Star performer under pressure

If they are not already doing so, asset managers specialising in real estate investment should take a close look at Germany these days. Consider these two important factors:

The first is macroeconomic. Following the slump of the previous four years, Germany's economy bounced back in 2006, when GDP expanded by more than 2%. The recovery should continue in 2007, with GDP growth at around 2%. Corporate profits and stock markets are currently at record levels, while unemployment has fallen below 4m for the first time in years. All of this has translated into a positive business and investment climate.

The second and more tangible factor is the increased level of investments in international real estate by German pension funds and other institutions with billions of euros in assets. Among the pension funds, notable examples are the BVV, an €18bn pension fund for employees in the financial sector; NAEV, a €7.5bn fund for doctors; and the VBL, a €12bn scheme for public sector employees.

In BVV's case, it is relying chiefly on European funds to raise exposure to real estate from 3.3% to as much as 8% of assets. International funds are also what NAEV is employing to raise its property exposure to 15% from 13% of assets. Finally, VBL, which already has 5% of assets invested in European commercial property, bought its first Asian property fund in 2006.

According to Markus Selinger, director of real estate investments at VBL, the Asian foray is due to "higher expected returns and the fact that Asia's performance is barely correlated with that of Europe". Indeed, property experts expect the Asian market to outperform those of Europe and the US in 2007.

Beyond wanting to diversify their portfolios more efficiently, as is the case with VBL, German schemes are investing more in international real estate due to a dismal performance of their direct holdings at home. For example, BVV has cut its exposure to German real estate to just 1% of assets, while NAEV has whittled down its own allocation to 0.8%. Germany's real estate market is recovering, but far more slowly than the economy as a whole.

Add all this up and Germany looks promising for any asset manager specialising in real estate. Yet due to the peculiarities of the institutional market, that asset manager must meet another challenge to win over the likes of BVV, VBL and NAEV: design, a so-called ‘Immobilien-Spezialfonds'.

A mouthful even for Germans, Immobilien-Spezialfonds (ISFs) are property funds created for pension schemes, insurers and other institutional investors. In exchange for investing at least €25m, an ISF affords them considerable transparency, lower fees and good deal of control over the investment process.

To set up an ISF, the institutional investor can either work with external managers or pool money with others to acquire properties internationally. The pooling method for ISF is known to be especially favoured by Germany's AEWL, a €6.9bn pension fund for doctors. The method accounts for 10% of AEWL's assets. The fund also has another 10% invested directly in real estate. "There are two other reasons why Immobilien-Spezialfonds are ideal for pension funds. First, they can concentrate on their core business and don't have to go the trouble and cost of hiring experts for research, taxes and legal issues," comments Reinhard Mattern, chief executive of iii-investments, a Munich-based provider of the funds.

"Second, through a wide diversification of properties in Germany and abroad, a high degree of security is achieved. The properties are professionally managed and as a result, can generate steady decent returns, which are important to these long-term oriented investors," he adds.

The transparency advantage of ISFs was also highlighted by Till Entzian, a Frankfurt-based lawyer who authors the Kandlbinder Report, an annual survey of Germany's real estate industry. "Transparency is extremely high. Investors are often better informed about the strengths and weakness of the objects they either acquired or thinking about acquiring than those who invest directly in real estate," he says.

ISFs are not ideal for German institutional investors that report under International Accounting Standards (IAS). These can include listed banks, insurers and companies.

The reason is that accounting for German Spezialfonds of any type under IAS can be both complicated and costly. As a result, these investors have tended to prefer the mutual fund approach to real estate investing.

In view of their advantages, ISFs have done very well among German institutions since their emergence in the 1990s. According to the latest Kandlbinder Report, there are now 105 of the funds - or 10 times as many as in 1996. At the end of last September, ISF volume totalled €20.2bn, and about a quarter of that volume was from pension funds. Partly because of an expected surge in ISF investment late in the year, the survey also noted that 2006 could emerge as one of the best ever years for the funds. Indeed, inflows to ISFs totalled €2bn for the first nine months of 2006 - not far off from a record €2.9bn in 2002. Citing statistics from German fund industry association BVI, the survey found that OIK, a unit of listed German real estate firm IVG, was the market leader for ISFs, with nearly a one-third share. Second place went to Mattern's iii-investments, which has an 11% market share, followed by Hansainvest, which has 7.5%.

Since the publication of Kandlbinder's survey, DEGI, the real estate fund arm of Germany's Allianz, has made a splash by taking a 6% market share with just one new ISF. The segment's impressive growth also led US investment bank Morgan Stanley to unveil its first ISF in late 2005. Another major ISF provider is Warburg-Henderson, a joint venture between German private bank MM Warburg and Henderson Global Investors of the UK. So far, the venture has five ISFs with a value of €634bn. For other foreign asset managers though, creating an ISF might not be all that appealing. This is partly because higher fees can be achieved by selling mutual funds.

