Performance Report 2007

Letter to investors and partners
Chronicle
Markets
Balance

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Real estate
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Market Report Real Estate

By Johannes Bitter-Suermann, Managing Partner at König & Cie. GmbH & Co. KG

Investors' Interest Focusing More and More on the Asian Market

Germany Continues to Be a Highly Attractive Location

The players in the real estate business are international, and the markets are closely meshed with one another. Building on the pillars of economic growth and the enormous demand, countries such as India, China, Russia and Turkey, even Kazakhstan or Ukraine are the subject of observation by international capital. The driving force behind the globally growing investment volume is the high demand for investments as well as the return expectations and the hopes for political stability.

The past year was also marked by the subprime and financial crisis. Many house owners in the USA were no longer able to make their mortgage payments owing to a fall in the value of privately used properties in the USA and the simultaneous rise in the interest rates. During the low interest phase, many loans were given to borrowers with little collateral; when the interest rates rose, their income was not adequate to cover the contracted repayments. Many of the loans were securitised and sold as securities to banks, hedge funds and insurance companies. This sell-out of claims functioned as long as the interest rates were in the cellar. But when the interest rates rose, the borrowers were no longer able to meet their commitments. The bursting of the bubble of US housing prices also meant that the properties encumbered with mortgages were overvalued. This was followed by the loss of claims and write-offs. The financial world went into a condition of shock. The banks were almost completely unwilling to lend free liquidity even to one other. Everyone was involved with the review of the risks of his own establishment and did not trust any other institute. The central banks jumped in and attempted to prevent a general lack of credit. Loans were granted only grudgingly.

The crisis has not yet been overcome even now in the middle of 2008. Banks are reporting write-offs in the billions, while bankruptcies and loss of jobs at investment banks are noted in the headlines almost every week. The countries in which citizens finance their consumption primarily through shortterm loans and where real estate properties serve as the subjects of speculation have been hit especially hard. The USA, Spain and Great Britain, where the financial crisis has developed into a real estate crisis, are examples.

But there are also winners in the crisis. Investors who generally held the properties for only a short time in their portfolio and speculated on a fast rise in prices have by and large disappeared from the market. Owing to the banks' reluctance to take risks and the rising interest rates, these investors have made room for real estate buyers who are investing in the properties with long-term potential for increased value. Such buyer groups include pension funds, insurance companies, open-end and closed-end funds and real estate corporations. These investors with their strong equity backing are in the meantime experiencing growing investment pressure. Germany and its sturdy economy are attracting more and more attention when it comes to investment decisions. But buyers continue to look closely at other countries in Central and Eastern Europe and in Asia. The real estate market in the east will play a major role in the future.

Germany

Germany did not lose any of its attraction as a business site last year. Economic conditions improved, and the gross domestic product rose by 2.6% in comparison with the previous year. Unemployment fell from one record low to another. As of the end of 2007, it had declined to 9.1% and was still falling. The economic upswing continued without change in 2007. Despite the crisis on financial markets, the German economy remains healthy.

Deutschland

However, the buyer structure in particular has changed owing to the ongoing liquidity squeeze. Whereas the first half of the year was dominated by financial investors working with outside capital, the investors on the market since the beginning of the crisis are thinking long term and are oriented to security. Financing measures have not only become more expensive. Banks also expect investors to provide a higher share of their own capital. This brings the "core" or "core-plus" investors into play as they are more interested in low-risk investments and future growth in value rather than in expectations of high returns. The earnings for such players come primarily from the property itself.

Although transaction volume declined in the second half of the year, AtisReal notes that the investment market, despite the financial market crisis, realised a record high of just under €60 billion, an increase of 20% in comparison with last year's result. Half of the transaction volume was effected at the office locations Berlin, Düsseldorf, Frankfurt, Hamburg, Cologne and Munich and recorded an increase of more than 44% in comparison with 2006. The highest demand, a share of about 80% or approximately €47 billion, was found in the office, retail trade and logistics segment.

