The Deutsche Bundesbank in Berlin
High interest rates are continuing to hobble Germany’s open-ended property funds, reducing cash inflows and creating downward pressure on property values, according to ratings agency Scope this week. As a result, ‘it cannot be ruled out’ that some funds may face closure next year, the agency warns.
Inflows into real estate funds plummeted by more than 60% in first half of the year as investors hold back from investing due to the slump in construction orders and the insolvency of project developers, according to consultancy Barkow Consulting.
Next year, ‘the balance could turn negative, as inflows are likely to continue to be low and at the same time there will be outflows, as fund units are successively returned after the required one-year period has elapsed, among other things due to cancellations,’ according to Sonja Knorr, a specialist for real estate funds at Scope.
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Sonja Knorr, real estate fund specialist, Scope
Back in the spring, it was anticipated that interest rates would fall again in the second half of the year but such a fall has not materialised and the current interest rate level could persist for much longer. Subsequently, this means that open-ended real estate funds are becoming less attractive than interest-bearing investments, which has a direct impact on capital flows. At the end of August, net inflows for all funds stood at €1.31 billion, a massive decline compared to €4.72 billion for 2022 as a whole, €6.57 billion the year before and €10.23 billion in 2019, according to Scope.
The recent insolvency of the Nuremberg-based developer Project Immobilien has also sent shockwaves throughout the industry. The non-insolvent investment arm of the group collected the money for the construction projects by launching funds - a total of €1.4 billion, subscribed by more than 32,000 investors. Three of the four companies in the group are bankrupt. Most recently, the group had an investment volume of €3.2 billion under construction or in the planning stages.
Other interest-bearing investments outperforming open-ended property funds
In addition, as investors are now aware, many interest-bearing investments now yield a significantly higher return than open-ended real estate funds: according to the BVI, they delivered an annual performance of a meagre 1.9% as of 30 September 2023. By way of comparison, the German 10-year government bond currently has a 2.82% yield.
When interest rates were low, property funds soared in popularity because they generated considerable returns. Special funds for institutional investors, for example, increased the net value of invested assets almost fourfold to €176 billion between 2012 and the end of June 2022, according to Barkow, who referenced data from the Bundesbank. Public funds, in which anyone with sufficient capital can participate, grew by 58% to €132 billion in the same period.
By assets, Spezialfonds dominate at €2,015 billion, succeeded by open-ended retail funds at €1,334 billion. As of mid-2023, the fund industry in Germany managed an impressive €4,001 billion for both private and institutional investors, marking a 5% increase from the beginning of the year.
Fund managers do not have to publish details about terminated fund units. However, investors who acquired their share certificates after 21 July 2013 can only get rid of their shares after a 24-month holding period. Nor do they not get their money back immediately if they send the fund company a termination letter, but only twelve months later - and then only at the value of their units 365 days later, and not at the price on the day of termination.
This 12-month notice period also applies to investors who buy used fund units on the secondary market. Those who buy shares traded on the stock exchange - currently at a discount - in order to pass them on to the fund company at a profit could run into problems if the value of their shares has fallen below the purchase price by the redemption date. Legacy investors - private investors who bought shares in open-ended mutual property funds before 2013 - can still return units to the tune of €30,000 every six months.
As funds wade into choppier waters next year - as properties face further write-downs and investors tighten their belts - they will do well to remember that the legislator prescribes a liquidity of at least 5% of the fund volume. Many funds have accumulated cash holdings well in excess of this minimum liquidity. Currently, €18.3 billion is available across all funds. The funds' volume-weighted liquidity ratio currently averages 15.1%, which is higher than in 2021 and 2022.
Sought-after properties are below the €100 million mark
An obvious move for funds in need of greater liquidity is to sell off properties but even that is problematic in the current climate. Sought-after properties are typically smaller, well-let buildings below the €100 million mark. Currently, buyers are mainly equity-rich investors such as family offices. Properties with letting and storage risks such as offices are going to be harder to offload, given that they are threatened with high markdowns. Yet offices account for 52% of the current values in the total investment portfolio of open-ended funds. If funds that invest exclusively in residential or retail are excluded, this share jumps to as much as 62%, according to Scope.
If, despite currently solid liquidity and possible property disposals, the liquidity of individual funds is not sufficient to stem negative cash inflows over longer periods, their only option will be to suspend the redemption of units. However, Scope does not expect a number of (temporary) fund closures. However, ‘it cannot be ruled out’ that individual funds could be affected by such measures, the agency warns.
Changes in the workplace since COVID are also affecting funds, particularly the trend towards working from home, according to Knorr: ‘Above all, properties that are not in A locations and that do not meet ESG requirements face devaluation risks,’ she told the FAZ.
Knorr also looked at how home offices have fared in various major German cities with important office locations. ‘In the German office strongholds, the three-day week has become established,’ she said. On average, office workers in Berlin, Düsseldorf, Frankfurt, Hamburg, Cologne, Munich and Stuttgart worked in the corporate office on just 3.2 days per week, according to JLL.
Retail slump also weighing on funds
The slump in the retail sector is also affecting the valuation of funds’ retail assets, as Scope notes: ‘The trend toward e-commerce, which was massively accelerated by the COVID 19 crisis, has already weighed on the sector in recent years.’ In tough economic times, people cut back on consumption, which is likely to lead to further challenges for the retail sector. This is particularly noticeable in the case of shopping centres, where tenants there have already been able to push through rent reductions but further rent losses are to be expected, according to those who track the market. Further devaluations are likely to follow. Scope therefore expects fund returns to fall and the difference in returns between individual funds to increase.
In July, Scope downgraded five of 20 German open-ended real estate funds, based on an increased risk profile and weaker net actual returns, noting at the time: ‘Participants see high and very high devaluation risks, especially for office properties in the periphery and B locations.’ The five funds that were downgraded were heavyweights: Grundbesitz Fokus Deutschland from DWS Grundbesitz, Hausinvest from Commerz Real, KanAm’s Leading Cities Invest from, UBS’ Euroinvest Immobilien and UniImmo Europa from Union Investment. ‘The downgrades were caused by both increased risk parameters and weaker yield developments,’ Scope said at the time.
