How can this be? Surely more jobs means more demand for office space, means higher rents, means investors prepared to pay higher prices to buy the buildings? Well, only up to a point, m’lud. Things aren’t really working out like that, much though we would like them to.

Let’s have a look at what’s happening. As we report in several articles in our REFIRE Intelligence Report throughout January, all the professional opinionators – from the consultancy groups such as KPMG and Ernst & Young, the specialist property advisory groups, and the economic think-tanks – are unanimous in their view that demand for German real estate will rise significantly this year, and with it, peak rents and prices in the prime business locations.

Our discussions with the main broker groups leave no doubt also that demand for office space in the largest cities rose sharply in the past six months, with many companies coming down off the fence and showing a surprising willingness to commit to new lease agreements after months of shilly-shallying – in many cases coming in between Christmas and New Year to lock up their new lease agreements or extensions. The bigger brokers, who concentrate on the six or seven largest German cities, will put the increase in rental take-up last year at 20-25% depending on markets measured. Other broker groups, such as the network Deutsche Immobilien Partner (DIP) which cover 14 regional markets, put the take-up at 12%. No matter – all are agreed it went up by a healthy amount.

The time lag, too, of six to nine months delay following a noticeable upswing in the economy before the impact is felt in the real estate economy, is not untypical. Deals are now being done, contracts signed, and from what we hear anecdotally, landlords aren’t having to be quite so generous with their packages of bon-bons to entice the tenant to sign on the dotted line. In short, the uptrend is real, and there’s no reason to think that a further rise of 8-10% in German office lease transactions is not achievable this year.

The big problem is the stubbornly high level of office vacancy rates which, from an investor’s point of view, continue to weigh down on the market and act as a damper on achievable yields. Ominously, real estate research group BulwienGesa reckon in their latest market outlook that the bulk of new jobs created will in any event bypass the office sector, which it sees as rising by 0.9%, at most.

Be that as it may, there is still more office space coming onto the market than there will be new employees to populate that space. Hence last year the vacancy rate in the 15 largest German office markets rose from 9.4% to 10.1%, according to the DIP. In certain cities, such as Frankfurt, the vacancy rate is above 15% (or even higher, depending on definitions used), which continues to give potential tenants plenty of bargaining ammunition.

The pipeline of new projects coming on stream, of which less than half have now been pre-let, will ensure that high vacancy rates will remain a problem for the next couple of years, at the least. Any extra demand by employers will be absorbed by new available space coming to the market, instead of feeding through in the form of higher rents – apart from the most exclusive properties.

The implications of this for investors in less-than-prime office properties are far-reaching. It will be only too easy to be sidetracked by any sustained German economic upswing which sees tenants migrating to modernised, efficient, sustainable (but not even necessarily state-of-the-art ‘green’) properties in the primest locations, leaving a swathe of functional but outdated office properties just outside the inner city core. Frankfurt is seeing plenty of evidence of this phenomenon right now, causing migraines for investors who bought into a ‘sure thing’ only a few short years ago – and are now faced with major upgrading costs or the slow write-down of what has turned into a withering asset.

Despite the up-beat news coming from the German economy, most of the headlines in German real estate are originating in the margins – such as peak rents, trophy property sales, and new high-profile lease agreements. This segment of the market represents 3-5% at most – with a whole separate universe of property realities existing in the bulk of the market below those exalted levels. As in the investment market for office properties, so too in the market for office rentals – the gulf is widening between the handful of winners, which everyone is chasing, and the rest.

Related posts:

1. EPRA to the rescue as German government amends GOEF rules
2. Anybody out there NOT looking for prime, core-plus, fully-let, to blue-chip tenant…?
3. Owls to Athens, Coals to Newcastle

Meanwhile, the European Public Real Estate Association EPRA vowed to continue its campaign to “liberate the German market” from what it sees as an unhealthy domination of the sector by the open-ended funds at the expense of the stock-market listed sector.

The drive by Berlin to reform the GOEF sector has been gathering pace over the last two years, but has intensified since May of last year when original proposals emanating from Berlin led to a fresh wave of investor panic leading to fund withdrawals, and ultimately, the announcement of fund liquidation by three groups – Aberdeen Immobilien, Morgan Stanley and the KanAm Group. These funds are currently unwinding their positions and have announced a series of staggered payments over the next three years to their shareholders as assets are progressively sold off. This month saw shareholders in Aberdeen’s Degi Europa receive the first tranche of 20% of their fund’s (albeit shrunken, after heavy write-downs) total value.