A large part of the portfolio transactions can be attributed in particular to the open-end real estate funds. Single investments were at the forefront primarily for private equity and real estate funds.

Foreign investors continued to dominate the market, but there was a declining tendency. German investors, on the other hand, were substantially more active in the past year than in the previous years.

While the purchase prices for commercial properties rose substantially in the first half of the year, there was a slight rise in the net initial return for B locations and older properties in particular. The purchase prices for prime properties in a 1A location, on the other hand, stagnated at a high level.

The economic upswing has had a positive effect on the office property market. Companies are realising higher profits and employing more people, so they need more office space. Total vacant inventory declined by about 3.5% or 8.7 million m². This reduction in vacant inventory was more likely to be found for properties which are fully equipped for modern requirements rather than for older premises which have not been updated. The basic vacant inventory of office premises which are difficult to lease increased, however.

The increased demand for office space had a positive effect on the development of rents. According to AtisReal, the top rents increased by 4.7% on the average. The top rent rate in Frankfurt is now €37.50/m², followed by Munich (€31/m²), Hamburg (€25/m²), Düsseldorf (€22.50/m²), Berlin (€22/m²) and Cologne (€21.10/m²). The average rents profited just as much as the top rents. Premises equipped with modern technology and in a good location recorded rent increases. In some instances, the rents for older properties are under pressure, and the owners are willing to make concessions with respect to rents.

We assume the decline in vacant inventory will continue in the current year. Although the amount of space under construction has risen to 2.3 million m², most of these properties will not be available to the market until 2009. On the other hand, these premises already have a high pre-occupancy lease rate of about 58%. This means that companies seeking new office space will be dependent on the vacant inventory properties. Attractive offices in 1A locations may even be in short supply in some places. This will have a further positive effect on the realisable rents. Total availability will presumably remain at the same level or rise slightly as a consequence of the increase in construction activity.

The projection for the German economy in 2008 has been raised. However, the economy is expected to weaken in 2009 as a consequence of the current price developments in the raw material and food sectors and of the strong euro.

Germany continues to be a popular and comparatively lowprice investment market. AtisReal expects a decline in portfolio transactions in favour of single investments in 2008. Foreign investors in the private equity and hedge fund sector will largely withdraw from the market owing to the margin and equity requirements of the banks. Investors with strong equity who place a high value on substantive income from the real estate properties such as real estate corporations and openend and closed-end funds will be among the winners in the current situation. Jones Lang LaSalle predicts that growth in value in the rent price sector will also cause the initial returns for commercial properties to rise slowly once again.

Sources: Jones Lang LaSalle GmbH & AtisReal

The Netherlands

The year 2007 continued the positive trend of the previous year and achieved economic growth of about 3.5%, exceeding once again the European average.

The high export level declined slightly because the strong euro took its toll here as well, but exports nevertheless made a decisive contribution to the gross domestic product (GDP). The unabated readiness to buy among consumers and an unemployment rate which remains low are testimony to a healthy economy.

The inflation rate did not quite reach the previous year's value of 1.1%, but a rate of 1.5% means that the Netherlands are still well below the EU average of about 2.1%. The change in the inflation rate is primarily a consequence of the rise in energy prices.

The primary driving forces of the Dutch economy – besides Schiphol Airport and the Port of Rotterdam – are the international corporations such as Shell, Unilever, Philips, ING and Akzo Nobel. Moreover, a large number of large midsize businesses have become established and contribute to economic growth as well. They are profiting from various factors: good accessibility of the country for internationally active companies, an attractive environment in terms of taxes and modern office locations. Foreign companies in the Netherlands come mostly from the USA and the Far East. Above-average economic growth is also expected for 2008, but it will be slightly slower than in 2007.

Office space inventory in the Netherlands has increased to about 44 million m². New office premises with a total area of 1 million m² are being constructed in Amsterdam alone. This corresponds to 15.9% of the inventory there – while vacant inventory stands at 14%. The volume of new construction is not quite so lavish in other Western European metropolises.

