German REITs

Table of Contents

1 Executive Summary

2 Introduction
2.1 Fundamentals
2.2 Definition and Characteristics of REITs
2.3 Proposal of the ‘Initiative Finanzstandort Deutschland’
2.3.1 Initiation
2.3.2 Proposed Legal Framework
2.4 Status of the German REIT Discussion

3 Overview of existing REIT-Regimes
3.1 Abstract
3.2 Methodology
3.3 Country Overview
3.3.1 United States
3.3.2 Japan
3.3.3 Netherlands
3.3.4 Belgium
3.3.5 France
3.4 Analysis of International Comparison
3.5 Best-Practice: A Recommendation for Germany

4 The German Real Estate Market
4.1 General Market Structure and Trends
4.1.1 Fundamentals
4.1.2 Office Real Estate Sector
4.1.3 Retail Real Estate Sector
4.1.4 Industrial real estate sector
4.1.5 Trends
4.1.6 Outlook
4.2 The most important German Real Estate Investment Vehicles
4.2.1 Open-end Property Funds
4.2.2 Closed-end Property Funds
4.2.3 Real Estate Companies

5 Market Potential for German REITs
5.1 Supply Analysis
5.2 Demand Analysis
5.3 Issues

6 Case for Action: Why to introduce REITs in Germany

Appendix

Glossary

Bibliography

Table of Exhibits

Exhibit A: Overview of existing REIT Structures

Exhibit B: Total Market Cap Distribution

Exhibit C: The German Property Stock

Exhibit D: The German Real Estate Market

Exhibit E: Performance of European REITs

Exhibit F: REIT Profiles Worldwide

Exhibit G: REIT vs. Non-REIT Trading Performance

Exhibit H: Cluster Analysis of European REITs

Exhibit I: European Office Markets Trends

Table Directory

Table I: US-REIT Performance

Table II: J-REIT Performance

Table III: BI Performance

Table IV: SICAFI Performance

Table V: SIIC Performance

Table VI: Worldwide REIT Structures

Table VII: Corporate Real Estate

Table VIII: Recent Residential Real Estate Transactions

Table IX: Overview of Real Estate Investment Alternatives

Table X: Overview of Existing REITs

1 Executive Summary

A Real Estate Investment Trust (REIT) is a property stock that is taxed, not at the corporate but at the investor level, which can lead to tax advantages.¹

The concept of REITs originated in the United States in 1960, allowing smaller investors access to large income-producing real estate, which facilitated the creation of a liquid asset class that has become a core part of institutional portfolio management.

REITs have proven attractive to investors because:

Their returns have beaten most major equity benchmarks over three decades, with lower volatility They have predictable cash flows and high dividend yields They have a low correlation with other asset classes, aiding portfolio diversification As US-REITs proved successful, other countries have introduced similar property investment vehicles. The Netherlands started in 1969, followed by Australia (1985), Canada (1994), Belgium (1995), Japan (2000) Singapore (2002), Hong Kong (2003) and most recently France (2003).

In Germany real estate has been the most popular investment theme of the past three years, despite its significant underperformance compared to European peers during the past 10 years, with open-end funds receiving almost all money inflows. The listed sector, however, is insignificant, both in terms of size and liquidity, and is in desperate need of a catalyst. The introduction of a G-REIT structure could potentially be the long-awaited saviour that could transfer the importance of German real estate into the listed sector.

Given the significance of real estate in their respective markets, the German and UK governments are currently considering the introduction of REITs. Depending on the progress of the consultative and parliamentary process, REITs are expected to be enacted by legislation during 2006 in both countries.

The REIT discussion in Germany has reached a serious stage, with all the mostinvolved parties seemingly agreed about the usefulness of a REIT structure.

The purpose of this paper is to highlight the case for REITs in Germany, to analyse the progress of REITs in countries that have installed these structures, to consider the on-going debate in Germany and what these developments may eventually mean for the German real estate market.

