At this year's World Cup hosted by Germany, billions of fans were mesmerized by matches whose results didn't sound too exciting to an American ear: 1-0, 2-1, 1-1. Something similar seems to be going on with Germany's commercial real estate market: some investors are excited, but upon closer examination of the numbers, it's hard to see why.

Is it the sub-2% GDP growth that most economists forecast for the next five years that investors find enticing, or the unemployment rate in excess of 10%? Could it be the 1% overall improvement in office occupancy rates that Property Portfolio & Research (PPR) of Boston predicts will kick in by 2010 — or the fact that 99% of all apartments are subject to strict rent controls?

Despite the depressing numbers, some institutional investors are now big fans of the market, excited precisely because it's rather staid. Like value-style equity investors who buy stocks in reliable but out-of-favor companies, institutional investors have been finding relative bargains in Germany.

“We see a lot of big volumes here, particularly from the institutional sector,” says Hendrik Broeker, national director of corporate finance for Jones Lang LaSalle in Germany.

In 2005, real estate asset sales in Germany totaled an estimated 25.6 billion euros, according to Ernst & Young. Of that total, analysts at Jones Lang LaSalle estimate that approximately 73% of the transactions included a foreign party. Among them were the best and the brightest of the global investment set — Fortress, Cerberus, Morgan Stanley, Blackstone, and Goldman Sachs.

Germany rates high on many lists, according to a recent survey by The Association of Foreign Investors in Real Estate, a trade group for cross-border real estate investors. Investors rated it the third-best market for capital appreciation out of all world markets, as well as the fourth most stable and secure market in which to invest.

“The market has become absolutely berserk,” says Martin Bruehl, chairman of the Cushman & Wakefield Capital Markets Group in Germany. Demand is so strong that portfolios now often sell for more than the sum of their parts.

Institutional appeal

“There are a number of factors which have come together to produce a very strong buy cycle in the German market in spite of questionable growth prospects,” says Bruehl.

At the top of the list: In a world where most institutional-quality products have low cap rates, property in Germany is yielding 50 to 100 basis points more than comparable property in Great Britain, according to Stephen Mallen, senior managing director of global client services for Grubb & Ellis.

“Because the economy is fairly soft and because supply and demand are fairly modest and muted, the cap rate of Germany is a little higher than you can get in the rest of Europe,” says Mallen.

A strict internal market structure and a slow-growing economy left Germany untouched by the boom that affected prices from the United Kingdom to Australia — a disadvantage that has now turned into a positive.

Financing is also still relatively cheap. The German equivalent of the 10-year Treasury yield is 3.9%, which looks good in an economy where inflation is running about 2%. At the same time, local lenders are offering 90% and sometimes even 100% loan-to-value ratios. Last year, for example, the Hesse provincial government sold a 1 billion euro portfolio of property to foreign institutional investors on a 100% financed basis.

Long-term bet

Perhaps most of all, investors see a promising long-term opportunity. “There are many international investors who see the overall potential of Germany. They believe that after 10 years of a weak economy, things have to get better over time — and they probably will,” says Andreas Schreurs, fund manager of Hines' new Pan-European Core Fund, and managing director of Hines Europe, a division of the U.S. developer and investment company.

A long-time player in the German market, Hines' holdings include a 907,000 sq. ft. Class-A office complex in Munich that features a 38-story office tower, and a 269,000 sq. ft. mixed-use project on the Friedrichstrasse, a high street in what was formerly East Berlin.

“With all the negativism of Germans in general about the weak economy we've had for 10 years, in terms of GDP we still have the third largest economy in the world,” says Schreurs. “Germany's not close to falling off the map.”

West Germany put in a generous social safety net after World War II to promote long-term political stability. Today, Schreurs and other real estate executives believe such generous unemployment and social benefits put Germany at a disadvantage in an increasingly competitive global market.

Many German investors appear to share his sense of unease. Sales in 2005 were dominated by foreigners, according to PPR, with German investors leading only 37% of domestic commercial property transactions in 2005.

Jones Lang LaSalle's Broeker estimates that American institutional investors are waiting on the sidelines with $8 billion to $10 billion to invest in the market.

“When we talk to U.S. investors about Germany, their first idea about [the German economy] is that what goes down must comes up,” says Steven Cornet, senior real estate economist for PPR. “We always say this is not necessarily true in Germany.”

So when will it happen? Mallen of Grubb & Ellis says investors are betting that in five years the German market will look considerably brighter than it does now — and at purchases made at today's prices, they can afford to wait.

Political obstacles

Despite a roughly 1 trillion euro investment, the states of what were East Germany are still in bad shape economically 16 years later, and act as a permanent drag on the economy and the property markets. “We have areas and villages where we have almost no economic activity, where just the unemployable and the elderly are still there,” acknowledges Cushman & Wakefield's Bruehl. “It's pretty bleak.”

Recently, many business people hoped that Angela Merkel, the new conservative chancellor, would make the country more business friendly, as Margaret Thatcher did in Great Britain in the 1980s — but Merkel has taken a more populist tack in order to keep left-leaning legislators within her broad coalition government.

In retail, restrictive zoning and tough labor laws have long made it difficult to open new centers, especially in the wealthier western part of the country. Low economic growth over the past five years hasn't encouraged Germans to spend anyway. An expected rise in a national tax on sales and services next year from 16% to 19% may also be dampening consumer spending, according to a recent market report from Cushman & Wakefield.

