German real estate: Opportunist investors leave room for those prepared to sweat
German residential properties have fallen out of favour with some of the big-name US private equity investors. Is their withdrawal a signal of market decline or is there still value to be had? Duncan Wood reports.
According to a popular German saying, even the stupidest farmer can grow the biggest potatoes. If you plant the seeds, sun and rain will do the rest. That sentiment has driven the German residential real estate market for the past four years: flocks of foreign investors have bought up over a million apartments, betting that the sun and rain of undervalued assets and high leverage would do all the work for them. But times have changed and the easy opportunities have gone, say market participants: anyone who wants to make money in Germany now has to be ready to sweat.
The clearest sign of the new market dynamic has been the exit of opportunistic investors such as Blackstone, Oaktree and Cerberus. Having been buyers in 2004 or 2005, the three private equity firms all became sellers this year, between them disposing of more than 80,000 apartments. Late last year, Morgan Stanley also sold a portfolio of more than 40,000 units that it had bought from steel-maker ThyssenKrupp in 2004, to French Reit Foncière Développement Logements (FDL).
"In terms of transaction volumes, this year has been on a par with the banner years in 2005 and 2006 but the rationale behind the activity has changed entirely," says Klaus Hölzer, director of corporate and institutional banking with Oliver Wyman in Frankfurt. "All the guys who were buying back then are now selling and the new buyers are not just looking to make a quick buck. It’s now about scale and making money over a much longer-term horizon."
The investors that are leaving the market tend to be tight-lipped when asked whether their foray into Germany’s residential market was a success. Morgan Stanley doesn’t even like to refer to its transaction as a sale.
"We retain some exposure to the assets we exited and also got additional exposure to a much larger pool of assets"
James Lapushner, the bank’s head of real estate for Germany, says: "You could call it a sale. But what we really did was recapitalize and diversify our position." In the transaction, FDL acquired the bulk of Morgan Stanley’s German residential portfolio, paying some cash and also giving the bank a substantial amount of shares in the company, he says: "We retain some exposure to the assets we exited and also got additional exposure to a much larger pool of assets." He says that the return on the transaction was positive. Blackstone declined to comment on its own exit. Cerberus failed to return calls asking for comment. For the most part, market participants think that these investors will be satisfied with the money they’ve made. "We believe that those who left the residential market have had good returns and have simply cashed out," says Marcus Lemli, head of capital markets for Germany with Jones Lang LaSalle (JLL) in Frankfurt. Christian Schulz-Wulkow, head of M&A and capital market services with Ernst & Young Real Estate in Berlin, says that most of the early entrants to the market managed to buy low and sell when prices had climbed: "Most of them made quite good returns. They’ll have met or exceeded their target IRR."
But there’s a question hanging over Cerberus. It acquired the Baubecon portfolio of more than 20,000 apartments in late 2005, when prices had already begun to climb – and then Ralph Winter, the co-head of its German real estate team, left the firm just six months later along with five members of his team. One real-estate research firm estimates that Cerberus paid €75,000 per unit for the Baubecon portfolio, compared with the €44,000 per unit paid by Morgan Stanley in its ThyssenKrupp deal. In July this year, after holding the asset for 18 months, Cerberus sold Baubecon to Pirelli RE and Deutsche Bank’s RREEF. The fund still has a stake in a second large portfolio that it bought in 2004 with Goldman Sachs – and these assets are believed to have performed well – but the Baubecon transaction is now attracting criticism.
"If you want to set up a €3 billion fund then you have to buy bulk, so bulk goes at a premium," says Alberto Matta, one of the co-founders of BMB Investment Management, a property investor that is about to close a Berlin-focused fund (see box). "If valuations had doubled then Cerberus and others might have hit their targets but the market’s only gone up 20%, so they’re selling now because they bought at a price that was too high. Anyone who works in real estate valuation will tell you the same."