2 Introduction

2.1 Fundamentals

REITs invest directly in property and pass almost all earnings to shareholders as dividends. By distributing most of their profits, REITs get special tax treatment and avoid corporate income tax.²However, income from dividends is taxable by the recipient, depending on nationality and status.

REITs can have a diversified portfolio strategy, or invest in one real estate sector or a specific geographic region. They are often highly liquid stocks traded on major exchanges and allow institutions and private investors to participate in large property ventures that would otherwise be beyond them. As such, a REIT share is similar to any other dividend-paying share that represents ownership in an operating business. Given that nearly all income is distributed, yields are high and stable, thereby ensuring transparency and lower volatility.

Since the introduction of REITs in 1960 in the US, REIT-regimes have been internationally expanding and are today well established and widely spread investment vehicles. Their basic features through out the world have been influenced by their American role model, but slightly adjusted and translated into country specific legislature.

Chronologically the introduction of REITs in the US was followed by the implementation of “Fiscale Beleggingsinstelling” (BI) in the Netherlands in 1969. Dutch BIs are today among the largest institutional real estate investors in Europe. Australia became the third country comprising of a REIT-regime when it introduced “Listed Property Trusts” (LPT) in 1985. Because of the impressive performance REITs were showing in the US in the 1990s, the pace of newly introduced REIT- structures throughout the globe has increased during the course of the past ten years. In 1990 Belgium introduced “Sociétés d’investissement à capitale fixe immobiliers” (SICAFI), which aimed at being a competitive investment alternative to the Dutch BIs. The Canadian government then in 1994 launched the “Mutual Fund Trust” (MFT). In 2000 Japan followed with the introduction of the J-REIT, Singapore in 2002 with the S-REIT and Hong Kong in 2003 with HK-REITs. In Europe, the last country establishing a REIT-regime has been France with “Sociétés d’investissement immobiliers cotées” (SIICs) in 2003. Currently, besides Germany, Great Britain and Finland among others are considering the introduction of a listed tax transparent real estate investment vehicle.

Exhibit A: Overview of existing REIT Structures

Abbildung in dieser Leseprobe nicht enthalten

Source: Kempen Research

(1) Datastream, as of August 8, 2005

At present, there is an ongoing debate in Germany about the introduction of REITs. While one can say it is very likely that REIT legislation will be introduced, it is unclear when this will happen, how it will be designed and what kind of advantages and disadvantages will result for real estate investors, real estate companies and the government.³

2.2 Definition and Characteristics of REITs

The term “REIT” as abbreviation for “Real Estate Investment Trust” derives originally from US tax-law. Generally REITs are defined as closed, publicly listed vehicles, which allow tax transparent structures and which pay out nearly all of their net income to their shareholders.⁴Regardless of national jurisdiction, tax efficient real estate vehicles generally have a series of common features, the most prevalent of which include:

Abbildung in dieser Leseprobe nicht enthalten

2.3 Proposal of the ‘Initiative Finanzstandort Deutschland’

2.3.1 Initiation

“Initiative Finanzstandort Deutschland” (IFD) is an organisation founded in 2003 by politicians and members of the German finance sector. Within IFD, a special committee consisting of 12 people is considering and pushing the introduction of a REIT in Germany. The current proposal aims to create a competitive framework for the development of a German REIT, establishing a liquid and transparent asset class for property.⁵As such it includes the main features of the proven US model, while seeking to address the concerns of the tax authorities.

One major goal of the proposed introduction is to mobilise the real estate assets of German companies. These assets are currently held not for operating purposes but rather for tax purposes.⁶ Due to high taxation on capital gains in Germany, companies tend to shy away from selling properties with book gains because of the high taxes that would have to be paid as a result.

