseldorf capable of providing this return. At the same time secondary cities in Germany are also attractive."

But over time, international diversification has become a priority, first to Europe - usually France and the UK - then to the US, and now to Asia. "The UK recovered strongly in 2010, and some of the Spezialfonds sold properties they had bought the year before," says Stolfo. "But values have now come back and the economy is declining."

However, Stolfo says that the UK will always be a regular fixture in German institutional portfolios. "The UK has always formed part of the allocation because of its liquidity," he says. "Its long-lease contracts are also popular with German pension funds, because they provide a long stable income stream."

Wolter says: "The established markets like London and Paris have seen such a yield shift in the past couple of months that the price level is unable to generate a total return of over 5%. However, German investors can spread their investments more widely in terms of location, going to secondary cities such as Edinburgh and Bristol."

And he says they can also achieve the required return by moving further up the risk curve in other ways, such as taking slightly more letting risk, or a shorter duration on lease terms. "These strategies are now more acceptable than they were two years ago," Wolter says.

But Hartmut Leser, head of Germany, -Aberdeen, believes clients are now more positive on the UK. "They say the market has started to move," he says. "It is more volatile than Germany but is liquid and reasonably priced, and the currency problem can be solved."
As the first step in diversification, however, those funds with German-only holdings tend to invest in a conservative core pan-European fund. "The Nordic countries are popular at the moment, partly because of their relatively sound economies," says Leser. "Although markets are cheap, it is not easy to invest."

Andrew Creighton, director of property, Henderson Global Investors, which runs several Spezialfonds in partnership with the German bank MM Warburg & Co, agrees: "Geographically, Scandinavia is popular, especially offices and retail, where investors perceive the potential for rental growth due to the positive economic outlook. However, investors are now having to get very stock-specific in all of these markets, both in offices and retail."

Other markets attracting investment are France, Belgium and central and eastern Europe.

"Poland in particular is still popular, although as investors are conservative, they are only looking at central business districts in very big cities, and at long rental contracts," says Leser.

Aberdeen's real estate funds include a number of CEE holdings, mainly office buildings in Warsaw and Prague, as well as a shopping centre in Budapest, although the latter has not been an outstanding performer.

However, Leser says that German engagement with the region will take time to mature. "German investors don't move quickly in terms of changing asset allocation," he observes.

"Poland never had a recession and is much more like Germany than the rest of eastern Europe," says Thomas Beyerle, head of CSR and research, IVG Immobilien. "It has enjoyed 10-15 years of stability, with some growth, which has surpassed expectations. And this has also brought about the existence of a wide-ranging infrastructure network, which can only boost further growth."

"Apart from the big cities, eastern Europe is still too risky for investors," says Wolter. "But we are optimistic on Warsaw and Prague. However, there are too many question marks over Bucharest."

Quite possibly the biggest question marks, however, hang over the Iberian peninsula. "Last year we bought a shopping centre in Bilbao for one of our retail funds, but whenever I've discussed Spain and Portugal in general with institutional investors, they are quite critical," says Wolter.

This reluctance to invest in the Mediterranean region is echoed by other German institutions, although Warburg Henderson also bought properties in Spain in 2010, and is looking for further acquisitions there, as well as in Italy.

IVG is also looking around the market for opportunities, says Beyerle. "The commercial real estate market in Spain is much healthier than people expect, but the Mediterranean stereotype acts against it," he says. "That means there could be a window of opportunity in terms of core investments at attractive prices."

The US is still considered a useful play, thanks partly to demand from US pension funds, says Hermann Aukamp, CIO real estate, at doctors' pension fund NAEV. "Last year, our funds bought into several multi-family developments, which will be selling at a good profit."

"The commercial market is difficult but we expect to see asset uplift in Manhattan," says Aukamp. "There are few new developments at the moment, so demand is picking up. Even if rents have not gone up, incentives have gone down slightly."

Outside Europe, investors are also interested in Asia because of growth, says Stolfo. "It also has a low correlation with Europe and the US, so it's a good diversification play," he says.

But he adds that the region is difficult for German investors to access because they prefer to invest via managed vehicles - giving them involvement in decision making and the ability to benefit from discounts - rather than the big investment funds. And there are few, if any, of these vehicles investing in Asian property. Invesco is developing its first Asian fund for German investors, which will offer German-speaking managers reporting in German and the possibility of investor participation in investment committees.
"German investors need a strong income element and we think the market is there to provide a modest income," says Stolfo.

"Our fund investments in Asia, particularly in Hong Kong and Singapore, have done very well," says Aukamp. "We are very worried about the Japanese market because of the earthquake, but office demand finally may pick up in Tokyo, so prices could stabilise. The big long-term unknown is China, although we still have investments there."

While German investors are venturing farther afield in geographic terms, they are also starting to demand more from their real estate managers.

"What has started to change is that people are beginning to pay more attention to competitiveness," says Leser. "Active management only pays if you have a good manager, and clients are asking, ‘What sets one manager apart from the rest? Do they have plausible investment policies?' This may not be new to the UK or US markets, but it's new to Germany."

And he says this trend has increased with the number of foreign managers entering the market. "Five years ago, when you went to a German client, they'd say, ‘We've got our own manager,'," Leser says. "Nowadays, they are always prepared to talk. And they use beauty parades and requests for proposals (RFPs) in the selection process."

Wolter agrees that it is becoming easier for investors to change managers, and besides increasing the capacity and knowledge within the institution itself the use of consultants is becoming more common.

He says: "This is bound to affect managers' fees - not at an absolute level, but in terms of closer alignment, performance fee structures and clawbacks."