A further nine real estate funds remain frozen to investor redemptions, in most cases availing of the maximum period of closure permissible under German law before having to declare whether they will re-open or likewise face liquidation.

The new regulations, which will come into effect in 2013, are designed to protect individual German investors, rather than the institutions who had availed of the funds’ structures to ‘park’ money in funds with short withdrawal notice periods. Increasingly disparate interests between the two groups and the threat of heavy withdrawals by institutions threatened the liquidity of the open-ended funds.

While in the past the funds had set and imposed their own rules on withdrawal, the new regulations will impose a cancellation period for investors of 12 months, with new investors subjected to a holding period of a minimum of two years, sources in Berlin said this week. Further reforms include only allowing investors to withdraw a maximum of €30,000 every six months, while foreign capital (the borrowing ratio) in any property investment would not be permitted to exceed 30% – as against the current 50% permitted by law.

Meanwhile, EPRA CEO Philip Charls made an outspoken plea last week to investors to support his organisation in its drive to boost what it sees as a “grossly undersized” listed real estate sector in Germany, and an unhealthy domination of the real estate sector in Germany by open-ended and Spezialfonds fund managers. These managers have about €90bn of property assets under management (of which about a third are currently frozen to redemptions), along with a further €50bn in an array of Spezialfonds.

Speaking at the EPRA Insight conference in Amsterdam, Charls stressed that there was a proper role for the German open-ended funds industry, but it must not be allowed to strangle the development of a healthy listed sector. The classic open-ended fund product was, he said, “an unclear product and it is quite often sold by misrepresentation to the customer.” The current industry structure made change difficult, he said. “We want to make clear that there is a way to live together to develop a proper listed sector and have the GOEF sector as it is. It is an uphill fight because the grip of distribution – the banks – is very strong. They make a lot of money selling GOEF units, a lot of money in managing them and they have very strong ties with the political system.”

While listed companies have a market capitalisation of about €10bn in Germany, or about 1.6% of the underlying real estate market, this compares unfavourably with the almost 6% represented by the listed sector in France and 4.2% in the UK, and to the European average of about 3%. “This should not be the case for the largest economy in Europe”

Charls rallied his audience by urging them to take all necessary steps to grow the listed German sector – “We are very excited that a lot of investors have already said they will be our allies and will march behind us to try and liberate the German market”.

Whether Charls succeeds in liberating the poor Germans from the intolerable yoke of oppression of the open-ended funds industry, it hasn’t been all fun and games for those hardy souls who’ve remained loyal to the funds sector through its recent troubles. A recent survey of fund managers Commerz Real, Deka Immobilien, RREEF and Union Investment would indicate that the recent upswing in commercial property markets has yet to manifest itself in payouts for sturdy savers. The funds association BVI said that the one-year returns on funds managed by the four surveyed companies ranged from 1.3% on Deka’s Westinvest fund to 3.3% at Commerz Real’s Hausinvest, well down on the usual 4-5% offered by the funds.

The funds offer no great hope of much of a change this year either, given the high liquidity reserves which they’ve felt obliged to hold, given investor nervousness. Union Investment said its funds were between 20% and 34% liquid, while RREEF and Deka also had liquidity ratios of more than 20% in most cases. All the funds are being noticeably coy in issuing statements about fund inflows and outflows, at least until the latest bout of legislation is formally enacted.

Funds association BVI also recently released statistics on the physical make-up of assets held by its open-ended fund membership. The figures show that the open-ended funds own 1,637 properties, with a total letttable area of 26.7m sq.m. and a market value of €87.9bn. Of all properties, 64.1% are less than ten years old, while 78.9% were built after 1995. In terms of usage, 63.3% of the assets were office space, while retail and hospitality (gastronomy) amounted to 20.1%. In terms of lease duration, between 10% and 11% of leases are due for renewal annually up till 2014, while 17.9% are not due for renewal until at least Jan. 1st 2020.

Related posts:

1. The importance of a good hedge, when doing God’s work
2. The nagging problem of German office vacancy rates
3. When I hear the word “Sustainability”, I reach for my revolver

Warren Buffett, not surprisingly, is siding with Lloyd Blankfein in Goldman Sachs’ trial before the Senate in the SEC civil suit against the bank. With his company Berkshire Hathaway earning $500m in annual dividends from its $5bn stake in the investment bank, what’s not to like about his partnership with the titans of Wall Street?  Besides, as he said last week at his annual shindig in Nebraska, he would never assume to second-guess what investors on the other side of a trade he was involved in were thinking.  “They could very well be shorting a product, they do not owe us a divulgence of their position more than any reason why we need to explain what we are doing with our position.”