Others have a kinder explanation. The global head of real estate with one large US bank says: "My guess is that Cerberus think that they bought at a fair price, but they realized that they couldn’t compete without buying further portfolios and wholesale prices had gone up too much to make that an option. If you’re not a buyer you should be a seller. And I’m sure that the departure of Winter also changed their view on the business."
In fact, Winter’s story neatly illustrates the changes taking place in Germany’s residential market. Having been behind two of the billion-euro-plus mega-deals that catapulted the market into the headlines, Winter is now operating at the other end of the market in terms of scale – still buying residential but doing so in bite-size chunks for his own company – Zurich-based Corestate Capital.
"He’s a very talented guy and he decided that he could do things as well on his own as he could with a big American backer – and he also wanted to go in a slightly different direction," says the US bank’s real estate head. "His strategy is very much focused on smaller portfolios whereas Cerberus has a lot of money to spend and would be less patient spending €50 million here and €100 million there."
So the character of the market has changed. The opportunity to make money by levering up a relatively small chunk of equity and using it to buy huge portfolios at low prices has gone, say observers. In part, that’s because the properties themselves are no longer so cheap and there are also fewer willing sellers. Equally important, though, financing (and refinancing) is more expensive and leverage harder to achieve – in part because of the sub-prime crisis. "Financing conditions have definitely become tighter, with banks lending at higher margins and lower loan-to-value ratios – leverage has gone down from almost 100% to 60% to 80%," says JLL’s Lemli.
"The first wave of investment was all about big, highly leveraged plays. Now, we’re seeing a wave of smaller portfolios coming to the market and this new phase, will be all about more traditional real estate investing"
That doesn’t mean that the market has ground to a halt, of course – only that eye-catching deals and eye-watering leverage are off the menu. "We’re entering a new phase," says Thomas Beyerle, head of research at DEGI in Frankfurt. "The first wave of investment was all about big, highly leveraged plays. Now, we’re seeing a wave of smaller portfolios coming to the market and this new phase, which will continue to play out for some time, will be all about more traditional real estate investing – development and redevelopment, renovation and re-letting." Companies such as Patrizia are keen to step into the limelight. The real-estate advisory firm floated 18 months ago and used the proceeds in part to massively expand its existing, small portfolio of residential real-estate from 1,500 units to 13,300 today, says Augsburg-based chief financial officer Georg Erdmann. The plan is to spend money refurbishing the apartments and then earn far more money by raising rents and also selling off the properties one by one or in blocks. As things stand, only 43% of Germans own their own homes, compared with 82% in Spain, and investors hope that can be changed.
"If we acquire a building with 100 units, the expectation would be that we’d sell roughly 40% of those to existing tenants, over a period of two to six years," he says. "During that period, a further 20% of the apartments become vacant and these are sold to owner-occupiers. The remaining 40% are sold to individual investors – people like you or me who might buy one or two flats for their private pension."
It’s a lengthy and labour-intensive process, but it’s one that Patrizia and many others are hoping will bear fruit over the next few years. Terra Firma, for example, was one of the first foreign investors to enter the market in 2000, and has continued buying property throughout the cycle – its colours have long been staked to the "wholesale-to-retail" business model, says the US bank’s head of real estate. But it’s not easy. "You need a great real estate acquisition team, but you also need people on the ground who can go and sell your message to the tenant, and people who can arrange mortgage finance," he says. Critically, it also needs a favourable alignment of economic and market variables: each apartment needs to be sold at a price that is attractive for the tenant, but that also provides the owner with a healthy margin on top of the acquisition and management costs.
Patrizia’s Erdmann says the strategy is working: "We are quite happy with the number of tenants buying." The equity market is less happy, he concedes. The company’s share price is trading at roughly 30% of last May’s peak – a pattern repeated across Germany’s listed real-estate investors.
