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Western EuropeMarch 6 2006

Property woes and wins

German open-ended property funds are in crisis, yet Anglo-Saxon players are doing well in the country’s real estate investment market. Jan Wagner reports.
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The opening line of the Charles Dickens’ novel A Tale of Two Cities, “It was the best of times, it was the worst of times”, aptly describes the state of Germany’s property investment market. Times could not be worse for German banks active in that market. Open-ended property funds – the banks’ premier real estate product with €88bn in total assets – are in crisis for the first time since their launch in 1959.

In December, Deutsche Bank’s DB Real Estate took the unprecedented step of closing its €6.1bn German fund temporarily following a wave of panic-selling by the fund’s investors. In 2004, market leader DekaBank was forced to restructure its €5bn German fund after investors withdrew €2.4bn out from it. The events have badly shaken the public’s confidence in the asset class, reflected in the €3bn in investor outflows in December.

Compounding the banks’ woes, a recovery in the commercial property market, where open-ended funds mostly invest, has yet to fully materialise after four years of difficulty. Vacancy rates in commercial buildings have rarely been so high.

A different story

On the other hand, times could not be better for Anglo-Saxon investors dealing in German real estate. Hardly a day goes by without the financial press reporting on the latest big property deal. The two houses making the news most often are New York-based Fortress and Terra Firma, the company founded by UK private equity mogul Guy Hands.

As commercial property is largely the domain of German open-ended funds, Fortress and Terra Firma have been finding opportunities elsewhere, notably in residential housing. In July 2004, Fortress bought GAGFAH, an owner of 82,000 flats nationwide, for €3.5bn. Last May, in one of the biggest property deals ever, Terra Firma paid €7bn to acquire the housing portfolio of energy giant E.ON.

The investors have also done big deals in commercial property. Most notable are Terra Firma’s €1.1bn acquisition of motorway service station operator Tank & Rast in 2004 and Fortress’ €2bn acquisition of buildings owned by Dresdner Bank in December. Now, amid signs that the commercial property market is slowly recovering, industry experts expect the investors to increasingly challenge the beleaguered funds on their own terrain.

So why are the likes of Terra Firma and Fortress accomplishing so much in Germany’s property investment market, while local banks are languishing? Industry experts say the answer is simply that the Anglo-Saxons are enterprising while the German houses, partly due to their difficult circumstances, are less so.

Opportunistic strategy

The Anglo-Saxons have not only sought out missed opportunities – for example, in residential housing – but also entered the market at a time when the stagnant economy pushed valuations to record lows. As classic short-term investors, their hope is that German property prices will recover soon so that they can sell their portfolios at a profit. Robert Kauffman, head of Fortress’ business in Europe, has signalled that his firm may float its German residential portfolio on the stock exchange this year.

Banking experts say that this opportunistic strategy of German property investment should bear fruit. “Lone Star and Cerebus [other Anglo-Saxon investors] already set a precedent a few years ago when they bought non-performing loans from big German banks for a song and then securitised them at a big profit,” says Konrad Becker, an expert at Munich private bank Merck Finck & Co. “I’m sure that the likes of Fortress and Terra Firma are just as competent in what they do as the other Anglo-Saxon investors in Germany.”

Terra Firma has already demonstrated that competence in the UK. It bought a property portfolio from the UK ministry of defence in the late 1990s and has since refurbished the housing and sold 10,000 units.

Fund constraints

German banks have not been able to take the same approach, partly because of the constraints of open-ended real estate funds. The funds had always invested heavily in the commercial sector because returns there were traditionally stable and better (in the upper single-digits) than in the residential sector. Until 2001, when the German economy entered a prolonged period of weakness, the strategy worked.

Bärbel Schomberg, chief executive of DEGI, a fund provider owned by bancassurance giant Allianz-Dresdner, says: “The open real-estate fund was created with the private, not the institutional investor in mind. Unlike what the foreign houses are doing, our funds do not have an opportunistic business model. We seek to deliver stable returns over a long period and our track record shows that the best way to do that is to invest in commercial property.”

Capacity problems

However, Oliver Mihm, chief executive of Investors Marketing, a Frankfurt management consultancy that focuses on the real estate and financial industry, notes that the funds are hindered less by philosophy and more by capacity. “The funds are already so over-invested in domestic commercial property that there is little room left for anything else,” he says.

“The problem has been aggravated by the fact that in many cases, German providers have burned their fingers and simply are unwilling to take on more risk. Fast-moving Anglo-Saxon investors exploited this situation,” he says.

German banks offering open-ended real estate funds cannot blame circumstances for all of their current troubles. On the contrary, they enjoyed a boom between 2001 and 2004, when open-ended funds investing in Germany and beyond achieved a near-doubling of their assets to €88bn.

Despite what Ms Schomberg says, a large part of the funds’ inflows came from institutional investors, particularly other German banks such as Sparkassen or state-owned savings banks, and co-operatives. Amid bearish equity markets and low interest rates, these investors were looking for an alternative that was safe and paid more than bonds.

Paying for mistakes

In the past two years though, many of these investors have abandoned the funds because returns dropped to about 2%, lower than some bond yields. In the case of DekaBank and DB Real Estate, the investor flight was also a result of a bribery investigation involving fund managers.

Valuation has been another issue. DB Real Estate’s fund suffered panic withdrawals last December, which led to its freezing, when it became clear that the properties were overvalued on its books. Now Deutsche Bank faces lawsuits from some of the fund’s investors. Following criticism from politicians, shareholder interest groups and other industry players, it has set aside €200m to compensate investors for any losses related to the closure.

Some real estate brokers, such as Jones Lang LaSalle and CB Richard Ellis, claim that the crisis in German open-ended funds is a result of problems with the valuation of real estate. One criticism often made is that the valuation methodology that surveyors use is geared more toward long-term achievable rents rather than the market rents. This could cause discrepancies of up to 50% in valuations.

Ms Schomberg of DEGI dismisses this view, telling The Banker: “The accuracy of the valuations is precisely why returns on the funds have dropped.”

New rules

Providers of German open-ended property funds have tried to improve their fortunes by diversifying the funds more out of Germany. German fund industry association BVI has come up with new rules aimed at reining-in the panic selling in the funds. Chief among the rules, which Ms Schomberg was instrumental in drafting, is a requirement that investors allocating more than €1m must disclose who they are to the fund provider and hold on to their fund shares for 12 months.

Although the situation is bad for German open-ended funds, experts say that the success of the approach that Terra Firma and Fortress take to German real estate is by no means guaranteed. “Their success depends largely on the [future] flotations of their portfolios on the stock exchange,” says Mr Mihm. “I don’t know what specifically these firms are doing with the property they’re buying, but the story that they will be selling to the market is the potential for higher returns with that property.”

Mr Becker says that one of the reasons why open-ended funds have shunned residential property is the legal difficulty of raising rents. A bigger worry for highly leveraged investors like Terra Firma and Fortress, says Mr Becker, is the possibility that interest rate hikes will spoil their business model. “These investors are under pressure to generate big returns quickly with real estate so they can still come out well ahead if interest rates continue to rise as they have been doing.”

Considering that such investors usually aim for double-digit returns, that is a big challenge indeed.

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