German pension funds are torn between avoiding the risks of real estate investment in the current recession and availing themselves of the rewards that a recovery is likely to bring. Christine Senior reports

The phrase that sums up German institutional investors' current attitude towards investing in real estate is "wait and see". Yet it is hardly surprising that German investors, with a reputation for conservative strategies, are taking a cautious attitude, with any new investments likely to go into prime properties and high quality locations.

Consultant Towers Perrin carried out a survey of pension investments by German companies in autumn 2008. The survey covered 24 large and mid cap companies, 16 of them constituents of DAX or MDAX, with pensions assets totalling €70bn. It found that 2% of their portfolios were in owner occupied real estate - that is, their own premises - and 3% in other real estate.

But these companies may not be typical of pension funds as a whole. Mercer estimates allocations to real estate among larger pension funds could be in the range of 12-13%, with allocations by smaller funds in single digits, giving an average allocation of around 10%. In terms of sector, Mercer's most recent figures show allocations of 60% office, 15% retail, 10% residential, and 15% other.

Traditionally German companies have financed their pensions through their balance sheets. Though they are not required to finance pension liabilities through a separate vehicle, or to have assets to cover liabilities, many - particularly the larger DAX companies and MDAX companies - have chosen to use contractual trust arrangements (CTAs) to shift their pensions obligations off their balance sheets.

One advantage of this is it gives companies the freedom to invest as they wish, so there is no limit to how much they could, in theory, invest in real estate. Other vehicles used to finance pensions - such as pensionsfonds, pensionskassen, support funds, and direct insurance - have different levels of permitted allocations to real estate.

Benedikt Kutschera, investment consultant with Towers Perrin, says that most of his clients are using CTAs to fund their pensions liabilities. "With that vehicle they are completely free. But I would be astonished if an allocation to real estate was much higher than 10%," he says.

German pension funds have traditionally invested directly in their local market. But in recent years this has been changing, says René Höpfner, an investment consultant with Mercer in Frankfurt. "In the past the ratio between direct and indirect was two thirds direct and one third in indirect vehicles, but pension funds are looking to increase exposure to the US and Asian markets and the best way to do it would be through indirect vehicles," Höpfner says.

The Spezialfond, the investment vehicle favoured by institutions, was given a boost at the beginning of last year when the range of permitted investments was extended. Under the new rules it is now possible to combine different asset classes within the one structure, or to invest directly in property and through funds of funds within one fund, or to use holding structures for acquisitions.

The changes put German Spezialfonds on an equal footing with Luxembourg funds, in terms of the flexibility they enjoy. Regulations that put foreign funds at a disadvantage to German funds have also been changed to ensure equal treatment.

"German Spezialfonds were given a bit more flexibility in structuring and taxation," says Claus Thomas, regional director, client services at LaSalle Investment Management. "There is more comparability. You can now do as many things with German Spezialfonds as you can with a Luxembourg fund, for example. That has been an issue but it has now been taken away."

However, it will take time for the new structure to gain traction. "Both investors and asset managers need to implement what has been allowed by the law to see how it works out," says Holger Naumann, head of RREEF in Germany. "I think it's given a push to German Spezialfonds.

There was a time when people were saying this business is going strongly towards Luxembourg, but I think with the change in the law German Spezialfonds have become very attractive again. We see new Spezialfonds being launched."

RREEF has launched two new funds, one investing in the US and Asia and the other in Europe. So how do German investors feel about real estate against the backdrop of the current dismal economic climate and property market? Opinion is divided on how they should proceed this year. Thomas at LaSalle suggests that investors can be split into two camps - conservative and opportunist.

"Some institutions say they're not investing in real estate at the moment at all because they are long term investors. They say it's clear that the market in many countries will go down at least for the next couple of quarters. They say they want the market to hit bottom and they want to see evidence in figures that markets are improving again, then they'll go back in. That's the very conservative crowd.

"Others say that the situation offers interesting opportunities and they are actively looking at funds, for example the UK, where the expectation is the market will be the first to bottom out. They think that now is an opportunity to go in to the UK market at historically low prices, and over five or 10 years make very good returns.

The same would go for pan-Europe with a little time lag and the US at a later stage because everyone is expecting it will not bottom out this year, but probably in 2010." Höpfner at Mercer says institutions are approaching new and existing investments differently:

"With existing investments they try to stabilise returns and try to keep good tenants, extending contracts or decreasing the rent. For new investment, generally real estate is on the watch list. At the moment transactions are very low. We believe there will be more activity in the third and fourth quarters, but more on core and core plus strategies, not opportunity or development funds."

The broader picture, which had been developing independently of the recent market crisis, showed a move away from direct investment in the domestic German market towards diversifying into foreign markets via unlisted funds. Institutions were willing to forego higher returns for the prospect of lower volatility and lower risk with funds. They also diversified into wider Europe, the US and Asia, and moved into value added and opportunistic investments in a limited way.