The Sage of Omaha is perhaps being a touch disingenuous, given his stake in the outcome and in the alleged perpetrator.  However, as a trader, he’s fully aware that moral compunctions have no place in the decision as to WHEN to enter or exit the trade.  We suspect that his views might be a little more tempered if he was paying advisory fees to the bank, presumably to act on his behalf, only to have them trade against him.

In the decisive moments of the trial, four key Goldman executives were repeatedly asked the question – Did you have a duty to act in the best interests of your clients?  Three equivocated, refusing to commit to a ‘yes’ or a ‘no’.  Only the fourth, the pivotal witness ‘Fabulous’ Fabrice Tourre, was upfront.  “I do not believe we are acting as investment advisers for our clients”, he stated.  Loud and clear.

Further questioning of more senior executives, including CEO Blankfein, failed to elicit a committed answer to the question, “Do you think Congress should impose a clear fiduciary duty on brokers to act in the best interest of clients?”.  Mumblings, but no response.

Many in the financial community are not shocked by this.  Whatever the outcome of the Senate’s findings, the Masters of the Universe at Goldman Sachs are likely to escape with a peremptory fine and a sharp rap on the knuckles.  At an average bonus of $1m per employee in the bank’s London offices, most are expected to survive the bruising to the bank’s reputation.  Robust resilience, and all that.  After all, nobody ever said that ‘doing God’s work’, to quote Blankfein, was easy.

What surprises us at REFIRE is the outrage that is greeting the Goldman Sachs disclosures.  Goldman may be the Master Vampire Squid, but in the rarefied world of private equity investing, where the punters pay hefty premiums for blue chip banking names to likewise ‘relentlessly jam their blood funnels into anything that smells like money’, they are not alone.

Take Morgan Stanley, the erstwhile 800- pound gorilla in German property investing.  In 2007, the bank invested €10.5bn in Germany alone, making it by far the country’s biggest property investor.  Several times then and before, REFIRE had listened to and questioned John Carrafiell, Morgan Stanley’s head of real estate worldwide and the man who set up the ill-fated MSREF VI Fund, as he justified paying premium prices for trophy German properties – despite frequently high vacancy rates and vulnerable tenancy agreements.

Last month investors stared aghast at the disaster wrought upon them by their alpha seeking ‘partners’ at Morgan Stanley, who had managed to lose $5.4bn of their $8.8bn equity.  The fund, with its ‘enhanced return strategy’, had buying power of more than $30bn in 2007.  This fund volume includes many of its German trophy acquisitions, now being sold off one after another at a loss, or which have been completely written off, with the keys in the post on their way back to the lender.

This destruction of investor wealth is staggering, even by recent standards.  What on earth could have led these hard-bitten real estate professionals to spend so much above what would be mathematically justifiable, and to barge in waving thick wads of cash where angels truly would have feared to tread?

Well, let’s see.  The Wall Street Journal has uncovered documents that show what Morgan Stanley charged for the ‘promote’, or fees to manage Other Peoples’ Money in the MSREF VI fund.  Just in 2007, these came to $104m in acquisition fees, $22m in fund management fees, $13m in financing fees, $36m in real-estate management fees, and $21m in financial advisory fees.  There’s your alpha returns right there.  For the promoter, of course.  Not the investor.  To no great surprise, the investing public is left wiser, more experienced – and wiped out.

The Morgan Stanley losses, along with those suffered by Goldman Sachs’ Whitehall Funds and RREEF, to name just two others who have taken a financial bath recently, will be written off, along with a certain loss of face.  The banks will recover.  The managers involved, unlikely to be personally out of pocket, have mostly already moved on to manage other funds.  The show will go on. 

Others can (and do) reflect on the positive side of the arrival of all that fresh money.  The German open-ended funds were big beneficiaries of the folies de grandeur indulged in by the living deities.  In a stroke of perfect timing, the funds managed to shift most of their unwanted properties into the hungry maws of the highly leveraged Anglo-Saxons, and were away scot-free, as it were.  (No disrespect – or pun – intended to RBS, who just happens to be left holding the can in both the Goldman Sachs trial and the Morgan Stanley ‘jingle mail’ Pegasus portfolio debacle).