2.3.2 Proposed Legal Framework

⁷The IFD committee proposed the following criteria for the introduction of a German REIT:

-Transparency on company level similar to open-end funds. G-REITs should be exempt from business and corporate taxes

-The REIT’s main activity should be the operation of properties A corporate structure (AG)

-Mandatory listing on a stock exchange

-At least 75% of company’s assets to be directly/indirectly linked to property investments

-Minimum dividend payout of 90% of net income

-International Financial Reporting Standards (IFRS) in line with other quoted companies, including fair market value reporting

-Conversion tax is set at approximately 20%, payable over four years

-In exchange, taxation at the company level would be abolished or strongly reduced. Moreover, the committee would like to see changes to several existing acts to facilitate lower transaction and taxation costs of property sales, to enable open-end funds to invest in G-REITs and account for them as real estate investments, and to enable insurance companies to treat G-REITs as real estate assets and not equity investments for accounting purposes. IFD estimates that the adoption of its recommendations would lead to a G-REIT market size of €37bn - €86bn by 2010, equalling 6x - 14x the current market cap of publicly listed real estate companies in Germany.

In principal there are two ways in which G-REIT legislation could be introduced: By creating a separate German REIT law completely outside the existing regulations, or by extending the German Investment Act. Under the first scenario, a G-REIT would be subject to the same regulatory requirements as a normal corporation. The IFD along with the German finance industry, which is pushing for the introduction of REITs in Germany, favours this approach because it expects an unregulated G-REIT structure in a separate law.

2.4 Status of the German REIT Discussion

The G-REIT model was published by the IFD in January 2005 and was generally

supported by the Federal Ministry of Finance (BMF) under the condition that REITs will also be favourable for the government.⁸In other words, the BMF has made clear that REITs would not be introduced if tax shortfalls were the result. The Bund-Länder REITs Commission identified potential tax losses in particular for the German States and therefore questioned the feasibility of REITs. Subsequently, the IFD has proposed a number of remedies.

The BMF stated that it recognizes the need to introduce additional liquidity into the German real estate market, in particular to help privatize government and corporate owned property stock. In addition, the fear is apparent to fall behind with regard to the development of financial markets throughout Europe.

In the meantime, lobbyists have been invited to participate in official discussions with regard to the relevant details in finalizing the legislation. It appears that the two major areas of on-going debate are the regulatory framework and taxation. The open- ended fund industry prefers a full integration of REITs into the strictly regulated framework of the Investment Companies Act. Lobbyists of the banking industry, however, prefer a rather de-regulated approach to ensure a broad and liquid REIT market.⁹

As to taxation, the Ministry cannot afford to lose tax revenues, nor is it willing to give industry a “free ride” when transferring existing assets into tax-transparent vehicles. The banking industry has suggested a reduced tax rate on hidden reserves to incentivise the transfer of real estate assets into REITs for a limited period of time.

Due to the upcoming federal elections, an introduction of REITs in 2006, as had been planned, seems questionable. While SPD, FDP and the Green party have not yet decided on how they will treat the issue in case of participating in the next administration, CDU/CSU announced to favor a potential introduction. Solely PDS/WASG have stated to counter G-REIT legislation. Since at present it seems likely that Germany’s next government will be led by a CDU/CSU headed coalition, an introduction of REITs within the next year remains within reach.¹⁰

Abbildung in dieser Leseprobe nicht enthalten

3 Overview of existing REIT-Regimes

3.1 Abstract

The term REIT is used as a generic term to describe a variety of vehicles with one common characteristic, namely, real estate investment vehicles that are tax transparent in exchange in paying out a high proportion of their earnings. Other than this common characteristic, REITs in various countries have a myriad of different forms.

The REITs market has grown faster than other asset classes for five consecutive years. Partly driving this growth has been the disappointing returns from equity markets, low inflation and falling interest rates. But the rise has also come from more countries putting in place tax-efficient real estate listing structures. In addition, investors’ growing need for long-term savings has made them seek out investments with low risk and steady returns, such as REITs.

