In the last two years the introduction of German real estate investment trusts (REITs) has dominated many of the discussions on the German real estate market. With the passing of the REIT Act in April 2007, the legal conditions for issuing German REITs have now been clarified. However, it remains to be seen how domestic and international investors will react to this new form of investment in property.

From a German institutional investors' point of view in particular it is important to look more closely at investment in REITs, especially given the increasing diversification of property investment. In the last few years, many institutional investors have started to restructure their investments in property and, despite the various approaches, there are trends noticeable that will in future influence the management of real estate investing.

A few years ago German institutional investors invested almost exclusively in the domestic market, preferring investment in individual properties to indirect investment, for example through real estate Spezialfonds. Today many investors have at least extended their real estate investment universe to wider Europe, and many are also investing in US and Asian markets. Simultaneously, investors are, within the context of this international diversification, increasingly using indirect vehicles like real estate Spezialfonds, mutual funds, REITs and other structures, which are in turn administered by external managers.

As a consequence the asset class has largely followed other investment categories such as bonds and equities, which have already undergone this process in the last 10-15 years. At the same time, real estate is now more often explicitly integrated within investors' strategic investment planning. Within the scope of this strategic asset allocation it must display a certain risk/return profile, which should realise the investors' expected diversification in the context of all financial assets as well as increasing the efficiency of the portfiolio.

The integration of property investment within the strategic asset allocation of an investor is of utmost strategic relevance and determines the required risk/return profile of the investment. Within the scope of a methodologically stringent and mathematically rigorous strategic asset allocation process, an asset/liability structure optimal to the existing profile of the investors' obligations is derived, which also provides for the return requirements and for the risk budget of the investor.

While in the past substantial experience has been gained in calculating an optimal strategic asset allocation, the integration of real estate in this allocation is, comparatively, still a young discipline. Problems often derive from insufficient data history. The qualitative demands of the optimisation process requires (statistically significant) data on the performance of individual real estate markets and market segments, information about the risk of these investment classes as well as information about the risk context, such as correlation to the other investment classes. Here, there are still large gaps regarding the differentiation of individual markets and segments - such as key figures for office, retail, residential and industrial segments - as well as in the duration of the time series available.

These deficiencies are additionally exacerbated by value calculation and reporting methodologies that often vary from market to market. Despite these deficiencies, the quality of the strategic asset allocation process does still depend decisively on the quality of the assumptions used to model real estate markets. Using a naive estimate beyond a methodically stringent derivation may lead to a certain optimisation result, but the quality of this result is only as good - in experience actually mostly as bad - as the forecast quality of the input data and frequently does not meet the requirements of a strategic allocation.

At this point of the optimisation process, all strategic questions should be answered:

❏ What should be the optimal real estate quota?

❏ How should the real estate be spread regionally and over sectors?

❏ What are the risk/return assumptions?

The open question is how to implement the desired strategy. Implementation is much more difficult with real estate than with equities and bonds where the realisation of a portfolio strategy in liquid markets does not require any special creativity. In this case, the implementation concept with the lowest market impact, and which causes the lowest cost, will usually be chosen. In particular, transition managers specialise in this task and may reposition portfolios completely within a very short period of time.

The implementation of a real estate strategy, however, demands the highest competence in completing transactions. The real estate must first be identified, then purchase negotiations have to be initiated and completed successfully in order to create the desired real estate exposure. In this context, REITs have proved to be option which is increasingly in line with investor considerations.

One central advantage of REITs is their liquidity. Investments may be implemented rapidly since the market liquidity of many REITs has increased significantly. Asset service charges like real estate transfer tax, broker costs, lawyers' fees and so on are erased completely when investing in a REIT, which consequently increases efficiency - all factors remaining equal. Liquidity, particularly when investing in more exotic real estate markets, would appear to be of great importance given that no particular expertise is required regarding the custom and practice of these markets. And investors particularly appreciate the liquidity of REITs when they intend to sell them. Of course, REITs reflect the supply/demand ratio of the respective markets, but the investor has a realistic option to sell his position at market price if he wants to.

Investing in REITs also allows investors to concentrate their portfolios precisely on their strategic target. For example, a strategy set to invest 20% in US and 5% in Japanese office real estate, 10% in US shopping centres, 15% in US industrial property and 50% in European multi-use real estate of all kind-of-use, may be mapped almost perfectly by investing in corresponding REITs. And this is possible with a modest investment budget because the diversification at the level of individual properties still takes place within a REIT. Consequently, REITs also allow a medium size investor to build a global diversified real estate exposure.

Of course, REITs also present disadvantages. The higher volatility of REITs compared to direct investments in property are a critical factor for many investors. This is particularly critical for those investors who only have a limited financial risk capacity and who correspondingly have to invest their risk budget carefully. In the context of normal market volatility it is also the rule, rather than the exception, that the valuation of REITs show a premium or a discount in comparison to the net asset value. This phenomenon, however, also occurs with every stock which is only quoted temporarily at its fair value.

The introduction of German REITs will attract plenty of institutional investors' attention in coming months. We are convinced that the suitability of REITs in general will also be discussed and that they will assume a crucial role in the portfolio construction of institutional investors. Perhaps soon the developed REITs markets will form the basis for real estate derivatives, increasing further the investment and hedging options for institutions.

Patrik Bremerich is managing partner of RMC Risk Management Consulting in Cologne

 

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