The big German funds are now the new powerhouses, flush with investors’ euros and welcomed across Europe with open arms (and pockets).  For now, nowhere is the welcome likely to be bigger than in Athens (we’re dismissing, as an apocryphal tale, the report of a Berlin taxi driver who recently refused a colleague’s Greek euro coins when paying his fare…)  In fact, we’re betting on gift-bearing Germany’s popularity remaining high for some time to come, as an investment and currency hedge.  Ceteris paribus, we too would be favouring those euros that have some residual Deutschmark genes in their DNA.  But that’s a whole other story…

Related posts:

1. When Masters of the Universe resort to Jingle Mail, listen up
2. EPRA to the rescue as German government amends GOEF rules
3. When I hear the word “Sustainability”, I reach for my revolver

Even the entertainment was low-key, in keeping with the buttoned-down tenor of the industry these days. Only the lawyers seemed to have no qualms about making a late-night splash on their harbour-side motor yachts, or in Cannes’ better class of hotel – but then, it’s good to be the winners, whether the market is leveraging up, or trying to negotiate its way out of a lost cause. Somebody has to salvage the MIPIM’s reputation as a glamour event, after all – now that the Russians no longer appear quite so keen to entertain all and sundry, and Europe’s now-nationalised banks have to be seen to be acting suitably chastened.

Back here in Germany, the first quarter has seen the highest level of new investment in two years. Berlin, Hamburg, Cologne and Munich have leapt out of the starting blocks, trailed by a rather more subdued Frankfurt and Düsseldorf – but the news from all the property brokers is the same cheerful good tidings, amid cau tious talk of even rosier prospects ahead.

A handful of major deals obviously played a big role in the early-year figures, such as Corio’s takeover of fellow Dutch investor Multi’s German retail assets, and the sale of three big Berlin shopping centres. But anecdotal evidence (as well as frontline reports from the big broker groups) suggest renewed interest from UK and US investors in Germany, as well as Asian and Middle Eastern sovereign funds, with first deals from the latter groups imminent. Overheating demand for London property also seems to be diverting attention to the German occupier market, as well as the well-publicised woes of the German retail sector, which may see some prime city-centre properties such as Woolworth and Karstadt soon coming up for grabs.

That’s the good news. However, with the bonhomie of Cannes now but a fading memory, we remain fixated on the commercial property debt problem looming in Europe, particularly in the UK and Germany. These two markets experienced the highest lever age in the final boom years, and together account for nearly 60% of the almost €1 trillion debt outstanding, at least a quarter of which is potentially distressed. Much of it is secured at high LTV’s on poor quality real estate, and nearly half of all the debt on this is maturing by the end of 2012. These are really scary numbers, and frankly, they scare the bejaysus out of us.

We shudder (metaphorically speaking, of course) when we talk to yet another equity-rich investor who is purely focused on core properties in central business districts, with blue-chip tenants of superior provenance, and water-tight long-term lease agreements, etc.…Just how many of these magical properties can there be, at affordable prices? Is this what the entire market has come to consist of, we ask ourselves? The big lending banks have major exposure to secondary offices and shopping centres outside the biggest cities – and with all the potential buyers expressing interest only in the top percentile of the market, it’s clear that asset sales be low this exalted level are going to be difficult without major further impairment. A ten-year unwinding period is still our best assessment of what lies ahead for the markets at large.

Not appealing, we admit. But whatever different approach bank lenders are taking to recouping value in different European countries, whether out-placing loans to a ‘bad bank’, or introducing special servicing to their relationships with asset managers and capital providers, the banks still have to manage the flow of assets back on to the market over the long term. The fall-out will be a large pool of secondary and tertiary quality property that will never recover materially in value. The best course of action for the lender is euthanasia – foreclose, take the hit, and recycle any proceeds back into the business. Will this happen? We hope so, and the sooner the better. We’re obviously not there yet.

It seems clear to us that spending cuts, both by governments and businesses, will shape the landscape in Germany and else where for the coming years, and this will inevitably exert further downward pressure on commercial rents. We think it’s highly likely, too, that the divergence between Ger man and neighbouring markets’ allocation of space per employee will narrow significantly. German office workers may not like having to make do with less than 23 sq.m. per office worker, compared to about 8-10 sq.m in the UK, but we talk to a lot of employers – and we know they are determined to make more efficient use of their office space.

This augurs well for cost improvements, but not for any imminent lowering of the vacancy rates in Germany’s major office centres. For investors, selectivity and market timing will be key. More and more we are seeing liquidity replacing pricing as the main indicator of real estate risk; with plentiful capital still available for investment, but the markets infected by risk phobia. As the markets slowly loosen up, new, smart money is looking to replace older investors in Germany, whose hands are likely to be forced soon enough. There will be winners – but plenty of losers.

