This time it is different

It has been a while since I have not written anything on alstria’s blog. I started from time to time, but never get to finish the work. This morning however, when I read the piece about the German real estate, that was featured in the daily newsletter of Property Investor Europe (which is usually the first think I read in the morning), I knew I would get through.

 

The “Expert view”, which is called “Upward trend on the German commercial real estate market” (and available here: http://aox.ag/PIE_German_office ) gives an overview about why investors should be investing in the German office sector, which per see, should not lead to any specific comments from my side. Except that, when I finish reading the post, I suddenly felt younger by 7 to 8 years. If you want a list of all the bad reasons to invest in the German office market, this post is definitely the right place to start. It is making 5 assumptions that should lead a decision to invest in German office space.

Assumption 1: Economic growth in Germany is resulting in increasing demand for office space

This is a graph that was published on this blog four years ago (and would lead to the same result if extended to 2014).

I am amazed to see that some commentators are still arguing about the fact the GDP growth correlate with office rental growth. This might have been the case 30 years ago, but it is clearly not the case anymore. The way tenants are learning to optimize their office space, and the efficiency gain they are realizing are by far outstripping any additional need of space created by GDP growth. Do not expect any substantial rental growth in the German office sector, nor substantial vacancy reduction.  It is unlikely to happen anytime soon.

Assumption 2: Financing of commercial real estate is becoming cheaper

That is absolutely true. Financing is cheap. I would have thought that I would never again hear this as an argument for buying  real estate (nota: alstria always underwrite assets based on unlevered returns), but apparently I was wrong.

Assumption 3: Rising demand for office premises with a positive impact on rental markets

See point one above. This has never happened in the past, and I see no reason why it will happen in the future. Absorption in the market is at best neutral, more realistically negative.

Assumption 4: Ongoing investment pressure is driving transaction volumes and is reducing risk aversion

The first part of the assessment is absolutely correct, investment volume is going up, and has accelerated drastically over the last weeks (mainly on long term leased assets, driven by yield seekers). But I am not sure that risk aversion is reducing. Short term leased assets, or other assets with potential operational risk/leverage are not so much in demand. Not sure though that the risk aversion is reducing, but clearly the risk return profile of some of the assets which are being considered for trading is deteriorating.

So what is the German office market all about then ?

Obviously we all have our views on the market and how it is going to develop, and mine is as good as any other. The fact of the matter is that our position is based on an educated guess, not a crystal ball. We believe that the German office market is going to be driven by operational excellence, vs. financial engineering. That real estate needs more operators and less financial sponsors.  that driving returns should come from increased market share, better scaling of costs, operational excellence, better services to the clients (some call them tenants). That expectation of market rental growth driven by macro factors, should not be considered, and will only enhance returns if its happens. 

In my last roadshow meeting, when I was discussing the state of the investment market and the increased transaction volume we are seeing in Germany, I was asked by an investor if I felt any similarity with 2006-2007. My answer at this point was that I did not, as I believed most of the players in the market still have the deep scares and bad memories of what happened then. I think it is Mark Twain who once said "History does not repeat itself, but it does rhyme". Well PIE this morning was rhyming very strongly with 2007 (and if in doubt here are the same arguments put together in 2007:  

Deutsche Bank research: German office Market (April 4, 2007) 

At that time DB concluded as follow:

"The greatest risk in the years ahead therefore lies not in a downswing on the property markets, but in exorbitant expections on the part of investors and project developers"

I guess this last point is still up-to-date

 

 

 

 

Adding the numbers

A short mathematical problem for my eight years old son to solve:



·       At 30/09/2011, the total NAV (Net Asset Value)of the German open ended funds was 85.151 mEUR.

·       At 30/09/2012 (a year later) the total NAV  ofthe German open ended funds was 83.173 mEUR

Assuming that over the period the asset value is only influenced by net flows, can you calculate how much theses in(out)flows are ?

Here is my son’s answer (and any other kid for that matter):The total flow for the period is equal 83.173 – 85.151 = - 1.979. Given that this number is negative, this is an OUTFLOW.

You think this is obvious. Well it is not. At least not for the Bundesverband Deutscher Investment-Gesellschaften or BVI. For the German Funds Association which states that “it enforces improvements for fund-investors and promotes equal treatment for all investors in the financial markets. BVI`s investor education programs support students and citizens to improve their financial knowledge”, the simple math above do not work.

According to the BVI the correct answer to the question above is a net INFLOW of EUR 2.766 mEUR. In other words 83.173– 85.151 = +2.766…

This is not an isolated mistake. If you look for the BVI net inflow publications for real estate open ended funds from 2007 to 2011 theses are the numbers you will dig out:

 

While “NET inflow” for the period was around EUR 13.7 b, the total NAV of the funds grew by a little less than a 10^th of that. How does this work? 

In order to understand the forces at work, you need to take a look at the same set of numbers, published this time by the Deustche-Bundesbank. The Bundesbank publishes two additional numbers. One is the total outflow, and the second one is the total distribution paid. The Bundesbank also make it crystal clear that the NET-inflow numbers disregard any distribution.

The previous table looks like this in the Bundesbank report:

 

 

With this additional information the numbers make sense (the reason why the numbers do not add-up exactly is because of the underlying performance of the funds which impacts the NAV). The so called Net Inflow, is for the most of it, not more than a dividend re-investment scheme. It has NO influence whatsoever on the amount of money available to invest in real estate.  

The information which is has been provided by the BVI to the market for years is highly misleading. The vast majority of the market participants believe that the net inflow which is publish is what it name says it is: Net inflow, ie. new money that is coming into real estate.  Here are a couple of example of some investors/advisors that have been across the years willingly or not mislead by the BVI communication.

http://portal.cbre.eu/portal/page/portal/RRP/ResearchReportPublicFiles/5_German%20Open-ended%20Funds_September%202012.pdf

http://eres.scix.net/data/works/att/eres2012_ind_103.content.pdf

http://www.prres.net/Papers/Seek_International_Property_Investment_Trends.pdf

Google will provide you with dozens of other examples. Since the publication of the last BVI figures last week, I have received at least 5 daily emails of investment banks mentioning the fact that open-ended funds had EUR 2,7 b of inflow year to date. All of them were hinting to the fact that this money will need to be invested (at least partly), therefore driving demand. This is just not the case. In actual fact, the total amount of money available for investment in real estate went DOWN.

The BVI recently published an analysis where it found that there are significant deficiencies in the corporate governance of German listed companies. That might as well be true. But assuming the BVI really cares about the topic, I would strongly encourage them to start cracking at their own issues first.

NB: all the numbers quoted in this post are sources from:

http://www.bvi.de/fileadmin/user_upload/Statistik/BVI_Investmentstatistik_201209.pdf

http://www.bundesbank.de/Navigation/EN/Publications/Statistical_supplements/statistical_supplements.html (supplement 2 as of 28/09/2012)