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Immo-AGs - a challenger to German property funds

As institutional investors are looking increasingly for cross-border real estate, suitable investment vehicles that meet their demand for liquidity and low transactional costs are sought after. Coinciding with these market forces, Germany is experiencing the beginning of a trend towards securitisation of real estate.

Germany's real estate market has experienced some hard times in recent years, as the real estate cycle, following a strong demand peak in the beginning 1990s, hit bottom. The boom of the first half of this decade, triggered by reunification and favorable tax conditions introduced to speed up economic development in the new federal states, was followed by a shock as the German economy slid into a deep recession and occupancy levels for commercial buildings fell to previously unknown lows. This is especially true for the new states, an striking example being Leipzig, where vacancy levels for prime office space reached new highs above the 30 per cent mark.

As other European real estate markets, especially in the UK and in the Netherlands, came out of recession, investors' appetite strengthened to invest abroad. Germany's open-ended real estate funds have progressively invested on an European scale, first in London and Amsterdam, and later in metropolitan Spain and France. For instance Grundbesitz Invest, a fund run by DGI based in Frankfurt followed this course. These strategic decisions are supported by comparative German yield levels for prime office space, which at present are below yields in other major European markets such as Belgium and the Netherlands. However, Germany belongs to the group of European markets coming out of recession well after the UK and the Netherlands, which should make it an interesting target for the international investor.

German markets offer the international investor three major vehicles as a means of investing his funds. Firstly, direct investment opportunities exist, with prime office yields ranging from 5 to 7% in major cities like Frankfurt, Munich, and Berlin.

Second, closed-ended property funds have played an important role to capitalise on the tax-deduction associated with real estate in Germany, especially building on the generous depreciation introduced in the New Federal States following reunification. Closed-ended funds represent basically a non-liquid investment, even though some fund originators try to organise a secondary market. Typically, an investment into a closed-ended fund binds the contracting partner for an extended period. A popular example of a closed-ended product is Leipzig Railway Station, originated by Deutsche Grundbesitz Management, which is developing the station into an exclusive shopping parade.

Thirdly, Offene Immobilienfonds (open-ended property funds) offer better liquidity, as originators are willing to redeem fund shares at any time. The performance of Offene Immobilienfonds has been mediocre as compared to stock mutual funds in the recent years, owing to the recession in Germany's real estate markets. In many cases, originators were forced to lower appraised property values. Return for Germany's Offene Immobilienfonds was 4.5% on average for a one year period and 16.2% for a three year period, according to BVI, the industry organisation that tracks the performance of German funds. Offene Immobilienfonds are undisputedly the predominant indirect investment vehicle on the German property markets today and are considered a low-risk investment.

It is perhaps little known that Offene Immobilienfonds do not only hold properties, but also have a considerable percentage of their portfolio invested in fixed-income securities to a larger and in stocks to a smaller amount.

Their total return is thus not only dependent on the performance of their real estate holdings.

Most notably, unlike in many other European countries and in contrast to the US, German real estate investments have been predominantly induced by tax legislation. Oversupply of office space in the New Federal States has been caused by investors who focused much more on tax savings rather than on the properties fundamentals. However, today there is almost no controversy in Germany's real estate industry that future investment strategies will have to focus predominantly on the performance and risk/return-characteristics of the property. Tax incentives, unlike in the past, will play a minor role in guiding the decision making process of investors. This should open up oportunities for securitised real estate.

Immobilien-Aktiengesellschaften

In the past, Immobilien-Aktiengesellschaften (here abbreviated Immo-AG, ie public quoted property companies) have not been an indirect investment vehicle of major importance in Germany until now. The origins of Immo-AGs in Germany are companies that traditionally held a lot of property, for instance breweries, textile producers, and the mining industry. Portfolio management could best be described as passively holding properties, whereas actively managing the portfolio was not an issue until recently. This is not surprising: real estate had not been the core business for most companies. Adding to that, German companies in general considered real estate as a means of building up hidden reserves with favorable taxation effects, performance pe se not being a major issue.

The markets sentiment suggests a fundamental change in Germany's approach to public real estate. The boom of REITs in the US and the wider choice of publicly quoted property companies in the UK are seen as accomplishments, a field where the German market has to catch up. As the shareholder value approach finds more support in continental Europe, German companies begin to reorganise their real estate departments into profit centres. Properties are being outsourced into independent property management companies and management is trying to maximise return from real estate. Bringing properties into a public company is one way of following this strategic approach. Moreover, higher liquidity, low transactional costs, and superior performance should pull investors on to the securitisation track.