Related posts:

1. The nagging problem of German office vacancy rates
2. Whatever happened to that wave of distressed selling?
3. When I hear the word “Sustainability”, I reach for my revolver

DeVito has been involved in numerous good movies as an actor, director and producer – but we’ll always remember his role as corporate raider and asset stripper Lawrence Garfield in the 1991 drama Other People’s Money.   Engaged in a battle for control of struggling New England Wire and Cable with ‘old school’ businessman Gregory Peck as the company’s patriarch, the high point of the movie is when DeVito as Larry the Liquidator persuades the reluctant shareholders to take his money and run.  Faced with the encroaching new technology of fibre optics and a share price in terminal decline, the shareholders finally succumb to Larry’s appeal to their pockets. “I’m not your best friend.  I’m your ONLY friend.   I’m making you money”, he explains to them.

Relaxing on the intercity train on the return trip to Frankfurt, it wasn’t long until our contemplations of DeVito and Schumpeterian notions of capitalism led naturally on to thinking about Morgan Stanley.  Not just Morgan Stanley, of course.  But they, and other blue chip custodians of global real estate who successfully helped to part armies of investors from those extra millions known as ‘the promote’.  This is the premium paid by hopeful investors for the alpha returns they expect from Morgan Stanley, rather than just the beta returns offered by the market.  The price you pay for the privilege of being parted from your money by the best, as it were.

If you’re Morgan Stanley, or Goldman Sachs, or Fortress, or any other high priest at managing Other People’s Money, it’s that extra layer of income, your gilt-edged, downside-hedged, honey-lined guarantee that makes it all worth while – should it turn out that you’re no better at investing in real estate than anybody else, heaven forbid.

Three years ago, Morgan Stanley was the biggest single buyer of German commercial real estate in the entire country.  The investment bank spent over €10bn in 2007, swooping in to scoop up Germany’s most visible and prestigious office buildings, partnering in syndications and joint ventures, teaming up with asset managers to profit across the whole value chain – and to enlighten the slow-witted Germans, who just didn’t seem to ‘get it’ – that is, ‘get’ the whole real estate thing.  In one of the last of the big deals before the crisis hit home heavily, Morgan Stanley paid €2.1 billion for the ‘Pegasus’ portfolio from fund manager Union Investment – presumably one of those German investors who ‘didn’t get it’.  (It’s maybe a good thing they didn’t, as it’s helped Union Investment become the largest cross-border investor in Europe over the past twelve months.)

The Pegasus portfolio, including prestigious landmark buildings such as the Frankfurter Welle and the Neue Kranzler Eck in Berlin, was bought on a non-recourse basis using €1.9bn of borrowings from Royal Bank of Scotland, or about 90% leverage.  With the securitisation markets about to collapse, RBS didn’t get a chance to bundle up and atomise the loan so that it could become Other People’s Problem.  Unsurprisingly, it’s still RBS’s problem.

Over in the US, Morgan Stanley’s acquisition of Crescent Real Estate Equities in 2007 for $6.5 billion in cash proved a master-stroke of bad timing. Two years later, the deal, which included 54 office buildings in big cities across the US, ended with Morgan Stanley simply handing the company over to Barclays Capital, to avoid having to cover a $2bn loan obligation.

Here in Germany too, Morgan Stanley has been on the retreat for the past year, selling where it can, cancelling joint project development agreements, and scrutinising the small print on all its previous deals to see what its exit options are.

With the Pegasus Portfolio, the answer was clear – Jingle Mail, or simply sending the keys back to the lender and walking away.  The unsuspecting British taxpayer, who owns RBS, has  – mirabile dictu -  become a major German landowner and is likely to remain so for quite a while.

In New York, investors Tishman Speyer and BlackRock also saw the writing on the wall when they walked away from their in vestment in the enormous Stuyvesant Town complex on the Lower East Side.  Like Morgan Stanley, their investment was gone, and it became pointless to throw further good money after bad.  The jig was up, any prospect of profits had flown the coop, the money was lost – forever.  They just handed back the keys and walked away.

In the world inhabited by these Larry the Liquidators, the actions taken by these financial titans makes sense. They will hopefully live to fight another day by taking their (investors’) losses today, rather than succumbing to death by a thousand cuts – or paralysis and stagnation, as we’re currently witnessing in the real estate markets.  Our biggest fear is the ongoing reluctance of investors, hanging on by their finger nails and the forbearance of their banks, to engage in the inevitable process of recognising their losses and committing to a clear exit strategy.  It won’t happen overnight, but we’re seeing some signs in Germany that others are girding themselves to follow the Morgan Stanley/Tishman Speyer route, and abandon a lost cause. It needs to happen.

