Open-ended real estate funds at the crossroads - heading for a European future?

9 marzo 2007

Riportiamo qui volentieri un'Analisi di Reinhard Kutscher, member of the Management Board of Union Investment Real Estate AG (formerly DIFA), sul tema dei Fondi aperti tedeschi
"The end of 2006 brought to a close a three-year period of turbulence for open-ended real estate funds, as evidenced by the changes in
investment volume. Rapid growth from EUR 50.4 billion in 2000 to EUR 85.1 billion in 2003 (+69%) was followed by a series of sharp declines to EUR 75.5 billion (-11%) by the end of 2006. Now the sector is growing again and everything could return to normal... were it not for the upcoming amendments to the German Investment Act, that is. The draft amendments were published on 18 January 2007 and contain numerous changes that relate in particular to open-ended real estate funds, based on a desire to draw lessons from the crisis. But what caused the crisis in the first place?
Without going into too much detail here, an unprecedented slump in the German commercial property markets triggered an equally unique
deterioration in performance, particularly among funds with an investment focus on Germany. A spiral of downward corrections by
valuation experts left returns barely in positive territory, leading to a surge in redemptions. The situation was further exacerbated by reports of misconduct by some companies and ongoing discussions about the need for further downward adjustments. This heady cocktail resulted in a liquidity crisis that culminated in the closure of three funds.
We already know how the story ended: The funds were able to reopen a few months later and no investors lost money. Overall, the situation has now eased. The market has also been reassured by the interest of foreign investors, who are buying properties in Germany ahead of an anticipated significant upturn. This has led to sales on a grand scale and prices that exceed expert valuations. So has the need for reforms passed?
No - because even a proven product can be improved. That is especially true with regard to liquidity management, which is a key issue for open-ended real estate funds. On the one hand, property assets are relatively illiquid, while on the other hand funds face the daily need to redeem units on demand. As a result of the liquidity crisis, the industry has learnt that many small investors with a long-term
investment horizon are better for retail funds than large investors who can withdraw hundreds of millions by way of a single redemption request.
Property investment management companies have adopted a series of voluntary measures to resolve these issues. These measures have fed into the draft amendment to the German Investment Act: new rules on maximum and minimum liquidity, options for investment management companies to introduce holding periods for large investors, more specific regulations on suspending the redemption of fund units, etc. While there is still scope for improving the efficiency of these measures, all of this is a step in the right direction.
Things look rather different with regard to another important aspect of the planned amendments to the law: investment limits. Why seek to curtail investment opportunities so drastically? The legislation would actually prevent the international portfolio diversification needed to reduce dependency on the German market.
Let me give an example: Open-ended real estate funds can currently hold up to 49 per cent of their property assets in the form of participations (with minority interests limited to 20 per cent). At first sight, this seems generous, but one needs to remember that in many countries it is only possible or sensible to acquire real estate indirectly via companies. Of the 52 countries reviewed regularly by Union Investment as potential investment targets, only five are completely suitable for direct investment. These countries include the UK and the Netherlands, in addition to Germany. In most other countries direct acquisitions are either illegal or subject to real estate transfer taxes or income taxes at prohibitive levels. Managers of funds created with an international investment remit therefore hit the 49 per cent limit very quickly, while older funds that are progressively increasing their foreign holdings come up against the same limit somewhat later.
Majority holdings are simply a legal wrapper without any additional risk compared to direct investment. It is therefore difficult to understand why the draft amendments reduce the investment limit to 25 per cent for funds defined as "security-oriented" and to 60 per cent for "yield-oriented" funds, rather than treating participations in the same way as direct investment in both fund categories. Taken to its logical conclusion, a 25 per cent limit would require the new fund categories to be renamed "Germany-oriented" and "internationally-oriented", rather than "security-oriented" and "yield-oriented", because only funds that focus primarily on domestic assets would be able to comply with this limit. And that has nothing to do with either "security" or "yield".
Irrespective of the fund categories, the amendments to the Act should open up a wider range of investment choices. That not only encourages the diversification in terms of locations, regions and usage types which is crucial for this asset class, but will also ensure that the funds are competitive in an international arena where there is already a high level of flexibility. The European option then also remains open because an EU real estate funds market is now starting to emerge, based on flexible structures governed by French law, for example. Modelled on German open-ended real estate funds, these "OPCIs" naturally have complete freedom over participations and associated optimisation strategies such as shareholder loans, security structures, etc. A White Paper produced by the European Commission has also addressed real estate funds for the first time. The prospect of a European passport for this product means that German legislation should allow a correspondingly high degree of flexibility".

Nella Foto: Reinhard Kutscher.