2006: A turning point in the German real estate market

Author: Hans Hofmann, Mayer Brown Rowe & Maw, Frankfurt

Germany is recovering. This is very good news. But looking back to the origins of Germany's downturn reveals how the German economic recovery relates to doing business in the real estate market. Germany's recent economic past was marked by various economic crises such as weak purchasing power, a steadily growing rate of unemployment, a high government deficit and an enormous downswing in the construction sector, to name but a few. This recent economic environment has affected the different real estate market segments. Consumer demand was low, which affected the retail market. The unwillingness of the German consumer to spend money on apartments manifested itself in low rents and generally diminished demand. At the same time, foreign investors were attracted by the very same seemingly adverse circumstances. Bold investors – mainly from the USA – seized this opportunity to acquire assets such as nonperforming loans and residential housing portfolios that they viewed as undervalued.

Times are changing and 2006 shows signs of a breakthrough. In new developments, the German real estate market shows three distinct trends. The first is privatization of state-owned real estate assets. The City of Dresden balanced its budget by selling apartments for (€1.75 billion ($2.3 billion) to Fortress. The second major trend of 2006 was corporate privatizations. Due to the large portfolio (€4.5 billion) sold by Karstadt and large sales by DaimlerChrysler and Dresdner Bank, the corporate sector became the largest group of sellers during the first half of 2006. Lastly, the newly elected government made a decision favouring the introduction of Reits on the German capital markets. The response of the market has been extremely positive. The government's plan to encourage the amortization of undisclosed reserves by transfer of corporate real property into Reits is expected to be very successful. For the first three years, only half of the gain therefrom will be taxed. In Germany, approximately 75% of corporate assets are held in the form of real property – in other western countries it is significantly less, typically closer to about 20%. This is where the Reit has considerable potential as a financial instrument, especially in the first few years. In addition, the structure of the German Reit will be comparable to those in countries such as the United States, which require a company to meet certain criteria to become a Reit. So the familiar structure of German Reits will encourage activity in the German market by foreign investors (in particular from the United States) who may have previously refrained from doing so due to the unfamiliar and more highly regulated structures of, for example, open-ended real estate funds. Another benefit of the German Reit that will appeal to investors is the fact that the European Directive regarding financial instruments will not apply. This will reduce the number of regulatory requirements that must be observed. One negative aspect of the German Reit is that most existing residential real property will not likely be eligible for a transfer into a German Reit.

Not only will the introduction of Reits have a positive effect on the German real estate market, but at the same time the German economy is once again experiencing significant expansion. Economists expect economic growth for 2007 to be between 1.5% and 2%, the job situation is expected to progressively improve and the exporting wholesale trade is also anticipating significant growth. Overall, the chances of a sustained economic recovery for the German economy and the German real estate market appear quite good. The DIFA Investment Climate Index, a measurement of the attitudes and expectations of European real estate investors, gained another seven points in 2006 with its current reading standing at 71 (source: DIFA Investitionsklima-Index). When investors were asked about the future significance of European countries, 65% were of the view that Germany has an "important role" as a site for investments. This optimistic figure was only outnumbered by 70% and 77%, respectively, for middle and Eastern Europe and Asia.

Prospects of business for the retail sector are at five-year highs (source: Handelsbericht 2006 des Deutschen Industrie- und Handelskammertags/Trade Report 2006 of the German Association of Chambers of Industry and Commerce). The ongoing surge in retail investment is expected to carry on for some time. However, the rate of purchase-price increase is expected to diminish, which will in turn lead to a stabilization of yields. Considering that market prices are still below the level of 1997, any fear of overheated markets is far fetched.

An upswing may also be expected in the flagging real estate sector for office space. The start position is good as the number of white-collar workers is expected to increase by about 4.5% by 2009. At the same time, new office space is expected to become available at a much slower rate. This is expected to remove some pressure from the supply side of the market.

A profound improvement of the economy will lead to an increased demand for residential space and, as a consequence, higher rents and prices. The largest source for the market will be the approximately 600,000 apartments held by the state which are expected to be sold.

The different strategies for taking advantage of these favourable market circumstances all come down to one basic idea: the real estate itself. The major part of the return should originate from the real estate, and any tax advantages should be no more than a positive side effect. A reasonable profit can be generated in two ways: either by making certain that the obtainable profits from the target property are higher than the investment costs or investments in the property are made which help to raise the return by increasing its market value. Such higher value can be realized by a sale of the property. While the latter strategy is better suited for short- and mid-term investments, the first strategy is the choice for mid- and long-term investments.