German stress points

Germany represents a curious investment proposition right now. On the one hand, it is in the midst of a supposed growth phase in terms of GDP and rental growth. On the other hand, a wave of distress could be about to arrive – not necessarily before the end of the year, but likely in a year's time.

Both of these factors – rental growth and distress – are whetting the appetite of some private equity real estate firms and equity dominant players. However, out of the two themes, it is the potential for distress that is the newer talking point.

Debt crunch
According to those with direct knowledge of the market, office properties are the most over-leveraged of the asset classes in Germany. A legion of foreign investors, not least from the UK, marched on the country over recent years attracted to its growth phase and cheap prices relative to other western markets. They were busy buying up offices at yields of four to five percent while leveraging at 85 percent of the value and above.

“It has been a disappointing market for those investors that bought in the past. [But] there will probably be opportunities arising out of that for us to purchase attractive investments.”

Those with perspective on the flurry of investment say many of these loans have been structured so that the borrower does not have to worry about paying interest on sums advanced for one or two years. They have one and two-year “reserve accounts” put into place (accounts arranged by the lender funded out of the loan to service interest rate payments). But the problem is that some of the rental incomes from investments are not convincingly covering the interest payments. When the interest reserves run out, the lender could be left exposed because its borrower may not be able to service the debt. This is why, according to people familiar with the matter, banks are putting pressure on borrowers to inject more equity into their investments.

For the less well-capitalized investors, this is clearly a problem. But it is a problem even if the borrower is able to inject more equity because he may be left feeling uneasy that he is throwing good money after bad. The general fear is that German rental growth may simply not be as strong as investors had hoped for.

Edward Bates, a principal at Doughty Hanson, says the growth in rental prices projected over the past several years had not materialized. “It has been a disappointing market for those investors that bought in the past. [But] there will probably be opportunities arising out of that for us to purchase attractive investments.” He also points out that investors hoping to exit their investments via the new REIT market in Germany would also be facing challenges because the market has failed to take off.

Nic Fox, head of Middle Europe at Europa Capital Partners, explains that investors who entered and exited the market nine months ago “probably did very well on the macro play” without necessarily doing anything “smart” with asset management. However, he adds, that there are still plenty of problems facing the market because of the changing shift in perception and valuations. “We are beginning to see a little bit of distress, particularly related to debt coverage problems. The remainder of the foreign money that went in over the last two years and that now wants out may lead to some fire sales particularly where a lot of leverage was used.” Those investors may not have the infrastructure to manage the property because they believed they would have exited by now, he adds.

Back to the future
But if the story about investors wading into German real estate and then facing the prospect of distress sounds familiar, it's because it has happened before. In fact, recent history is repeating itself because you only have to turn the clock back seven years to find distress in Germany.

In 2001, Germany was meant to be next on the list of European countries set for economic recovery following in the footsteps of the UK and France. Just as in the UK and France, “capital allocation players” piled in. And there were understandable reasons for doing so. Ever since the Berlin Wall came down in 1987 there has been widespread optimism that Germany would finally become a place to invest in real estate.

By the year 2000, GDP figures encouraged that optimism. The economy shifted from two to three percent and growth had started to trickle down to real estate fundamentals. In the main markets – Berlin, Cologne, Dusseldorf, Frankfurt, Hamburg, Leipzig, Munich and Stuttgart – vacancy levels had fallen from five million square feet in 1997 to below four million in 2000.

However, as it turned out, 2001 was the end of the recovery, not the beginning. Structural difficulties, the technology bubble burst, 9/11, all culminated in sending the country into recession. The poster boy of foreign capital, Goldman Sachs' Whitehall Funds, suffered badly, famously acquiring the Top Tegel business park – measuring 807,000 square feet near Berlin airport – in the mistaken belief that the main tenant, Deutsche Telekom, would renew its lease. Deutsche Telekom didn't renew and the keys were handed back to lender Eurohypo. But it wasn't just Goldman Sachs. Many more investors got their timing wrong.

Those big investors (and indeed smaller ones) that went into Germany from 2004 onwards may also have got their timing wrong – or least failed to time their investments to perfection. Taking advantage of cheap debt and tax advantages, highlyleveraged funds were able to blow away the competition in auctions for sizeable portfolios and large single assets. Today, those winners are not breaching any contractual lending terms so the banks are not forcing sales. But, there is tension among lenders and borrowers arising from a feeling that things in the near future are going to get uncomfortable.

Turning the tables
Rainer Thaler, managing director in Germany at GE Real Estate, recognizes that his firm was one of those to miss out on transactions in the past year. Senior figures at GE, including himself, sat down at the beginning of 2007 to formulate an annual investment target in the country. However, the investment target (which GE keeps private) has not been met because the conglomerate was bidding “realistically.”

The tables might well be turned in favor of GE and other equity rich investors in the coming months. “We think there will be a lot of opportunities coming back,” says Thaler. He highlights two main reasons why investors will have to sell: One is to execute reasonable returns, the other – perhaps more importantly – because they acquired assets with short-term financing. Thaler thinks banks will sign a new finance contract, but not on the same terms as before given the tightening of the credit markets. “The banks will say, ‘We are very happy to sign the debt financing contract, but we have to ask you to put more equity on the table or we have to increase our margin.’”

“We are beginning to see a little bit of distress, particularly related to debt coverage problems. The remainder of the foreign money that went in over the last two years and that now wants out may lead to some fire sales particularly where a lot of leverage was used.”

He thinks that if the two scenarios are put to fund investors – refinance on less attractive terms or sell the asset – the answer to fund sponsors will be sell because the investment is unable to reach the targeted return.

At the moment, Thaler is not seeing product from the type of investors he describes. In the last quarter, transaction volumes have been driven by fresh and new assets for sale, not those bought in 2007. The big transactions signed in the last quarter include the €4.5 billion ($7 billion) sale of Arcandor's 49 percent interest in German department stores to a consortium including RREEF and Pirelli Real Estate. “New products are coming from some companies looking for sale and leaseback structures, or from closed-ended funds. But there has been no wave coming from opportunistic funds.” But his prediction is that opportunity funds will begin to sell from the second half of the year as first-year investment results fall due and following discussions with lenders.

This means that German real estate may witness sizeable sales volume in the second half of the year and into 2009, but not necessarily in the form of uber-large portfolios. Clearly, to sell the same portfolio would alert potential buyers to a degree of distress. If they have time, they will probably opt for sales asset-by-asset in order to achieve higher prices, suggests Thaler. After all, the days of buyers willing and able to pay premiums for portfolios are over.

Rainer Nonnengaesser, co-head of northern Europe at Axa Real Estate Investment Managers (AXA REIM), says his firm saw competition from leveraged investors in the first half of 2007. But now they have all but disappeared giving way to mainly equity-based investors. “If you go to pitches nowadays, you primarily find German funds, German investors or core European investors,” he says.

Four perspectives on German real estateA snapshot of views and approaches from four different real estate firms operating in Germany