German institutional investors are looking to increase their allocation to real estate in the coming years and managers from as far apart as the US and New Zealand are on the road to tout their wares.

Attractive on-going returns of 6-10% – depending on the market sector – and low correlation to fixed income and equities, are frequently the attraction. “Property as an asset class has become an important topic recently,” says Patrik Roeder, managing director at Henderson Global Investors in Frankfurt. “Many recent ALM studies, which institutional investors have carried out because of three poor years of eq­uity returns, recommend a strategic allocation of 5-20%,” he says. However, the cur­rent average allocation is still more like 5%.

According to a survey of German pension funds and insurers carried out by the Wiesbaden-based consultant Heissmann in the first quarter of this year, these investors want to raise their property allocation by 1.3%, from 4.3% to 5.6%. Some experts calculate an increase in institutional real estate investments of E8.6bn by 2008. According to the German investment and asset management association BVI, institutional real estate fund (Immobilienspezial­fonds) assets amounted to E13.8bn at the end of March, or 2.45% of the total Spezialfonds assets of E532.4bn.

The lion’s share of new investments will be channelled into foreign property. “The bulk of property investments is very Germany-oriented,” says Roeder. “If you look at the current real estate allocation of German insurers and pension funds, you notice that the proportion invested in Germany amounts to 92%, EU investments only to around 5% and the non-European proportion to 3%,” says Sebastian Thürmer, head of marketing and sales at LB Immo Invest in Hamburg. Many institutional investors would aim for widely diversified portfolios, but they lack the appropriate market knowledge of the various countries. Many are making use of external institutional fund expertise and not least because of this.

The Bavarian pension fund for professional groups, Bayerische Versorg­ungs­kammer (BVK), Germany’s largest first pillar fund, has invested in non-German property for about three years and exclusively via institutional Spezialfonds.

The fund invests 5.7% of its E30bn in assets in real estate, a proportion that it intends to increase by means of foreign investments.

“We want to retain our domestic property exposure and raise that abroad,” says Daniel Just, BVK’s board member responsible for asset management. “A few years ago we had a portfolio dominated by residential property, largely in Bavaria. Thereafter we developed a Germany-wide policy – where we invested in the principal cities – and more in office space, in order to have a balanced portfolio.”

Three and a half years ago the BVK invested abroad for the first time, through a E500m iii European Spezialfonds, with HVB Invesco as manager. In early 2004 an international property fund followed, with GLL in Munich. It had the same target size, but with a broader investment horizon that included the US. The pension fund is currently working on its third E500m international real estate placement, which will include Europe, the US and Asia. It is now looking for a consultant.

Nordrheinische Ärtzteversorgung in Düsseldorf, the E7bn first pillar fund for doctors in northwest Germany, is also investing more abroad. Its strategic allocation to property is 10-15% of assets; its current allocation is around 11.5%. “Demographic trends force us, as a long-term investor, to reduce [our exposure to] Germany. It is one of the countries that will see a reduced demand for residential property from 2010, and also for other property sub-classes because of this,” says Dr Dirk Lepelmeier, the fund’s managing director.

All the doctors’ fund’s foreign property investments are conducted through external managers. This year the fund has already invested in three European property Spezialfonds; the fourth and final fund investment was with MEAG Munich Ergo KAG and took place in July. The E300m funds are constructed with a 50% participation from the doctors’ fund and a 50% external participation. Apart from this, the fund’s real estate portfolio includes investments of around E50m in US and Asian real estate investment trusts (Reits), and a E100m investment in real estate trading, holding or development companies worldwide, with a 60% eurozone ex-Germany exposure and 20% each in the US and Asia.

According to the Heissmann study, 52% of the institutions polled managed their property portfolio internally and only 24% outsourced it. (The question was irrelevant for the remaining 24%.) However, this set-up appears to be changing as investors seek to reduce costs and diversify investment risk. Direct investments consume resources and contain risks because of the lack of diversification.

Experts tell us that they observe a trend towards indirect investment and outsourcing to specialists.

“Targeted outsourcing of real estate can increase the chances of good returns, can increase flexibility and open up new possibilities for financing,” says Thürmer of LB Immo Invest. “People are thinking about their property investments. For many it is clear that they must depart from these investments,” says Herwig Kinzler, Mercer’s Frankfurt-based head of German investment consulting. “Then the question arises as to whether they will manage the real estate in co-operation with other institutions, whether they sell them to a fund, or whether they will invest in a Spezialfonds.”

However, not all experts are convinced that investments are being made for the right reasons. “People are not going into property because they find it such a great asset class, but because it is a second- or even a third-best solution. Three to five years ago people did not invest greatly in property because bond returns were much more attractive,” says one experienced Swiss pension adviser.

Crispin Lace, who is responsible for Watson Wyatt’s German investment consulting business, also attributes the current interest in real estate to low bond returns. “Investors of pension assets [in Germany] have a relatively low allocation to property because the bond market has provided decent real returns. I believe that we are seeing a change here,” he says.

However, the Swiss expert we spoke to says that this may not be the right moment for increasing property investments: “I would be very careful with property at the moment, as valuations have increased markedly worldwide and you even have to say that there is a partial overheating. If we assume long-term rising interest rates, then property valuations will suffer.”

Investor professionalisation and growing product supply is one thing, but the management of a diversified real estate portfolio is not a simple undertaking.

For one, higher allocation to foreign investments leads to greater currency risk. There is also a lack of transparent regional or sector indices for investors to use as a performance benchmark. And the lack of liquidity in this asset class makes asset allocation and manager selection choices particularly difficult.

Some investors are prepared to take on currency risk in their portfolios. Nordrheinische Ärtzteversorgung, for example, only partially hedges these risks.

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