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Ever since the banks started having more restrictive bank lending policies to fund real estate investments, real estate companies have had to come up with alternatives. The stock market is just one of several possibilities.

Structured funding is made up of senior and junior loan components, Mezzanine capital and equity. The latter, within the framework of share funding, is provided through, for example, funds (private equity) or through stocks from the stock market (public equity).


Photo: Restrictive bank lending is forcing real estate companies to resort to private equity. An IPO is just one of many possibilities.

Loan rationing causing a change of heart
For companies, debt financing was the preferred and generally the typical form of real estate financing in Germany for decades. Banks were willing to take high risks for low interest rates, so that borrowed capital would be available in sufficient scope and at good terms. Potential risks for the banks were not adequately considered, at least from today’s perspective. On the other hand, companies— for optimisation reasons (leverage effect)—were not interested in a high equity ratio, because borrowed capital also gave them a tax advantage.

The banks also financed projects that would have required a clearly higher share of private equity from a return-risk perspective. The consequences of this are well known: the financing risks became ever larger, and that—measured by their default probability—non-risk-adequate pricing led to an increase in non-performing loans. The banks were forced to change their lending terms, make billion-Dollar adjustments in their balance sheets, and decrease new business activities.

In the meantime, banks have taken on the Anglo-American standard as well as the Basel II rules, valid as of January 1, 2007, and now work with return-risk-oriented interest rates and margins. Thus, borrowed capital has become more expensive for high-risk projects, and/or projects carrying too much risk are no longer financed through banks.

The consequence is a limited issuance of credit volume, or in other words, loan rationing has been initiated. As a result, market efficiencies and market liquidity increased; however, loan rationing causes equity gaps that are widened even more through an increasing project volume, which promises higher profit margins but also increases the demand for more private equity. The latter aspect is more important according to popular opinion. With a higher project volume, private equity is by definition insufficient, and thus, a financing gap inevitably develops, which can only be filled through high interest rate Real Estate Private Equity (REPE).

Real Estate Private Equity (REPE) is equity capital that external investors provide for a high interest rate for real estate investments. The high interest rate requires a short to midterm sale at least in some areas. On the other hand, the private equity part must be kept as low as possible. Only then can the used resources be optimally leveraged, and thus, a high interest rate (IRR) for the investors achieved.

For short and mid-term REPE: Opportunity Funds
Opportunity funds represent the dominating form of REPE in the true sense of the term. They identify undiscovered value creation potentials, purchase suitable real estate or companies—if these find themselves in a difficult situation—with a high share of borrowed capital, and then work on solving their problems. The required capital is acquired through funds (blind pools) outside of the stock market. Fund vehicles are chosen that are not subject to the Investment Act (InvG) or the Banking Act (KWG), and are mostly constituted as a GmbH and Co. KG with a GmbH as a general partner, and the investors are set up as limited partners or alternatively as a KG (limited partnership). The business model is based on a higher value creation than typical real estate products, but also has a risk that should not be underestimated.

Photo Real estate stocks show good performance. Still, investors seldom use this asset class. If the stock markets boom, other industries seem more promising; when the stocks are down, investors avoid real estate stocks too.

Oriented long-term: closed-end real estate funds
Private equity for targeted investments in individual properties is collected through closed real estate funds. Fund properties (mostly core +) and agreements are known to the investors at the time of subscription, and thoroughly described in the issue prospectus. The funds are closed after full placement. Selling fund shares is principally possible at any time; the fungability is limited, since there is no functioning second market. An ongoing appraisal does not take place. A closed fund deals with a long-term, real participation outside of the stock market, which has been able to assert itself despite some past turbulence. Particularly international products are being increasingly offered and willingly taken in the market.

Open real estate funds as an outsider?
After the stock market decline, investors invested more in open real estate funds. An open real estate fund is a legally dependent real estate special asset, and is managed by an investment trust (KAG) separately from its own assets.

Billions of Dollars were shipped to so-called safe harbours over the past years. Ever since the flow of capital started to slow down, and nervous investors started pulling out their funds, the market has been quite disillusioned. The slogan “A piece of office building for 50 Euros: solid returns, long-term value increases” no longer seems credible. The negative consequences are known. The outflow of funds of the 23 open real estate funds in Germany amount to 8.2 billion Euros in the first half of 2006 and investment volume has shrunk to 74.2 billion Euros. Still, the openended real estate fund has not yet become outdated; in fact, it will more likely be enhanced by REITs in the future. As opposed to REITs and opportunity funds, open-ended funds prefer fund investments in management and lowrisk real estate.