In the past five years the global market capitalisation of REITs has increased by 86%. Of this growth, 40% occurred between 2002 and 2005, and 11% in the past year.¹¹

Abbildung in dieser Leseprobe nicht enthalten

Source: Dealogic, June 2005

Germany currently represents only 0.6% of the current market capitalisation within the FTSE EPRA/NAREIT Global Index. Since it is the largest European economy with the largest stock of real estate, this suggests that the German market is underdeveloped in quoted property investments. The potential for development is therefore very high.

Comparing real estate returns from different countries shows that quoted property investments in Germany have underperformed over three of the last five years. Over the past year, however, the returns from German real estate stocks have improved with the prospect of German REITs being introduced.

In the following an overview of existing REIT-markets will be given. Each country profile will consist of an introduction with a brief description of core fundamentals, an analysis of legislature and a performance examination.

3.2 Methodology

The risk/return profiles of several investment forums will in the following be specified by their Risk Adjusted Performance and the Sharpe Ratio.

Sharpe Ratio¹²

The Sharpe ratio is calculated by subtracting the risk free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. It thus measures the excess return of an investment on top of the riskless rate in relation to risk, derived from the standard deviation. It is calculated as follows:

Abbildung in dieser Leseprobe nicht enthalten

Pi = Expected portfolio return p.a.

Pg = risk free rate p.a.

σi = Standard deviation p.a.

Risk Adjusted Performance (RAP)¹³

Through measurement by risk adjusted performance, all compared investment alternatives are transferred to one common risk - the risk of a benchmark. The RAP is calculated as follows:

Abbildung in dieser Leseprobe nicht enthalten

Pi = Expected portfolio return p.a.

Pg = risk free rate p.a.

σi = Standard deviation p.a. of investment

σi = Standard deviation p.a. of benchmark

3.3 Country Overview

3.3.1 United States

Fundamentals

Although REITs date from 1960 in the US, notable activity only accelerated in 1986 after a favourable tax reform.¹⁴Stock market turmoil after 2000 prompted a second REITs boom. The REITs market has had a compound annual growth rate of 32% since the 1970s, when capitalisation totalled $330m. Today there are 137 REITs listed, capitalised at $250bn.¹⁵

REITs have been introduced as a new investment vehicle through which one could indirectly invest in diversified real estate portfolios. During the course of time their regulation has been eased further and further in order to make REITs more attractive to investors and to increase their competitiveness as an investment product. The target group of potential investors has changed during that same time period. Originally they had been designed especially for small investors while they later aimed stronger at institutional investors, who dominate their shareholdings today.

Legislation

REITs have to be incorporated in one of the 50 US states or the District of Columbia as taxable for federal purpose. Their shareholdings have to be open and publicly tradable, a listing is not mandatory. To ensure stock liquidity, five or less investors may not own more than 50% in a REIT (“five-or-fewer rule”).¹⁶

REITs may own, manage and develop real estate. 75% of all assets must consist of real estate, investments in other REITs, T-bills or cash. Further 75% of gross revenues must comprise of rents, interest or the disposal of real estate assets. Generally at least 90% of taxable income must be paid out as dividends to shareholders. Income generated through divestures does not need to be distributed to investors.

Publicly listed REITs are generally liable to the same disclosure requirements as other listed companies (especially extensive annual and quarterly reports). The government authority to monitor listed REITs is subject to the Securities and Exchange Commission (SEC). REITs are regarded as “Investment Conduits”, which avoid taxation in the sense that only net income distributed through dividends is taxed on an individual shareholder level. There is no taxation on a corporate level. Only income generated through real estate disposals which is not paid out to shareholders is taxed regularly on corporate level. If a company plans to become a REIT, the firm’s inner reserves do have to be taxed as “built-in gains” in that very moment. Dividends from REITs are taxed on an individual level with the full income tax rate.

