Degrees of optimism

Last August, a wave of excitement swept over Germany's real estate investment industry. After nearly three years of discussing the idea, the government finally announced that it would legalise real estate investment trusts (REITs) from January 2007.

This was great news for the industry. Hopes were that the arrival of German REITs (G-REITs) would spawn a new market worth €50bn within three years and, in doing so, greatly strengthen Germany's competitiveness as a financial centre.

Yet on 23 October 2006, the finance ministry surprised the industry with this announcement: residential housing built before January 2007 was to be barred from G-REITs, reducing the vehicle's potential market capitalisation by between 14% and 19%.

The abrupt change to the G-REIT legislation was made to gain support for it among MPs from the governing Social Democratic Party (SPD). The MPs argue that if residential G-REITs are permitted, there will be negative social consequences like higher rents and condominiums that people cannot afford. The Conservative CDU/CSU, which governs with the SPD in the Berlin coalition, staunchly disagrees but has - so far - accepted the change in the interest of moving the legislation forward.

But what about Germany's real estate investment industry? Is it still as upbeat about the prospects of G-REITs as it was in the summer? Well, if a G-REIT congress that took place in Frankfurt in November is any guide, the answer is a tentative yes. Players were just pleased that a vehicle was emerging that should invigorate investment in German real estate due to its tax-privileged status, high degree of liquidity and, hopefully, decent returns.

One particularly optimistic player at the congress was Oliver Puhl, head of real estate investment banking at Morgan Stanley in Frankfurt. Puhl noted that despite the exclusion of residential property, G-REITs were on track to create a new €50bn market "in the mid-term". The reason, he said, was that while the exclusion removed €20bn in potential issuance, as much as €92bn could still be mobilised by 2010.

Almost 60% of the €92bn in potential issuance comes from what Puhl terms ‘corporates', including German companies, insurers and pension funds. "The rationale for corporates creating REITs from direct holdings (in commercial real estate) is that they can re-invest the capital employed into their core business," he told the G-REIT Congress. G-REITs should also benefit from the fact that these investors are switching from a direct approach to real estate to an indirect one to diversify their portfolios more efficiently and chase higher returns.

Regarding the remaining €37bn in potential issuance, Puhl sees it within the real estate fund sector, with €20bn mobilised from closed-end funds, €10bn from open-ended funds and €7bn from so-called Spezialfonds, vehicles which provide institutional investors tax efficiency, transparency and considerable influence over the investment process.

According to Puhl, the reasons for the conversion of real estate funds into REITs include the need for increased liquidity, more efficient asset management and a re-balancing of domestic portfolios. Indeed, several providers of the funds, including Deutsche Bank Real Estate, DekaBank and Commerzbank's CGI have already hinted that they are considering launching REITs.

Players at the congress were also encouraged by news that the G-REIT legislation does not impose overly tight restrictions on investment from insurers and pension funds.

According to Uwe Wewel, a finance ministry official who deals with the investment industry, G-REITs will not be counted toward the equity portion of the investors' portfolios but rather the real estate portion. If G-REITs had been treated as equity investments, demand may have suffered as the insurers and pension funds are legally barred from allocating more than 35% of holdings to the asset class. German regulator BaFin says the restriction is need from a risk management standpoint.

On the other hand, it seems certain that residential property built before January 2007 will be excluded from G-REITs. Leo Dautzenberg, a CDU MP who is rapporteur for the legislation in Germany's Bundestag, commented: "We will do our best during the parliamentary process to persuade the SPD to include residential housing in the draft law. But we have to be careful, as the SPD could then bring up its former grievances about REITs for tax reasons and then we would get nowhere."

The SPD formerly opposed G-REITs on the grounds that it would cause huge tax shortfalls for the public sector. In the meantime, the finance ministry has predicted that G-REITs will actually generate €1.12bn in additional revenue for the public sector by 2011. In any event, approval of the G-REIT legislation by the German parliament is not expected before early this year, meaning that the vehicles would be legalised retroactively from the start of the year (see box).

Although the G-REIT legislation may not be all what the real estate investment industry wants, players at the congress indicated that they would do their utmost to make it work. "For the sake of the industry, we have to make the best of the legislation. If G-REITs are not a success, investors will go with alternatives like synthetic REITs as they too are very tax efficient," noted Hans Volker Volckens, a Munich lawyer and expert on REITs.

As an example, Volckens cited Gafgah, a listed German real estate firm that has its base in Luxembourg and hence faces a corporate tax rate of 3-4%.

Jan Wagner is German correspondent for IPE Real Estate

n November, Germany's federal cabinet approved a draft law introducing German real estate investment trusts (G-REITs).

Like other REITs, G-REITs will not face any corporate tax but rather taxes will apply to its dividends. To qualify for this status, the draft law requires that a listed firm be based in Germany and generates its revenues from the trading and leasing of real estate.

Other requirements are that the firm has a permanent 15% free-float and that outstanding debt not exceed 60% of total assets. No one investor may, moreover, hold 10% of the firm.

When commercial property is sold to create G-REITs, the draft law also provides for a halving of the relevant tax rate. The rebate, which the German finance ministry calls an ‘exit tax', is only in effect until 2010.

Finally, the draft law bars the use of residential property for the creation of G-REITs. The exclusion only applies to properties built before 1 January 2007.

Prior to the exclusion, industry experts had predicted that G-REITs would have a market capitalisation of €50bn by 2010. US investment bank Morgan Stanley is sticking to the €50bn figure, but now says it will be reached in the ‘mid-term'