A Property Market on Ice

How Deutsche Bank has chilled German real estate funds

For risk-averse German retail investors, real estate funds once seemed like the perfect way to avoid the stomach-churning ups and downs of the stock market. The funds invest in bricks and mortar such as office buildings and are designed to pay a modest but steady return of 4% to 6% a year. Investors can redeem their shares at any time for a price based on the estimated value of fund holdings, but the shares aren't traded on any open market, and big price movements are rare.

Little wonder that, in the wake of the tech-stock meltdown, Germans poured billions into property funds, making them No.3 in popularity as a vehicle for retail investors -- after stocks and bonds. "I was always told it was an absolutely secure investment," says Ingrid Naab, a Frankfurt schoolteacher who bought shares in a fund sold by Deutsche Bank's (DB ) DB Real Estate unit.

Now these brick-and-mortar investments aren't looking so solid after all. On Dec. 13, Frankfurt's Deutsche Bank shocked the German banking world by freezing the $7.2 billion fund. The bank made its unprecedented move after investors were spooked by Deutsche Bank's announcement that it would conduct an unscheduled revaluation of the fund. Since that could only mean a sharp markdown of the underlying assets, investors crowded bank branches to redeem their shares. Freezing the fund amounts to the equivalent of a bank closing its doors to a mob of frantic depositors, and the result has been alarm in the German banking community about the reliability of the country's $105 billion property-fund industry.

Yet Deutsche Bank's decision to revalue its real estate funds was the result of a long-simmering problem. Germany's commercial-property market has been in a four-year slump, with rising vacancy rates and falling rents. Now the German banking world is waiting anxiously for the results of the independent valuation commissioned by Deutsche Bank of its frozen fund. The assessment is due in early February.


German bankers fear a major write-down may shatter fragile investor confidence, creating a domino effect. Other real estate funds heavily invested in property might also be forced to close and liquidate their assets, probably with big losses. Legally, investors carry all the risk, but in practice German banks won't be able to avoid covering some of the loss from investments they often sold as "mündelsicher" -- good as gold. The funds were sold almost exclusively to ordinary Germans, rather than institutional investors. "If a second one closes, then there could be a run," says Alexandra Merz, managing director of Scope Analysis, a Berlin firm that rates investment products.

Fearful of just such a panic, regulators at Germany's Federal Financial Supervisory Authority have ordered real estate fund managers to supply figures daily on outflows. So far, regulators say, investors have trusted the assurances from fund providers and haven't lost their nerve. Edgar Meister, a member of the executive board of the Bundesbank, Germany's central bank, sought to calm markets by telling the business daily Handelsblatt in an interview published on Dec. 27 that he thinks the nation's banks are strong enough to absorb any shock in real estate funds.

The big flaw with the funds is that they promise investors liquidity but are themselves tied up in illiquid assets such as shopping centers or industrial parks. If too many investors demand their money back, fund managers have trouble raising enough cash. The most troubled funds are generally those most exposed to the German real estate market.The Deutsche Bank fund currently on ice has some 65% of its capital tied up in German property such as the Focus Teleport, a Berlin office building that counts DaimlerChrysler (DCX ) among its tenants. Declining rental income had already pushed the fund's annual return below 3%, prompting investors to withdraw more than $1 billion in the year before the fund was closed.

Deutsche Bank's fund is hardly the first to get into trouble. Other funds have also seen huge withdrawals. Commerzbank's (CRZBY ) hausInvest europa fund, the biggest German property fund, suffered an outflow through November, 2005, of $1.6 billion, leaving fund volume at $10.7 billion. But so far, the institutions behind the funds have always used their resources to prevent a panic. For example, Allianz Group (AZ ) bought buildings worth $2.1 billion from a fund operated by its Dresdner Bank subsidiary, avoiding a fire sale of properties to raise cash.


Deutsche's rivals are privately seething that the bank, Germany's largest, didn't take similar steps, especially since there are signs that commercial real estate is improving. "We think the low point has been reached," says Peter Birchinger, an associate partner at real estate consultant Cushman & Wakefield Healey & Baker in Frankfurt.

Instead, Deutsche promised only to provide "fair" compensation to people who have bought shares during the past two years. That, however, "doesn't conform to the traditional way of doing banking in Germany," says Reinhard H. Schmidt, a professor of international banking at the University of Frankfurt. Perhaps the bank's un-German move shouldn't come as a surprise, though, considering that DB Real Estate answers to Kevin Parker, Deutsche Bank's head of asset management, who is based in New York.

In fact, Deutsche Bank, which has increasingly focused on investment banking, might not be sorry to see real estate funds die out. The bank has led the drive to win government approval to create real estate investment trusts, the exchange-traded instruments popular in the U.S. and other countries. But a switch to REITs wouldn't help investors who have already sunk savings into traditional property funds. "I wanted something for retirement. I'm not a speculator," says Naab, the Frankfurt schoolteacher. Once again, Germans are discovering that risk is part of any investment.

By Jack Ewing

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