But the market downturn has changed things. "Now the problem is many of the so-called open ended funds are not open any more in Germany," Kutschera says. "In the past investors thought they didn't have to incorporate an illiquidity premium because open-ended funds provide seemingly liquid investment, but now in times of crisis they realise the asset class cannot deliver the kind of liquidity that they thought this asset class should deliver.

"This will really for the time being stop the trend to be more risky with real estate investments, to invest in funds with a higher risk profile and to diversify globally. German investors wonder what will happen to those open ended funds, when will they be open again.

"All investors, if they're thinking about investing in real estate nowadays, are focusing more on core asset classes, on income rather than capital appreciation, and they're a bit careful about investing into certain countries like US, the UK, Spain," he says. "In all countries where you have seen a bubble, and prices are falling, the question is when will prices be really attractive."

REITs, as has been widely acknowledged, have not been a great success in Germany since their launch a couple of years ago, and institutional investors have shown little interest in them.

"Normally the interesting thing with real estate is you have something that is not highly correlated with equity," Kutschera says. "When you invest in REITs you have a much higher correlation with the equity market. Some investors use them as a bridge when they want to invest in closed-ended funds at a certain point in the future, and want to have at least some exposure to real estate until they do. But REITs are not that popular in Germany so far."

Höpfner at Mercer sees some small sparks of interest in REITs: "Some of the pension funds we talk to believe that now could be the right moment to invest in REITs because you can buy stocks very cheap and you get an attractive discount compared to net asset value. So that could be an investment opportunity, but it would be a small portion."

Some institutions anticipated the market collapse and sold directly held assets at the top of the market to reallocate to indirect investments. "Many insurance companies and some of the pension funds have used good market timing in 2007 to sell out of their portfolio, achieving relatively good prices for the assets with the intention to reallocate that money to indirect real estate investment," says Thomas.

Last year investors withheld new investment until they had a clearer picture of how the market was evolving. This year, there is evidence of a cautious return to the market, says Naumann at RREEF:  "Investors are starting to come back to the market. They are mostly looking at traditional products, core assets. They are not looking for the highest possible return.

They are looking for cash flow and risk reduction. That means that they are focused mostly on core assets with high quality location, high quality assets, long-term leases and good quality tenants.

"They are looking at traditional European investment markets - the UK, France and Germany. I think we will see some interest in the US going forward throughout the year. The US is a market which has corrected and where we see now more opportunities coming up. It's the main real estate markets that people are most interested in. They are less interested in niches, and smaller markets.

"In addition to investing in core assets, the larger institutional investors are also interested in opportunistic investments through funds."

The Nordrheinische Ärzteversorgung, a regional pension fund for the medical profession, a property portfolio worth more than €1bn has what it considers a relatively high allocation to real estate at 12 to 16%. The fund has made some timely sales over the last few months, taking profits at the peak of the market.

"We came down in our range in the last 18 months," says Hermann Aukamp, the fund's chief investment officer and director of real estate. "We started selling properties at the peak of the market and sold 25% of our portfolio during this time. I think a lot of German institutions sold portfolios during this time to private equity investors from overseas, mainly from the US, mainly residential and some offices. These institutions now have deep pockets and they can look for opportunities whether in the German, UK or US markets."

The fund currently has a property portfolio worth more than €1bn, half invested directly in Germany and half indirectly in the US, Asia and Europe. It sold its indirect holdings in Prague and Warsaw early in 2008, with impeccable timing. "We saw problems emerging in these countries. It was the right decision and we made money in these markets," says Aukamp.

The fund's domestic property is 25% residential and 75% office. Most of the office investment is concentrated in prime offices in Munich, Hamburg, Dusseldorf and Berlin. It quit the Frankfurt market because of the city's dependence on the financial sector.

The fund reduced its residential portfolio with the sale three years ago of the lower quality half of the portfolio to a private equity firm. The focus now is on good quality housing and good locations, says Aukamp. "We concentrate on modern, high standard residential only, in Hamburg, Dusseldorf and Cologne at the high end.

We still try to do investment in this theme because we see it as a stable market. Of course this only works if you have specialised manpower in these sectors and you invest in good neighbourhoods."

WPV, the pension fund for accountants, has an allocation of 15%, but Hans-Wilhelm Korfmacher, the fund's managing director, does not consider this high. "We do not think that we have a high allocation to real estate. On the contrary our allocation to real estate is rather low in relation to the requirements of our ALM study," he says. The fund is considering increasing its real estate allocation in 2009/10.

The WPV fund invests solely through funds, chiefly because of risk.  "We invest in funds in order to avoid ‘concentration risks'," says Korfmacher. "We prefer funds due to diversification and efficiency as we do not intend to employ our own staff."