May 18, 2009


Real Estate Investment Trust or REIT, is a global trademark which started in the US in the 1960’s, and is now spread across the globe. When a company define itself as a REIT, it mean that it adhere to a number of simple concept. Its is usually a listed company, its business must be real estate investment it is tax transparent, and it pays most of its profit as dividend. Although the local legislation differs here and there, those are the main characteristic of REIT worldwide.

In Europe, REIT have existed since long in the Netherlands and in Belgium, have been introduced in France in 2003 and in the last two years in the UK, Germany and Italy. alstria office REIT AG (, has been the first company to adopt the newly enacted REIT legislation in Germany, and is now the largest German REIT.

Over time, REITs have been tremendously successful in each and every country where the concept was introduced as it solves two of the major problems of direct real estate investment: High transactions costs, and low liquidity. Moreover, given the tax transparency of the REITs, it allows investors to get access to the same cash flow profile than the one they would have if they were holding the asset directly. So in theory, REIT has been designed in order to be a good proxy of the direct real estate investment.

The reality is somehow different. The liquidity of the REIT shares, the low transaction costs, as well as there publicly traded characteristic makes REIT a unique investment profile somewhere between the regular equities and the direct real estate investment. Experience has showed that on the short term, REIT will tend to correlate with equities, whereas on the long term they will tend to correlate with the direct real estate market.

Why shall REIT outperform open ended funds in the long run.

REITs present structural competitive advantages that no open ended fund can beat. The concepts of the open ended fund (at least the German open ended funds), and REITs are very similar. As a REIT, an open ended fund is designed in order to provide liquidity characteristics to an illiquid asset. However, in order to achieve that goal, the open ended fund which is not listed has to undertake to buy back its units at anytime. In order to be in a position to do so, the open ended fund will always keep a large amount of cash, or cash equivalent as liquidity on its balance sheet

Given that the liquidity of the REIT share is provided by the stock market, the REIT is not constrained in the same way For any given real estate asset, an open ended fund need at least 5% more equity than a REIT in order to meat its minimum liquidity requirements.

The reality is even more striking. According to a study published in 2006 in the Journal of Real Estate , on average the German Open ended funds hold 30,8% of there Net Asset Value as liquidity. If I was to extrapolate this number to alstria, this would mean that we would keep on our balance sheet around EUR 240 million as cash invested at money markets returns whereby it is now invested in (usually) solid real estate providing real estate returns.

The returns of the open ended funds are also hit by the payment of an entry fee (which is usually 5%) to the fund manager. Whereas the REIT is designed in order to limit the transaction cost to the maximum extend possible (which is achieved through the listing in public markets), the fee driven business model of the funds impose on the retail shareholder to pay out a fee of 5% in order to buy the shares. In other words, when an individual invest EUR 100 in an open ended fund, he ends up buying in reality only EUR 95 of shares and pays EUR 5 of fees. The same EUR 100 invested in a REIT would buy the same individual shareholder around EUR 99,5 of shares (with an over average estimate of 0,5% transaction cost).

The table below summarize the difference of performance of a REIT versus an open ended fund, under the assumption that they both invest in the same real estate portfolio delivering 8% compounded returns.

At this stage I need to be very precise. I am not saying or suggesting that because alstria is a REIT, it is better than any open ended fund. Any open ended fund invested in Germany that would convert into a REIT would, everything else being equal, provide significant better returns to its shareholders. For a simple undisputed reason: REIT would regardless of the capital structure used, require less equity to hold the same portfolio. It does not need the liquidity reserve for the shares.

It is not because you don’t see it that it does not exist

One of the major critics I heard about REIT since we have listed alstria is that share price is volatile. And I have to confess that this is true. As mentioned previously, the REIT shares tend to correlate with equity on the short term. It is correct that the share price of alstria today, is different than the share price yesterday, and will be different tomorrow. And the differences can be as high as 10% per day. Volatility comes with liquidity. But volatility should not matter for the long term investor, as by definition it only reflects the shot term movement around the average long term returns. As REIT and open ended funds are tailor made for long term investors rather than day traders, the volatility should not be a concern.

Moreover, the lack of volatility of open ended fund is in reality one of their major weakness. As this happened in 2006 for some German Funds or more recently late 2008, the sudden anticipation of heavy losses can trigger high redemption demands which will force the fund manager to freeze redemption. At this moment, the open ended fund does not provide liquidity to its shareholders and become an illiquid asset. And this is when investors brutally realize that it is not because you do not see the volatility that it does not exist.

It is relatively easy to illustrate the advantage of the volatility in the real estate shares in today’s markets, where REIT and property shares are all trading at significant discount to NAV, linked to the global uncertainty in the financial market. This reflects in part the belief that some equity investors have that the value of the direct real estate investment will fall. If they are right, than the share price of REITs have already adjusted to that whereby the open ended funds shares still need to adapt (and will without doubt fall by the same proportion at one moment in time). If they are wrong then the share price of REIT will recover and trade again closer to NAV. In both scenarios the REIT shares adapt smoothly to the changing environment, whereby in the first scenario the open ended fund shares would have to adapt drastically to the market.

Looking for real estate or for money markets?

It is now widely admitted that if one can overcome the hurdle of the 5% entry fees, open ended funds can be a good replacement for money market funds, or treasury account. On the short term they provide slightly higher returns with limited volatility. However, if one is looking for long term real estate returns (and can leave with short term visible volatility) than the REIT is set by construction to outperform the open ended fund structure.

This is one of the main reasons that make me believe that the REIT can only end up into a success story in Germany. Although there are yet still some hurdle to overcome, among which the most substantial is the 1 b€ of annual fees generated by open ended funds managers, it is only a question of time for resource to be reallocated to the most competitive asset class.

Tax is a rich man problem

I almost forgot to speak about the tax considerations. As investors I learnt very early that no investment decision should be based on tax consideration solely. Tax structuring can only enhance the returns but in no circumstances can deliver the returns. Although for a German resident, it seems that investing in REIT is the most efficient way to get real estate exposure I would not use that argument to justify any investment in REITs. A tax only comes with a profit. Before trying to save taxes, you want to make sure that you will make as much profit as possible on the long run.


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