Related posts:

1. The importance of a good hedge, when doing God’s work
2. EPRA to the rescue as German government amends GOEF rules
3. Owls to Athens, Coals to Newcastle

 As it happens, the Greek capital did have a large owl population in its day, even meriting a reference by local author Aristophanes in his play “The Birds”.  However, the popular expression is more likely to refer to the owls printed on the coins in circulation in the wealthy Greek capital.  As such, they stood for a surfeit, an abundance – with the expression coming to mean that adding to the existing stock would be an exercise in futility.

As the EU and the European Central Bank rally round to bail out the modern Greek state, it’s clear that a lot has changed since those halcyon days of Hellenic prosperity.  Although the Greeks are in trouble now, they’re unlikely to be the last nation in Europe in need of assistance.  Others are likely to join them before this year is out.

So it was interesting to hear the views of Andreas Quint of Jones Lang LaSalle Deutschland at this year’s CIMMIT event in Frankfurt.  He told the assembled throng that real estate investment flows are again concentrating on the largest economies, with Germany therefore likely to profit disproportionately.

This new-found concentration on the strongest economies is a reaction to the crisis in the real estate markets, he said.  Smaller markets that rose quickly and subsequently collapsed, such as those in Eastern Europe, will take longer to recover than more developed markets.  More stable markets, like Germany, will benefit sooner from the huge war-chests accumulated over the past two years as prices cool to more reasonable levels. 

Quint is convinced that, after an almost total absence in 2009, we will see many more foreign investors returning to the German market this year, with adapted strategies.  His own company is engaged in many new negotiations right now with these investors, he told us.   Many are looking for a good hedging option to dollar and sterling exposure, and for them, investing in Germany makes the most sense.

A lot of people in the German real estate industry hope he is right.  However, there’s no escaping the fact that many of those war-chests have so far failed to be wheeled into action – largely because sellers aren’t prepared to sell at current prices.  Hence the current dearth of transactions.

Equity capital is the key, everyone agrees.  If you’ve got it, there’ll be plenty of opportunity to flaunt it.  But not quite yet, apparently – since everyone is also agreed that unemployment is going to rise as the industrial sector and exports suffer from the collapse of our neighbours, like our Greek friends.  At the same CIMMIT event, the chief economist of the ECB expressed his confidence that pressure by institutions and open-ended funds to invest in office properties will hold prices firm, despite rapidly rising vacancy rates. 

I can only conclude he meant prices in Germany.  For if he, and Andreas Quint of JLL, are both correct, funds will start to flow from the peripheral regions of the Eurozone and into the dominant string-puller, agenda-setter and ultimate Schatzmeister – at the expense of other markets.

For it’s not easy to see how prices of office properties in the weaker peripheral European nations can avoid further weakness in the short term, given the cutbacks and constraints their economies are being exposed to as the price of their economic salvation.  Ireland, Spain, Italy, Portugal – all are likely to suffer from lowered demand as their industries and public sectors are pushed through the wringer over the next two years.

Those other old Greek owls, of the aviary variety, were often depicted sitting on the shoulder of Athens’ protector, the goddess Athena.  Their reputation for wisdom stemmed, above all, from their ability to see in the dark.  They’re about to need all the visibility they can get.

Related posts:

1. JLL’s Quint sees Germany benefiting as larger economies are favoured
2. The importance of a good hedge, when doing God’s work
3. Whatever happened to that wave of distressed selling?

The basic thrust of his premise was this:  This new-found concentration on the strongest economies is a reaction to the crisis in the real estate markets. Smaller markets that rose quickly and subsequently collapsed, such as those in Eastern Europe, will take longer to recover than more developed markets. The most stable markets, like Germany, will benefit sooner from the huge war chests accumulated over the past two years and now waiting on the side lines to enter the market, while prices cool to more reasonable levels.

Quint is convinced that, after an almost total absence in 2009, we will see many more foreign investors re turning to the German market this year, with refined and adapted strategies. His own company is engaged in many new negotiations right now with these investors, he told us. Many are looking for a good hedging option to dollar and sterling exposure, and Germany makes the most sense.

I certainly hope he is right. But who are these people, and what are they looking for? Commercial rents are still slated to fall throughout the year – and I don’t see any immediate bottom forming there, particularly in the non-prime segment of the market. Are these the same private equity funds and buccaneers that swept into the ‘innocent’ German market only four years ago? Or is this a new breed entirely, committed to the long-term and dedicated to ‘best of class’ sustainable relationships with their local asset managers and tenants? It seems like we’re about to find out.