Europe's office property markets are on an upswing. The leasing business is developing well, and rents are rising. Project developers are optimistic: new buildings are going up from Oslo to Madrid.

But the volume of office buildings now under construction is at many locations significantly higher than the forecasts of the independent analysis and prediction company for large European cities, the "European Economic Research Consortium" (ERECO). The rate of new office space is higher than the future growth in office employees. This has not yet presented a problem to project developers. They currently find tenants quickly or can sell their new buildings to investors.

At this time, every worker in the USA has office space of only 10 m². In Germany, France, Italy and the Benelux countries, the average is more than 20 m². This indicates there will be a consolidation which will also extend to the Netherlands.

The most important office locations in the Netherlands continue to be Amsterdam, The Hague, Rotterdam, Utrecht, Haarlemmermeer (Schiphol and the surrounding area), Eindhoven, Arnheim, Den Bosch and Groningen. But there has been substantial growth in the peripheral areas as well.

Real estate prices maintained a high level in 2007, a consequence primarily of the interest of German and Anglo-Saxon investors in the past years. The reasons for the continuing willingness to invest, when compared to other European locations, are a high market transparency, limited volatility and acceptable returns. Amsterdam, The Hague and Rotterdam are clearly preferred as locations.

Sources: CB Richard Ellis & Savills Immobilien Beratungs-GmbH

India

Due to the economic developments in Asia which have caused such a stir in recent years, international players are focusing more and more on the continent's real estate markets as well. As they continue to search for investments with high returns, their activities in these countries have increased significantly. Nevertheless, the markets remain unknown territory for many market players in Germany.

China and India undoubtedly remain the centre of attention for economic development because dynamic prospects for growth Johannes Bitter-Suermann are to be expected here. This development is also reflected by the real estate markets. The middle class with high buying power which is rising is the main source of demand for residential properties. In the long term, India is regarded as having an even higher growth potential than China as a consequence of high population growth rates. The same is true for the office property markets. In addition to its economic development potential, India profits from the fact that the people of the country speak English. The high level of general education also means that the market for office properties has outstanding opportunities for development. India therefore has an excellent basis to ensue a stable, positive development trend on the real estate markets which will continue for a long time.

When measured by the nominal gross domestic product, India has already become the world's tenth-largest economy. Nonetheless, a per capita gross domestic product of barely US-$800 means that India must still be counted among the poor countries. A quarter of the population lives under the poverty line of US-$1 a day. These circumstances are also reflected in the country's economic structure.

Despite the structural transformation in the direction of an industry and service society, 19% of the gross domestic product is realised in the primary sector in which more than 50% of the work force is employed. The secondary sector contributes 27.4%, the tertiary sector 53.6% to the gross domestic product, but there is a distinctly rising trend. The liberalisation process in the Indian economy which has been pursued for years in a stable political and social environment is an important growth factor.

Although India has not yet reached the development level of the Chinese economy, it has enormous potential for the long term: a large workforce of well-trained people who speak English, a positive demographic forecast and a stable political and social environment in combination with a tremendous amount of catching up to do.

The Residential Real Estate Market

The residential real estate market in India features a high concentration in urban centres. However, these centres are not located exclusively along the coastlines; instead, they are spread all around the subcontinent. Observers note a growing urbanisation, including smaller households which are growing in number and the generally rising prosperity of the population. In addition, a middle class with high incomes is appearing in India, and these people are creating a demand for home ownership. These are factors which lead to expectations for a dynamic market development for residential properties. The demand for high-quality residential units in the financial centre of Mumbai is currently coming from the foreign workers of internationally active companies. Since the desired residential units are not available in sufficient quantity, prices and rents in this segment are on the rise. In the middle term, the situation will be alleviated because the native households will no longer be held back by high interest rates and their income is also rising parallel to economic developments.

Wherever shortages in supply appear, the market participants are moving to the suburbs. This trend is supported by the efforts of local administrations to expand the public transport infrastructure.