G-REIT—a victim of German politics?
The real estate industry is putting its hopes in the G-REIT (Germany Real Estate Investment Trust). The particular appeal of this special publicly traded stock company, which is subject to strict capital market controls, is its tax privileges. Regular disbursements of at least 90 percent of the returns are required. Internationally, the REIT is treated as an asset class on its own. In Germany, the government still has not made a decision on the introduction of the REIT—a competitive advantage for Great Britain, where the UK-REIT is meanwhile regulated by law, and there are discussions of awarding non-stock-noted real estate companies the REIT status and, thus, tax advantages. Even if the G-REIT comes in 2007, it is only partially suitable to small and mid-sized real estate companies because of its high capitalisation standards. A stock-noted G-REIT must possess at least five million Euros. More flexibility would be recommended here.

Real estate stock companies with good performance
Existing real estate stock companies are often neglected in the REIT discussion. The real estate stock has traditionally had a tough time in Germany. During a stock-market high, industries such as media, telecommunications or the internet boast gigantic returns and value increases—no one wastes time looking at real estate stock. If the stock market is down, investors avoid the stock itself as an investment possibility, even if it is real estate stock. Thus, this is seldom the investment vehicle of choice.

Still, there is potential. Real estate makes up two-thirds of the total assets of German companies—it is less than one-third in the USA. A part of this real estate can be shifted to real estate stock companies. The fact that this type of company certainly is successful can be seen by a few figures: the market capitalisation of the real estate stock companies that are listed on the real estate stock index E&G DIMAX, amounted to 11.1 billion Euros as of June 30, 2006. This indicates a value increase of roughly 20 percent since the beginning of the year. The DIMAX amounts to around two-thirds of the traded real estate stocks.

However, a look at the statistics reveals a high concentration on only a few values: ten companies make up roughly 75 percent of the market value.


Source: Ellwanger & Geiger Onvista; Date: 30 June 2006

June 30, 2006. This indicates a value increase of roughly 20 percent since the beginning of the year. The DIMAX amounts to around two-thirds of the traded real estate stocks. However, a look at the statistics reveals a high concentration on only a few values: ten companies make up roughly 75 percent of the market value.

A problem with real estate stock companies was their low free float, the share of stock that was not in possession, but rather is—at least in principal—freely tradable. Luckily, the free float of real estate stock companies has increased over the last ten years. Thus, over 75 percent of IVG stocks are in free float, while, even with blue chip companies, like BMW or SAP, half of the stocks are not traded. The top ten real estate stock companies measured against market capitalisation have meanwhile increased their free float to over 50 percent. With the rest of the DIMAX quotation, this value averages 30 percent, and thus, still has some potential.

Initial Public Offering as an alternative to REIT
Particularly for mid-sized companies, the classical initial public offering is the more pragmatic solution than waiting for the REIT. After all, open market and entry standard offer interesting conditions. Transparency and disclosure requirements allow the company a cost-efficient capital market access. A publicly traded stock company is advantageous when the stocks are traded with the lowest possible spread (the span between bid and selling rate). Particularly, institutional investors are increasingly discovering the advantages of real estate stock. Not only do established market players profit from them, but also newcomers.

Private placements and IPOs (Initial Public Offering, the initial placement of a stock on the stock market) of the mid-sized real estate companies were in part clearly oversubscribed over the past years. Fortress, for example, wants to profit from this development by putting 40 percent of its German residential holdings (Gagfah, Nileg, WOBA Dresden) on the stock market. This way, the company hopes to pull in roughly 1.3 to 1.5 billion Euros. However, interest rate fears are slowly clouding up the stock market. Some IPOs have been, thus, already postponed or even cancelled. Time will tell how interest rates and general stock levels will develop on the stock market over the next few months.

Considering all of these examples, there are more alternatives to financing real estate companies today than ever before. In order to leverage these possibilities, the new vehicles must be handled with an open mind and professionally. Only when the new vehicles complement and enhance the traditional ways can new market potentials be leveraged.

The process of banks loaning capital cannot be made more efficient, therefore, investors must find new ways of funding. There is no single answer as to whether it is better for a company to acquire the necessary capital for its success through the stock market or by other means; it depends on each case. However, one thing is certain: the changing financing conditions are contributing to the increase in professionalism, transparency and market efficiency in the real estate industry.

The Topic at EXPO REAL 2006
Monday, 23 October 2006
INVESTMENT LOCATIONS FORUM
Hall C3
3.00 pm – 3.50 pm

REITs in Germany– Expectations and the status quo

For detailed information click here.

By Dieter Rebitzer
Dr. Dieter Rebitzer is Professor for Financing and Investment in the Department of Real Estate at the Nürtingen University for Business and Environment (HfWU).