Later, on the same day, Claus-Jürgen Cohausz, board member responsible for the €20bn loan book of commercial property at Westdeutsche Immobilien bank, highlighted again the very real issue of valuations. Despite isolated financing problems, his bank has seen almost no impairment on cash flows of any properties the bank has financed since end-2007. It is a fact, he stated, that no matter where Westimmo has financed property around the world, we now have historically high spreads on property assets compared to 10-year gilts. This is preventing all those war chests that have been amassed from being wheeled into action – there are no transactions, because sellers aren’t prepared to sell at these prices.

His solution is for a general reappraisal of appropriate real estate yields, in other words fresh and market-relevant valuations, so that Germany can experience what the UK is experiencing, and get markets moving again. He said it was one reason why his and other banks were often surprisingly relaxed about covenant breaches of loan to-value ratios – because he doesn’t see current valuations as being sustainable. Citing an example from Japan, where one of his bank’s fully-let office buildings is yielding 5.9%, while the 10- year treasury is paying 0.5%, he asked whether this is sustainable.

It’s an uncomfortable question – but not the only one he raised that makes me uneasy.  Everyone seems to agree that unemployment is going to rise as the industrial sector and exports suffer from weakened neighbours. Nobody doubts (at least publicly) that the low point of the crisis has been reached, the worst is over.  At the same Frankfurt event, the chief economist of the ECB expressed supreme confidence that the pressure by institutions and open-ended funds to invest in office property will hold prices firm, despite rapidly rising vacancy rates.

Can it really be that cash-flow is all that counts? Shouldn’t all the above, particularly the little matter of industrial prospects, be pointing to a deflationary environment ahead? We have to admit, we’re starting to see a number of projects – funds, mainly – that depend for their success on the willing suspension of the investor’s disbelief. If the preservation of capital is subsumed in the rush to worship at the altar of cash-flow, it’ll be a bonanza for the promoters and creative artists of the industry, pandering to the ever-shorter time horizons of the yield-seeking community. Spending money is easy.  Getting it back fully intact and well-serviced after ten years is another matter altogether, as we’re likely to find out.

Related posts:

1. The nagging problem of German office vacancy rates
2. Owls to Athens, Coals to Newcastle
3. Whatever happened to that wave of distressed selling?

Perhaps it’s understandable – transactions, after all, are the life blood of the brokerage and advisory industry. But an up-tick in trading volumes in the third and fourth quarters of this year is no basis for assuming that property prices have reached a new equilibrium, and it’s upwards from here.  We are uncomfortable, too, with the now widely accepted notion that, since the wave of distressed selling in Germany has been conspicuous by its absence, it no longer poses an immediate threat.

No, not an immediate threat, perhaps. But the pernicious nature of the current market serves to hide a multitude of deceits, whose effects are debilitating rather than instantaneous.   Headline-grabbing announcements of new financing deals provide some distraction from the cold reality being experienced at the coal face of property investment by those with their own skin in the game.  Banks and governments’ attempts to prevent ‘distressed’ selling are promoting the wide spread side-effect of stanching the flow of credit for investment, and postponing the day when losses are realised.  Their hope is that capital values and LTV ratios will float magically upwards so that they can re-finance and somehow escape the hangman’s noose.

It’s a vain hope, and has resulted in a market that is constipated, with few laxatives in sight.  Any ‘normality’ that is hoped-for is one at a permanently lower price level, certainly for several more years.  In the early 1990’s, despite far more moderate price declines, panicking banks dumped their distressed property in a heartbeat, rather than convulse themselves by trying to stomach the indigestible.  Many of today’s most successful US REITs got their start at that time, and went on to build up sizeable businesses.  But today’s collective climate of government bail outs, bank restructurings, and paralysis in the face of the wave of CMBS maturities coming down the turnpike from 2011 onwards – put at ?€13.5bn for Germany alone for 2013 – will ensure that any market clearing will be slow and protracted.

It’s the banks who are ‘managing’ the risk now, since many investors have been nominally wiped out.  But since investors are disinclined to leave the party while their hosts hold out the prospect of another drink, this could all take some time.  So long as investors are servicing the interest on their loans, banks will turn a blind eye to breaches of loan covenants, which are now widespread.  We expect defaults on interest payments to become much more common next year, and banks to take a harder line as they reduce their whole exposure to the property sector.  They still won’t want to book losses, and buyers still won’t want to pay over the odds, but the high margins and fees on new property business will help the banks to get their creative juices flowing again.

