By Michele Lerner

With the debut of U.K. REITs around the corner, expectations for the introduction of German REITs are high.

Germany's Ministry of Finance announced on Sept. 20 that the approval of REIT legislation is expected to take place in early 2007.

"Germany has two different branches of parliament, the lower house and the upper house. According to the Ministry of Finance, the lower house is expected to meet in December 2006 to vote on the REIT legislation. The upper house won't meet until after the holidays, which will still put the German REIT on track for sometime in January or early February," says Dr. Hans Volkert Volckens, an equity partner with the Beiten Burkhardt law firm in Munich.

Becker

Schultz

Volckens

REIT Reasons

Martin Becker, a researcher at the International Real Estate Business School (IREBS) in Germany, points to a number of economic reasons for why the country should adopt REIT legislation. "First, REITs have become the worldwide industry standard for indirect real estate investments. Secondly, Germany has a well-developed private real estate market, but the public real estate market lags far behind in terms of maturity and market volume," Becker says. "Thirdly, there has been a glut of capital from foreign opportunity funds into the German real estate market during the last two and a half years that is looking for capital market exit strategies over the next three to five years. The German real estate capital market has to become more competitive on a European comparison. Finally, Germany might lose international capital flows into real estate to other European markets that have introduced or will introduce REIT regimes."

According to Dr. Florian Schultz, a partner with Linklaters law firm in Frankfurt, the competitive situation with both the United Kingdom and France having REITs in place or about to be introduced has added pressure on Germany to move forward more quickly with its REIT legislation.

Schultz says indications are that Germany will follow a similar approach to that of the United Kingdom, with what he terms a "plain vanilla" REIT structure which will be completely tax exempt at the corporate level.

Party Preferences

According to Volckens, REIT legislation has a good chance of passage in part because the Social Democratic Party, which forms part of the coalition government, is beginning to adopt a more neutral position toward REITs.

"There has been a strong confrontation between the liberal and conservative politicians, with the left wing politicians expressing the fear that REITs would have a negative impact on low-income residential housing," Volckens says. "There already are strict controls that would not allow rents to be increased, but the public nevertheless was influenced initially by some of these arguments. Now there seems to be hope that the left-wing will accept REITs."

Becker agrees with this analysis. "Apart from potential adverse tax implications due to double taxation agreements and EU law, the political discussions recently have focused on potential threats to the residential user markets," he says. "Since residential users have always been firmly protected by the legislature, some special restrictions on residential investments by REITs are expected."

Schultz says that while some left-wing members of the Social Democratic Party are concerned about the negative impact on German apartment prices, nearly all other political groups are supporting REIT legislation.

"There are some rumors that housing might be excluded from REITs, but other people say that's not the case," Schultz says.

Tax Environment

"The biggest issue with the REIT structure in Germany is the tax treatment of non-German investors," Volckens says. "If non-German EU shareholders hold at least 10 percent or more of the REIT, then Germany loses the right to tax them and therefore loses revenue. This was resolved in the U.K., and will likely be resolved in Germany as well, by limiting foreign direct shareholding to less than 10 percent.

Foreign indirect shareholding is not restricted at all." Volckens explains that shareholders with less than 10 percent are subject to a dividend withholding tax.

Volckens says he believes that the issue of imposing an exit tax on companies transferring their assets into a REIT also must be addressed before legislation can be approved.

"We expect that a number of companies are willing to transfer their assets into a REIT, but this will only happen if the tax environment for converting to REITs is attractive," Volckens says. "It depends on the actions of the legislators."

"For tax reasons, the German REIT will probably be most attractive to domestic institutional investors. Established German private real estate vehicles have failed to attract foreign investors because of a uniquely German set of regulations. However, by introducing REITs, some increase of long-term foreign investment also is expected due to the familiar name and regulation of the product," Becker says.

The REIT Race

Economically, most industry observers are optimistic that the introduction of German REITs would enhance real estate prices and increase the number of transactions.

"There are lots of expectations of an initial market capitalization in the range of €30 billion to €100 billion," Schultz says. "These predictions mostly are coming from the bankers and lobbying groups who are pushing REITs."

Should REIT legislation be approved, speculation has centered on several existing real estate companies that appear to be ripe for REIT conversion.

"The biggest companies are IVG, Deutsche Wohnen and Deutsche Euroshop, which together account for approximately half of the free floating overall market cap," Becker says. "IVG has already founded a subsidiary focusing on German real estate investments, which is ready for REIT conversion."

Schultz says there are approximately 18 public real estate stock operations now, and nearly all of them have announced some REIT plan.

"Realistically, there could be 15 or so REITs introduced," Schultz says. "If the first one commits, the others will follow quickly."

Schultz anticipates that the commercial sector will be the most likely starting place for REITs because several companies are intending to outsource their office buildings. According to Volckens, all asset sectors will be converted to REITs, with a higher number of residential properties initially.

Volckens expects German REIT investors to be primarily international. "More than half of all real estate transactions now are sales to foreign investors, in part in anticipation of the introduction of REITs," he says. "Lots of people are thinking of REITs as an opportunity for international investment and as an opportunity to open the market to foreign indirect investors. But REITs are also designed to encourage Germans to invest in Germany."

Schultz says that at the moment there is so much interest from overseas in buying German real estate that there are concerns Germany may have too many overseas investors.

"The finance minister will not have a problem as long as there are enough German investors, because German investors are taxed on their dividends," Schultz says. "There's lots of interest from private equity funds, especially those from the United States, some of whom have already purchased German real estate with plans to convert into a REIT once the legislation has passed. This makes it a political problem if too many shareholders are foreign."

Becker says estimating the initial market capitalization is difficult until the actual legislation has been passed. "The initial market cap and its rate of growth will critically depend on the regulatory framework, exit tax and competitiveness against non-domestic real estate vehicles. For now, no sound forecast can be made."

Volckens says, "Some bankers have said that 127 billion euros of real estate will be transferred into REITs, but that is not convincing without the tax structure on the table. If the German approach is perfect, it could be more. If it is imperfect, it could be less."