Indeed, several asset managers have been trying to win over European institutional clients with real estate fund-of-funds (REFFs). REFFs are arguably one of the best-diversified funds available, but this advantage comes at a steep price, namely two sets of fees (see IPE Real Estate January/February 2006).

REFFs have not yet had a big impact on Germany's institutional market both because of the fee issue and because the investors cherish the control they get with ISFs.

Another problem for REFFs, regardless of how good they might be, is their cannibalising effect on the market. With a volume of €74bn, open-ended real estate funds are already a big industry in Germany. While these funds are mainly targeted at retail investors, institutions, particularly those reporting under IAS, have invested in them to some extent.

As successful as ISFs have been in Germany's institutional market, they do have drawbacks. There is the already mentioned hassle for firms reporting under IAS. Another one, according to German property experts, is the limited supply of properties for the funds.

"Many providers of (ISFs) say they could grow their business more if they could find the right properties," comments Entzian. "Properties that offer good returns over the long term are getting rarer which is partly because of fast-growing demand for real estate among institutional investors." While ISF providers are trying to get around this supply problem by thinking more globally, Entzian points out that there is a downside in that they may not know these markets well enough. "This can be solved by finding a competent and reliable partner for those markets," he adds. But this is often easier said than done.

On the other hand, Henning Klöppelt, chief executive of Warburg-Henderson, denies that there is a supply problem in Europe to begin with, adding that German pension funds should consider the region as a core investment. "The main markets of UK, Germany, France, Spain, Italy and the Netherlands all are big enough and have enough liquidity to build a portfolio that is sufficiently diversified," he says. "We are convinced that pan-European commercial real estate will deliver attractive returns over the next five years, though of course the right objects have to be found."

Klöppelt also believes that while the Asian and North American markets can offer attractive returns, German pension funds should not regard them as core investments due both to currency risks and the peculiarities of those markets.

Mattern, meanwhile, feels that there are still attractive investment opportunities in Scandinavia. "For example, returns in Finland are well above other European markets. Moreover, there is a strong local economy and growing trade with Russia and other areas of the Baltic."

Still, investor demand for ISFs may suffer somewhat now that Germany has decided to legalise real estate investment trusts (REITs) from the start of 2007. Compared with ISFs and indeed any type of real estate fund, REITs - essentially listed property firms - are more liquid and offer greater tax advantages. Generally speaking, REITs also aim for higher returns than ISFs, which are more concerned with offering steady income to investors.

Regarding the advantages of German REITs, Entzian feels that the one related to tax is most compelling as it provides them with a wider choice of properties than ISFs currently have. "German REITs will replace Immobilien-Spezialfonds as the investment vehicle of choice in some, if not many cases. This is because of the tax break an owner of a property gets when he sells it to a REIT. He doesn't get the same break when he sells to other buyers (like ISFs)," he says.

To further boost their attractiveness, the German government has also decided that investments in German REITs will be seen as real estate in nature rather than equity. If German REITs had been seen as equity investments, demand may have suffered as numerous insurers and pension funds are legally barred from allocating more than 35% of holdings to the asset class (please see related story in this issue).

German pension funds have not been willing to say whether they plan on investing in REITs once they are legalised. But the schemes' reaction to news of their emergence has undoubtedly been positive - especially as they themselves can sell direct holdings in commercial property in a tax-efficient way. "In my view, German REITs hold the key to unleashing institutional investment in German real estate," says Dirk Lepelmeier, managing director of the medical scheme NAEV.Even so, those seeking to benefit from German REITs - whether investors or providers - are not getting everything they want. All residential property built before January 1 will, for example, be excluded from the listed vehicles. This means that many German institutions, including pension funds, will not get a tax break if they sell their residential property holdings. The exclusion should furthermore reduce the market capitalisation of German REITs by 10-15%. Prior to the exclusion, the market cap of the vehicles had been put at at least €50bn by 2010.

In any event, major ISF providers like iii-investments and Warburg-Henderson are not overly concerned about the competition their products may get from REITs. According to them, German REITs will speak to those investors who want more risk in exchange for higher returns, which they don't get with ISFs. "You have to remember that REITs are shares whose value is not only dependent on the underlying property but also on supply and demand as well as other economic indicators. As a result, they are far more volatile and speculative in nature than ISFs," notes Mattern.

Adds Klöppelt: "Immobilien-Spezialfonds are a very successful and established form of indirect investing. They have excellent growth prospects regardless of the existence of REITs."