As always, rental incomes and replacement cost remain the fundamentals of property valuation.  We see both of these pillars remaining under steady pressure in Germany next year.  The current infatuation among investors with prime CBD office properties in Germany clearly provides a degree of support for the top end of the market, to the exclusion of the middle and lower divisions.  With rising vacancy rates and a still very uncertain outlook for employment in Germany next year, this will put disproportionate pressure on office rents in second and third-rate properties.  Tenants re-negotiating leases in all but the primest of properties will remain in a strong bargaining position throughout 2010.

We are assured by Axel Weber of the Bundesbank that there is no credit crunch for ‘real’ companies in Germany, i.e. companies that actually produce and export things.  That’s comforting to hear, although we doubt its veracity, and it doesn’t tally with our anecdotal evidence from businesses outside the real estate industry.  Given sufficient security, however, there’s plenty of credit available even for property lending, as the healthy state of the German residential market can testify.  And as cash rich equity funds can attest when contemplating buying commercial property.  Sufficient security, of course, is the rub.

The German market is not in dire straits – quite the contrary.  But German business es are dependent to a high degree on the financial well-being of their neighbours and key export markets, and we see little sign of major upturns elsewhere, in a manner that would lift the uncertain cloud hovering over German employment prospects.

Perhaps this very uncertainty about business prospects has partly underpinned the sizeable capital sums flowing into German residential property this year and, as we expect, next year as well.  The fundamentals of residential investment in German urban conurbations are on a much sounder footing.  The market for alternative financing in the sector is growing rapidly, with a broader range of refinancing options open to investors.  The capital markets, too, are showing confidence in the sector and a willingness to respond to cash calls.  This augurs well for the German listed property groups, who have learnt much from their dalliance with foreign private equity investors.

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Like “liberty” or “justice”, the concept of sustainability threatens to become nothing other than a feel-good buzzword with no real meaning or substance.  If,  two years from now, the talk is still all about sustainability, it will be obvious that we are still in a deep and ongoing recession, and the real estate industry hasn’t come up with significant new ideas to get the markets moving again.  Sustainability will still be top of the agenda, but green-fatigue will have to be countered by specific commercial marketing of the individual merits of a waste-reducing, energy-efficient, employee-friendly building that can provide solid financial returns to investors and tenants. It will soon have to be more narrowly defined, if it is to continue to have any meaning.

Now, don’t get me wrong.  Sustainability, in all its facets, is indeed an admirable goal and clearly more than just a passing fad.  At a recent conference I was chairing on corporate real estate, the senior managers on the discussion panel all confirmed the key role that sustainability now plays in their decisions.  The impetus is coming from big enterprises, with their corporate mission statements committing themselves to the highest standards of green and eco-friendly manufacturing.  A Google or a Coca-Cola, or any leading consumer products company, will now never move into anything other than a state-of-the-art sustainable building, given the potential negative impact on their bottom line.  With the world-wide threat of lower consumer spending looming, the perception of health and eco-friendliness associated with their products is their business raison d’etre, their very life-blood.

By contrast, the real estate industry, until recently bedazzled by the glare of abnormal financial returns, is scrambling to catch up.  But it’s scrambling fast, and never faster than in the last twelve months, as it seeks to jump aboard the great sustainability gravy train.

If anything, the priority given to sustainability has risen markedly since the onset of the financial crisis.  Given the extra costs involved in improving energy, water and material efficiency, this may come as a surprise in these cash-strapped times.  In fact, it’s likely to prove the catalyst in shaking out the older, financially-engineered speculative investors in the recent boom years, from the new wave of capital that will drive property markets into the next upswing.  With the current over-supply of office space in Germany’s leading cities, owning outdated and energy-inefficient properties will not be an enviable place to be for investors who are short of capital.  That’s a lot of investors.

We all now know that buildings use 40% of the total energy consumed in the US and Europe, and are responsible for 38% of carbon dioxide emissions – far more than all the cars, ships and jet airlines that criss-cross our highways and continents.  The sustainability industry can look forward to years of lucrative contracts in reducing the environmental impact on buildings.  These specialists are already proving the beneficiaries of this new awareness, hiring staff and expanding into overseas markets, while the ‘classical’ real estate industry continues to shrink and consolidate.  Accountants and other cost-cutting specialists are enjoying a new field-day, while over-leveraged investors with over-priced investments are trying to come to grips with the changed environment  Under water and faced with higher bank charges, for them, clearly, the situation will soon prove unsustainable.

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2. EPRA to the rescue as German government amends GOEF rules
3. Whatever happened to that wave of distressed selling?