Open-ended trouble

Germany's most successful real estate investment vehicle, the openended real estate fund, is in deep crisis. Private equity investors stand to benefit—at least for now. By Philip Borel

Millions of Germans are deeply worried about their exposure to real estate. That's not because they overpaid for fancy homes. (It couldn't be: the majority still rent rather than own the properties they live in.) But a key pillar of their retirement planning has been shaken to the core by the crisis engulfing the country's €85 billion ($101 billion) open-ended property fund industry.

According to data published by the BVI, an industry association, more than €3 billion of capital was withdrawn from the sector in December alone, and market insiders believe that in January the trend continued unabated. Since then, the assets of three multi-billion dollar open-ended vehicles overseen by high-profile managers Deutsche Bank and KanAm have been frozen in a desperate attempt to stop investors from fleeing the sector en masse.

If the closings were intended to stabilize the market, the move does not appear to have paid off: consumer confidence in the sector remains at an all-time low, and managers of openended funds are having to deal with a host of problems, including poor performance, limited transparency, governance scandals and a widely criticized valuation methodology at odds with international standards, which has brought accusations that overpriced assets have been sold to investors for years.

It is a dramatic reversal of fortune for a longestablished investment product that has enjoyed tremendous popularity, especially in recent years. Following the demise of the technology boom in 2000, Germans turned their backs on equity instruments and switched into open-ended property funds. In 2002 and 2003 alone, the ensuing rush into real estate pumped nearly €30 billion of capital into the sector—significantly more than could be sensibly invested, as managers soon discovered.

It may not be a bad thing that €85 billion fund management industries typically don't just die overnight.

Looking for ever-larger acquisitions and struggling to find enough purchasable assets, some managers took to investing in new developments, at times with disastrous consequences. As the wall of money rose, performance deteriorated and investors began to withdraw. The subsequent outflows forced some of the managers to liquidate assets cheaply; in the case of Deutsche and KanAm, it triggered the decision to freeze funds altogether.

Whether the sector can recover is subject to intense debate. Skeptics take the problems as evidence that open-ended funds are fundamentally flawed: in good times they are prone to attracting excess capital; in bad times, given the absence of a regulated secondary market, a manager may find itself under so much pressure to give capital back that the viability of the entire fund comes under threat. Despite ongoing efforts to restore faith in the product, some practitioners believe its days to be numbered—especially if publicly listed real estate investment trusts (REITs) are introduced in Germany.

So it should not come as a shock that foreign investors are salivating at the prospect of successful bargain hunting. These include US and UK opportunity funds, which over the past year have already emerged as a major force in the German market.

Not only are foreign private equity buyers likely to be first in line to pick up cheap assets from open-ended sellers in distress, they also appear well positioned to acquire the high-quality real estate being sold off by German corporates and public institutions that are beginning to reduce their real estate holdings. Those close to the German market predict heavy deal flow over the coming months, and it looks as though the local players, having dominated the market in the past, simply won't be there to participate.

No wonder private equity firms are rubbing their hands. However, there is also the argument that opportunity funds should not wish for their competitors' permanent demise. By definition, successful private equity deals don't happen without exits. If the open-ended sector does not recover to absorb the assets that private equity firms will be looking to sell in a few years time, the exit route available to them will be no Autobahn. By that time, REITs could of course be ready to pick up the slack. But seeing that legislation has not yet been passed, such an outcome is no guarantee.

And so, from the perspective of private equity firms, it may not be a bad thing that €85 billion fund management industries typically don't just die overnight. There are those who believe there is plenty of life left in the open-ended model. And perhaps the country's retail investors are not alone in hoping that at some point, today's crisis will be over. Given their long-term objectives, private equity funds should hope so.

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