Rents for prime retail property vary by submarket, from a high of $337.28 sq. ft. per year in Munich to a low of $134.91 sq. ft. per year in the eastern city of Dresden. Yields of 5% on retail assets prevail in much of the country, but are about 6.25% in Dresden — almost exactly where they've been for the past 10 years, according to Cushman & Wakefield.

Howard Davidowitz, chairman of Davidowitz & Associates, a New York-based retail consulting firm, thinks the retail climate may improve soon. “So far, nothing is in the numbers,” he admits, “but I think there is hope because [former Chancellor Gerhard] Schroeder is gone and I think Merkel has a much better chance of getting this economy moving.” Indeed, retail sales in 2005 rose 182% over the previous year.

Numbers aren't the whole picture

By U.S. standards, the office vacancy rate doesn't look bad. But by German standards, vacancy rates in major cities hovering between 8% and 10% — 9.5% in Berlin, 10% in Munich, aren't stellar. Worse, PPR forecasts an average of only 1% improvement in vacancies between now and 2010.

For Class-A type office properties, rents range from $44.52 per sq. ft. in Frankfurt, the country's largest office market, to a low of $12.15 per sq. ft. in Dresden, according to Cushman & Wakefield. Yields on office properties in West Germany hover between 5% to 6%, but Dresden office owners pull a richer 7.50%. Many tenants are trading up now into better space, and leases often come with incentives.

Frankfurt is in the worst shape as the country's office markets go. DB Research estimates that the market expanded by 20% between 2001 and 2003, causing vacancy rates to rise from 2.1% in 2001 to 15% in 2004.Currently, the vacancy rate stands at 17.8% — more than double the previous historic high of 8.5% in 1995, according to PPR, which was itself a high number for such a slow-building country. The analysts don't expect much relief for Frankfurt owners either between now and the end of the decade as vacancies are projected to only slightly dip to 16% by 2010. “Quite frankly, Frankfurt will not get out of the office market [slump] if they will not demolish or convert a lot of this office space,” says Cornet of PPR.

Yet there have still been some sizable transactions anyway. Sale-leaseback transactions have been one popular move, according to Mallen. In 2005, Dresdner Bank sold a $2 billion portfolio of 303 properties, 80% of which are occupied by Dresdner offices, to Eurocastle Investment Ltd., a unit of Fortress.

Multifamily doesn't look much more promising. Vacancy rates reportedly run around 7% for the country as a whole. As of 2005, prices for apartment buildings had stayed flat for the previous five years, according to a report by Eurohypo, a German mortgage bank.

Yet deals are moving fast in this area, too. Transactions in the multifamily market reached a whopping 17.8 billion euros in 2005, according to DEGI, a German real estate investment company. Many of these transactions were concentrated in massive institutional investments.

For example, Terra Firma, a European private equity firm, in a deal with Citigroup Property Investors, bought 138,000 flats for 7 billion euros from Viterra, a German real estate company.The firm's plan is to sell to the tenants over time, a daring strategy in a market with generous lease terms and limited rent increases.

But the big driver to Germany may simply be diversification. Many European investors are trading across borders in ways they didn't even a few years ago. In 2005, according to a Jones Lang LaSalle, cross-border property transactions constituted 59% of commercial real estate volume in Europe, the first time that number has been above 50%.

Broeker says, “It's a trend you can see all over Europe.”

Bennett Voyles is based in New York.

German open-ended funds rattle investors

Distressed sales have added supply to the German market. A number of cash-strapped states, such as Hesse, have sold off substantial real estate portfolios. The headline grabber of the last six months, however, has been billions of euros in distressed sales caused by panicked investors in the German open-ended real estate funds.

Invented in the early 1950s, open-ended funds are a pooled ownership vehicle for individual investors. Often sponsored by banks or insurance companies, the funds have always been sold as something as slow and steady as a Treasury bond, and in recent years have grown to nearly 100 billion euros of the property market — a substantial figure in a 2 trillion euro economy.

Fund performance has been anemic for years. Average annual five-year returns have been 3.7%, according to BVI, an industry trade group — not a very enticing number at a time when the hotter European markets are posting double-digit returns. But conservative investors liked the idea of something slow and steady.

The open-ended funds, however, aren't traded on an exchange, like REITS. Instead, values are determined by regular assessments of the underlying property values. The problems in the open-ended funds began last December, when Deutsche Bank's Grundbesitz-Invest Fund shareholders heard rumors that the funds' assets were being reappraised, so they pulled out their money.

The Grundbesitz-Invest Fund lost 300 million euros in assets in one day after client withdrawals. Several other high-profile funds suffered similarly. In all, over 11 billion euros left the funds between December and March, according to Property Portfolio & Research.

One reason for the underperformance is the fact that most open-ended managers are fund managers, not operational asset managers, according to Hendrik Broeker, national director of corporate finance for Jones Lang LaSalle in Germany. Some 50% to 65% of properties in the funds were well-leased and managed. Some of the rest will require reinvestment or repositioning. Today, the funds are continuing to reallocate assets — selling in slower-growth Germany, buying in external markets such as Eastern Europe, and Asia.

Diversification sounds sexier to disillusioned German individual investors, according to Broeker, and diversified funds haven't suffered as much as funds with largely German portfolios.
— Bennett Voyles