Run on German Real-Estate Funds
Exposes Flaws in Regulations

German real-estate legislation is under fire. After big outflows caused three open-ended real-estate investment funds to be closed temporarily this month -- for the first time in their 40-year history -- the government is considering stepping in to shake up how the funds' real-estate holdings are evaluated.

Investors withdrew €3.05 billion ($3.75 billion) from Germany's 35 open-ended real-estate funds in December, the German funds association BVI said yesterday. That dwarfs November's €108 million outflow.

For all of 2005, Germany's real-estate funds had outflows of €3.43 billion, BVI said -- mostly in the fourth quarter -- compared with net inflows of €3.06 billion in 2004 and net inflows of €13.7 billion in 2003. The value of the 35 real-estate funds fell to €85.1 billion as of Dec. 31.

BVI spokesman Frank Bock said December's outflows were "unusual," because some institutional investors withdrew capital from the funds. He declined to give further details.

Last week, German real-estate investment fund KanAm Grund Kapitalanlage GmbH closed its US-grundinvest fund after investors pulled about $50 million out of the $579 million fund over a few days.

Investors were nervous after a German ratings agency cut the fund to "sell" because of its investments with troubled U.S. real-estate investment trust Mills Corp. That helped cause a surge in withdrawals that left the fund with no cash to pay investors, forcing the real-estate investment fund -- a unit of Munich-based KanAm Group -- to freeze it. German law mandates that open-ended funds have 5% of their investments in cash or other liquid investments.

Two days later, KanAm closed its €3.2 billion European grundinvest fund, after investors put in orders to withdraw about 20% of the fund's assets in 24 hours.

In December, Deutsche Bank AG's DB Real Estate Investment GmbH closed its €5.9 billion Grundbesitz-invest fund to stop further investor outflows, which came after DB Real Estate announced the properties in the fund were to be re-evaluated.

German financial watchdog BaFin "is now presiding over a major crisis, so it will have to do something," said Guy Barker, chief executive of Invesco Real Estate's European operations, based in Munich. Invesco Real Estate is owned by Amvescap PLC.

Industry experts say Germany's real-estate funds can weather the storm, if the government reacts to the problem in the right way. The feeling in the market is that the future of the funds will be less bleak if the valuations of funds' real-estate holdings are overhauled, and if limitations are imposed on large shareholders' withdrawals of capital on short notice.

At the heart of the problem is the way real estate owned by the funds is evaluated. Each regulated fund has a committee made up of Sachverständigen, or evaluators with a Germany-recognized qualification. This committee evaluates properties in a fund's portfolio once a year, using the "sustainable long-term value model," rather than the "open-market value model," which is more commonly used internationally.

The sustainable long-term value model smooths peaks and valleys in the market, because evaluators don't adjust the value of properties as soon as there is a big market fluctuation. Instead, they wait and see if it is a temporary blip or a more permanent market movement.

Typically, this model undervalues foreign assets and overvalues German ones, because it doesn't fully take into account how much real-estate prices have risen in some markets in recent years, such as in the United Kingdom. In contrast, the open-market value model looks at what the best price would be if a given property were sold today.

To deal with recent outflows, funds will have to sell more real estate to make sure their holdings don't drop below the 5% liquidity requirement. However, because German real-estate funds aren't allowed to sell below appraised values -- which could be significantly higher than market values -- they typically come under pressure to sell any foreign assets they own.

"Germany needs to reflect market practices elsewhere, so it could make sense for BaFin to ask funds to switch to the open-market valuation model, or perhaps a combination of both models," Mr. Barker said.

Another issue is how independent the evaluators are. "As they are appointed by the funds, not the regulators, it is conceivable the valuers come under pressure from the funds not to write down values too severely," Mr. Barker said, noting this is just a small part of the problem.

Any changes to the valuation process would be initiated by Germany's Finance Ministry and implemented by BaFin, said a BaFin spokeswoman. Germany's Finance Ministry is "considering if and how real-estate legislation for the open-ended real-estate funds should be changed," said Finance Ministry spokeswoman Nicole Rosin, adding that no decisions have been made.

Email your comments to rjeditor@dowjones.com.