How well have Immo-AGs fared so far? Bankhaus Ellwanger & Geiger has developed an index that tracks the performance of Immo-AGs in Germany. The index, named E&G-DIMAX, claims to be the first comprehensive index for this particular segment of the German stock market. Unfortunately, in the last years, E&G-DIMAX underperformed the general German stock index DAX, as real estate markets still suffered from the deep recession in the 1990s, the German stock market surging at the same time. However, volatility for real estate stocks was lower. Bankhaus Ellwanger & Geiger also recently introduced an index for European public quoted property companies named EPIX which takes into account the European momentum of securitisation. The index only covers European companies of which a significant percentage of earnings stem from real estate.

New-style real-estate investing

For the individual shareholder contemplating a buy decision with his broker, the liquidity, fungibility, and distribution of many Immo-AGs shares still is not enough to risk unlimited orders, as the free float of some companies is even beyond the 10% mark. However, in the long run, total market capitalisation should expand rapidly, as it has been the trend with US-REITs. It is not easy to assess total market capitalisation of the securitised sector, given the fact that most Immo-AGs have several divisions, the real estate actitivies only representing a fraction of total business volume.

The points supporting securitisation are numerous: close monitoring of performance through capital markets and investigative stockholders, companies providing information through investor relations for the international investor, high liquidity, and low transactional costs. When holding a fungible Immo-AG there should always be the chance for an exit strategy if the market sentiment turns against the property asset class or against the particular stock. Additionally, there are Immo-AGs that hold large portfolios of residential property, an asset type, that Offene Immobilienfonds usually do not touch. So Immo-AG provides for liquid residential investment opportunities as well, which has proved to be an interesting diversifier.

Given the advantages, why is Germany still waiting for a large-scale breakthrough of Immo-AG? Tax is probably the main factor hindering a rapid market development at present. Whereas Offene Immobilienfonds are Kapitalanlagegesellschaften (German investment trusts), thus being exempt not only from corporate income tax, but also from municipal trade tax as well as capital levy, the Immo-AG is burdened by corporate income tax when selling its property. The legal framework for German property companies taken public is quite different from the US, where REITs which pass the 95% income test and meet additional requirements are not taxed at the corporate level.

However, comparing Immo-AG with tax-favored Offene Immobilienfonds is a far-fetched endeavour. It should not be ignored that the two investment options differ significantly in risk, meaning that the variance of returns for Offene Immobilienfonds is lower than for Immo-AGs, and so is the return potential for Offene Immobilienfonds as well. All in all, Germany's high transactional costs for direct ownership benefit exchange by shares, and so will most likely do the pending tax legislation on real estate.

Germany's Immo-AGs company names are little known even within Germany. Probably one of the most innovative players in this young field of modern securitised German real estate is IVG in Bonn. The company has announced that its holding period for properties is expected to be less than 10 years, almost a revolutionary approach within the traditional German framework of property management. IVG is adding European property to its portfolio, and for this purpose has bought a majority stake in H Stodiek & Co of Bielefeld. And it does not stand alone. For instance, Rinteln-Stadthagener Eisenbahn AG acquired the Luxembourg Airport Center in 1996 and is expanding its European portfolio as well. Deutsche Beamtenvorsorge of Munich is also targeting shareholders in this young market, with real estate valued at approximately DM800m as of De-cember 31, 1997.

So the market is still small, but it is likely to grow fast. One factor: there is no shortage of expertise when it comes to securitised real estate in Germany. For instance, Deutsche Grund-besitz in Frankfurt, building on close ties to US-Reit Cornerstone Properties, just recently came to market with REIT-Fund PRIMUS". This REIT-Fund has an innovative closed-ended structure which offers the investor tax incentives, demonstrates that know-how for securitised real estate is abundant in Germany's real estate profession. But the legal framework still isn't perfect. Moreover, fungibility and market capitalisation of most shares is unsatisfactory so far. That means it will need time for Immo-AG to evolve into a much more significant segment of the real estate investment market. But it is not a question if there will be a breakthrough for Germany's Immo AGs - but only when.

Bernhard Funk is responsible for European marketing at Deutsche Bank subsidiary Frankfurter Hypothekenbank Centralboden AG in Frankfurt/ Main, due to be renamed EUROHYPO. He is co-editor of an upcoming book on securitized real estate in Germany."

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