In the US generally three types of REITs exist: Equity-, Mortgage- and Hybrid-REITs. While Equity REITs solely invest in real estate, Mortgage REITs’ main source of revenues are mortgage loans. Hybrid REITs invest in both real estate and give out mortgage loans to third parties. In other countries only Equity REITs exist, which in 2004 composed 91% of market capitalisation of all US-REITs and which were thus the dominating category.

Core Data and Performance

The NAREIT currently comprises of 193 publicly listed REITs in the US, which reach a combined market capitalization of $308bn.¹⁷Further there are 800 non-listed REITs currently operating in the US market. The highest market volume have Equity REITs ($275bn), followed by Mortgage REITs ($26bn) and Hybrid REITs ($6.6bn). Small investors hold approximately 15% of the total investment volume of US REITs.¹⁸

Between 1980 and 2004 REITs delivered a return on equity of 13.8% per annum on average. US-REITS therefore show similar performance compared to standard shares, but have profoundly lower volatilities. Risk-adjusted returns are thus higher than alternative investments in shares. This fact applies to bond-investments just as well. Risk-adjusted REITs are a better investment in the long run.

Based on long term considerations REITs show a positive and rather high correlation of 0.46 to the general stock market. Correlation to the bond market on the other hand is rather low with 0.14 respectively.

Table I: US-REIT Performance

Abbildung in dieser Leseprobe nicht enthalten

Source: ZEW

3.3.2 Japan Fundamentals

In November 2000 REITs have been introduced in Japan as a medium to increase liquidity of capital markets after the burst of the Japanese speculation bubble in the 1990s. The Japanese government has been strongly oriented by US legislature in order to also allow small investors to participate in the real estate market.¹⁹

The Japanese REIT market has been growing strongly in recent years caused by an upswing in the Japanese real estate market. After phase of deflation especially foreign and institutional investors are keen to invest in Japan.

Legislation

In order to be registered as a J-REIT a company needs to posses a license as a Asset-Management company. J-REITs do not necessarily need to be publicly listed enterprises.

Further restrictions are that at least 75% of total assets consist of real estate and at least 50% of these assets must generate revenues. J-REITs are obliged to primarily invest in “quality assets”, which consist of direct or indirect investments in real estate, but also real estate backed securities. External management is mandatory. There are no restrictions regarding leverage, J-REITs show a debt capital rate of 45% on average though, just like most US-REITs.

Profits and income generated through disposals must be paid out by 90%. Profits are defined as the taxable earnings after depreciation, so that sufficient capital necessary for maintenance can be retained. There are no special restrictions on the change of legal form when companies become REITs, inner reserves are fully taxed.

Institutional investors have to pay taxes of 7% on dividends of publicly listed REITs. Further their dividend income is summed up with other income and fully taxed with the corporate income tax rate of 42%. Non-corporate investors are charged with a withholding tax of 7% in addition to a local tax of 3% on dividend payments.

[...]

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¹Brueggeman, W. / Fisher, J. (2001), p. 565

²Erickson, John (2002), p. 58

³Handelsblatt (2005), Nr. 134

⁴Block, Ralph L. (1998), p. 14

⁵Ackermann, Josef / Koch-Weser, Ciao K. (2004)

⁶Freyend, Eckart John von (2005)

⁷IFD (2005) I

⁸Die Welt (2005), Nr. 179

⁹Frankfurter Allgemeine Zeitung (2004), Nr. 237

¹⁰Platow Brief (2005), Nr. 114

¹¹NAREIT (2005)

¹²Sharpe, William F. (1966), p. 121

¹³Modigliani/Modigliani (1997), p.46

¹⁴Howe, John S. / Jain, Ravi (2004)

¹⁵Merrill Lynch (2005), p. 18

¹⁶Garrigan, Richard T. (1997), p. 89

¹⁷Bloomberg, as of August 2005

¹⁸NAREIT (2005)

¹⁹Sasaki, Takehito / Ross, Kerley (2005)