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REITS ON THE RHINE

Germany’s government seeks a trust structure for real estate investors

BY DONNA MITCHELL

Hoping to rev up a relatively staid property market and make Germany attractive for foreign investors, the German government is pushing to create a REIT structure.

The Finance Ministry announced its support of the idea in January. Two months later, government officials were working on a paper outlining how the companies would be structured and governed. At press time the government was expecting to issue a first proposal in April for legislation to be drawn up by next January.

German firms are in favor too. “The competitive situation [of German companies] on the international market could be much better,” said Hubert Bonn, head of investor relations at Deutsche Wohnen, a Frankfurt-based residential property investment firm.

The U.S. REIT system, created in 1960, pays out at least 90 percent of its taxable income to shareholders and therefore owes no corporate tax. REITs add stability and diversity to individual investment portfolios, and they have also expanded the U.S. property market by infusing liquidity into the system. Such a structure would benefit Germany, professionals say, because it would create excitement and liquidity for what many see as an undervalued real estate market. It would also bring in a lot more tax revenues and, the government hopes, play a part in making Germany the most sophisticated and competitive financial services center in Europe, says Martin Allen, Morgan Stanley’s senior REIT analyst in London.

The German property market could use a little shaking up, sources say. In March German real estate stocks had a projected double net asset value of -9 percent, versus an overall European average of 6 percent, says a report by Amsterdam, Netherlands-based equity research firm Kempen & Co. (Double net asset value is based on a company’s net operating income minus debt and deductions for deferred tax liabilities.)

Roughly 200 German corporations own an aggregate €60 billion ($77 billion) worth of property, says Kempen. And some German retailers own properties that could be sold to REITs. KarstadtQuelle is among these. The Essen-based department store company, one of Europe’s largest retailers, ran into trouble when it tried to operate a retail warehouse concept. It is now trying to dispose of those assets. Another retail holding company, Metro Group, of Düsseldorf, holds 2,445 stores, totaling some 11.8 million square feet. If there were a REIT structure in place, Metro would have a market for these holdings; it could cash them in and invest the money in its retail operations, sources say.

“Germany might become one of the largest listed property markets in Europe,” says the Kempen report. The German property market is popular with individual and institutional domestic investors, who appreciate the stability long-term real estate investments offer. But a REIT structure would encourage them to trade more actively for shorter-term gains.

“Up to now, real estate has been a tax-saving model for most people,” said Patrick Kiss, head of investor relations at Deutsche EuroShop, a Frankfurt-based shopping center development and investment firm. Private and institutional investors buy and hold the properties mainly for the tax deductions from depreciation. “If REITs were introduced,” Kiss said, “there would be more transactions.”

Domestic open- and closed-end funds, for instance, with a combined market capitalization of about €115 billion, are candidates for REIT status, says Kempen. (Closed-end funds operate with a limited number of shares; open-end funds can issue additional shares.) This dwarfs the market capitalization of the publicly traded property companies. Deutsche EuroShop, Deutsche Wohnen, office specialist IVG Immobilien and residential and commercial property owner Hamborner together make up most of the publicly listed sector but have a combined market cap of only about €4 billion, says Kempen.

Already, talk of a REIT structure is injecting liquidity into German property stocks, especially those considering REIT status, such as Deutsche EuroShop. Since Finance Minister Barbara Hendricks voiced support for REITs in mid-January, U.S. investors have bought about 4 percent of Deutsche EuroShop. The stock rose from €38 to €42, says Kiss. In anticipation of REIT legislation, Kempen raised its price target on all four public companies.

Broad support notwithstanding, the German government will first have to simplify the country’s complex tax structure if the industry is to reach its potential, observers say. German companies pay a corporate tax of 35 percent. Investors have to pay a purchase tax of 3.5 percent on the properties they buy. And there is also a speculation tax, under certain circumstances, for selling a property within 10 years of purchase, says Kiss.

And yet the annual property tax rate is next to nil, says Allen. “The German government is potentially sitting on a gold mine of tax receipts. They are actually not getting very much at all from some of these companies who are deciding they’d rather not sell.”

But well-capitalized REITs with access to mounds of cash from the stock market could tempt these companies to sell their properties, says Kiss. “Daimler Chrysler could sell its property to concentrate on building cars,” Kiss said. If corporations do sell their properties to REITs, that could raise the value of the German property market to about €100 billion by 2010, from the current €4 billion, says Kempen.

Companies opting for REIT status could pay a one-time tax of about 15 percent for conversion and be free of corporate taxes from then on, says Kempen.

All well and good for the future, but the industry first has to decide how the REITs should operate, sources say. Private and government officials are trying to figure out whether REITs should operate like investment funds or corporations.

Those who favor a corporate structure say that German REITs need to be distinguishable from open- and closed-end funds and that the corporate structure requires a level of transparency long lacking from the country’s investment fund market. More important, if Germany intends to put its property market on equal footing with other major economies that have REITs, it needs to follow the widely used corporate structure.

German open-end funds already share some similarities with REITs. Like REITs, open-end funds pay out their earnings to investors and are exempt from corporate taxes, says Kiss. Corporate REITs would distinguish themselves from open-ends by following corporate law and international accounting standards and by subjection to the “withering scrutiny of Anglo-Saxon equity investors,” said Allen.

And international investors would be more familiar with a corporate REIT structure anyhow. The U.S. and Australia have such structures, and of the four existing REIT markets in Europe — Belgium, France, Italy and the Netherlands — only Italy uses the fund structure.

Under the current open-end fund structure, the managers determine share prices and guarantee that they match the fund’s net asset value, says Max Berkelder, an equity analyst at Kempen. But on the broader stock market, the open market determines prices, with no guarantees that they reflect a net asset value.

“It would be a catastrophe if German REITs adopted the fund structure,” said Bonn. “That structure is not competitive with the international capital markets.”

Germany is not alone in aiming to implement a REIT framework by early next year. Britain is pushing to have one in place by this spring. But the German case seems too ambitious to some. “My gut reaction is, that is a very fast time frame for the German authorities to move,” said Clive Bull, vice president of real estate structured finance at JPMorgan Partners. “It is not the fastest-moving government in Europe, and it is a big change.”