It wasn’t always like this. In 2006, private equity firm Fortress refinanced its Gagfah real estate company via an initial public offering of a 20% equity stake. It was a brilliant success. "My understanding – without knowing about the exact structure of the deal – is that selling that stake allowed Fortress to take out the equity they had sunk into Gagfah and they still own 80% of the company," says Patrizia’s Erdmann. Patrizia itself saw its share price rocket from an issue price of €18.50 to €26 six weeks after it came to market, he says. "At the time, all you had to do was go to investors, and tell them that you were German and investing in real estate, and they bought your shares. But last year’s extremely positive mood has now become extremely negative."
acause equity markets expected too much, too quickly. Patrizia will come good, he insists. "We haven’t yet stepped up our sales volume to the level that the capital markets was expecting," he says, "but you can’t make money overnight by renovating and selling and a lot of the apartments we’ve only owned since March. The returns are still to come."
Other observers agree that the sell-off has been overdone. DEGI’s Beyerle attributes the sour mood to the wrangling over Germany’s Reit law, which includes tough constraints on the inclusion of domestic residential assets in any trusts and more or less ended the chances of companies such as Patrizia converting to Reit status. "These companies were all seen as candidates to be the first German Reit, but that’s out of the question now and their shares have fallen as a result," says Beyerle. "It’s not a problem with the underlying business – it’s much more about disappointment from capital markets investors."
German politics also present an obstacle to investors that are seeking to increase rents. The country already has tough laws on the pace and size of any rental increases but even increases within those limits have attracted fierce criticism from politicians and the German tenants’ association (DMB), especially when foreign private equity firms are the landlords. The negative publicity can make it harder for firms to compete in property auctions, or to increase rents as quickly as they want. Patrizia found itself on the receiving end of an outburst of opposition when it raised rents on some of its Munich apartments earlier this year. On that occasion, the company was able to count on support from Munich’s mayor. "He came out and said that we had every right to increase the rent and that anyone else would have done the same," says Erdmann.
More generally, the company seeks to stay in the good books of tenants and the DMB by getting in touch when it acquires properties and outlining its renovation plans. "We are sitting at the same table as the DMB, but on different sides. However, both sides are interested in finding the best solutions for all parties," he says.
Despite these difficulties, there’s no shortage of people who believe that German residential assets are a good bet. JLL’s Lemli says that the market remains "very active". He says: "We still see a strong case for Germany as the economy continues to perform well. However, rental growth is not improving as rapidly as expected, so investors will have to take a mid-term view on value appreciation."
Wolfgang Koppert, Nord/LB’s Hannover-based head of real-estate banking for Germany, also warns that investors need to be picky when it comes to locations: "I don’t see much increase in prices or rents in rural areas or smaller towns. I see those increases in cities like Munich, Hamburg, Frankfurt, Stuttgart, where flats are in short supply. People who buy flats in these large cities will do well out of it in five to 10 years."
|A decade of deals: €1bln-plus portfolio transactions from 1997-2006|
|Year||Seller||Buyer||Portfolio name / type||Number of units||Price in € billions|
|1997||Deutsche Post||Deutsche Grundbesitz Management, Viterra||Deutschbau||39,000||1.05|
|2000||Federal Republic of Germany||Deutsche Annington||Railway workers’ apartments||64,000||2.05|
|2000||Federal Republic of Germany||Consortium||Railway workers’ apartments||50,000||1.75|
|2004||Bundesversicherungsanstalt fuer Angestellte||Fortress||Gagfah||80,000||3.5|
|2004||State of Berlin||Cerberus, Goldman Sachs||GSW||65,700||2.1|
|2004||ThyssenKrupp||Morgan Stanley, Corpus||ThyssenKrupp||48,000||2.1|
|2004||WCM Beteiligungs- und Grundbesitz||Blackstone||n/a||31,000||1.39|
|2006||Morgan Stanley, Corpus||Foncière Développement Logements||ThyssenKrupp||40,000||2.1|
|2006||City of Dresden||Fortress||Woba Dresden||47,500||1.75|
|Source: Corpus Sireo Research|