Moreover, there has been a noticeable increase in new construction so that the current shortages will most likely be only temporary. Rents in the capital city Delhi have stabilised again after increasing by about 30% in the third quarter of 2006 due to the high demand. Many people looking for residential properties have chosen to take the less expensive B locations in this case as well. Among them are many embassies, multinational companies and even the United Nations who are responsible for obtaining accommodation for their personnel. The shortage in supply in Delhi is being eased by new construction. However, the level of demand will remain very high. The situation in the IT centre of Bangalore is similar. The demand for high-quality residential properties is coming from foreign employees of the companies located here as well. Since the IT sector is growing rapidly and qualified workers are in short supply, correspondingly high salaries are paid here. As developments continue, the local workers will also earn higher income, increasing the demand for comfortable residences even more. The examples show that the Indian residential real estate market has enormous potential in terms of demand. All of the long-term growth factors, without exception, are positive: a population growing in the long term, rising income levels for the middle class and favourable financing conditions. The Ministry for Urban Development and the Fight Against Poverty estimates the shortage in supply now existing to be about 30 million residential units. If the population growth is taken into account along with the trend in India towards smaller households, about 8 million residential units would have to be completed annually between now and 2030 to cover the demand.

The Office Real Estate Market

The Indian office real estate market is characterised by a shortage of suitable spaces and the consequent rise in rents and prices. About 75% to 80% of the demand for office space (inventory 2007: about 9.3 million m²) in India comes from IT service companies and the BPO (business process outsourcing) industry. Both played a major role in the 9.8% growth of the Indian service sector in 2006. 0.8 million new jobs will be created by IT companies by 2008. Even today, companies are increasingly moving to locations outside of the metropolises because these locations also have a good infrastructure network while offering lower costs for the office space.

Overall, India is going through a boom phase on the office real estate markets.

The share of the three metropolises Mumbai (13%), Delhi (12%) and Bangalore (19%) in the completion of office properties will be 44% in 2008. In Mumbai, the demand for office space comes from financial services providers and pharmaceutical companies as well as IT companies. Office rents there rose by 15% to 30% last year. This increase, together with the record low in vacant inventories of 5% to 8%, is a clear indication of a booming market with a shortage in supply.

The lack of high-quality office properties is forcing many companies out into Mumbai's suburbs, which are still able to offer space. Additional projects are already in planning in these areas. The construction of the "Mumbai Metro Rail" will lend even further impetus to this development. In total, rent increases of about 10% are expected for Mumbai this year, while the vacant inventories will remain at about the same level as last year.

The real estate markets in Delhi are also influenced by a metro project. The "Delhi Metro Rail" is a permanent improvement in the urban infrastructure and raises the value of the parts of the city connected by it.

Office space in Bangalore increased by a total of 90% in the time from 2003 to 2006; nevertheless, the shortage of supply typical on India's office property markets exists here as well. Vacant inventories of less than 5% and rent increases of up to 20% in the past year are indicative of this. Rents and prices in Bangalore are expected to increase by 5% this year, while the vacant inventories will stagnate at the same low level. Overall, the long-term development of the Indian markets for office properties can be assessed as positive.

Conclusion

As globalisation continues to progress, further IT and other services will be spun off in the future. India can depend on a well-educated population, while the pay scales are far below the level of the industrialised countries. Moreover, India's demographic development is much more positive than that of China, so there is a greater potential for growth. There is a definite possibility that India will even exceed China's economic development. But a precise market analysis must be carried out and the requirements of the portfolio must be clearly defined before any investment decision is made – once this has been done, all of prerequisites for success in Asia have been met.

Source: NORD/LB Global Markets Real Estate – Asia

USA Subprime and Mezzanine

In the middle of 2007, the so-called subprime crisis, which grew out of the crisis of certain parts of the US real estate market, led to massive turbulence on the international money and capital markets. Risks related to the subprime crisis have been distributed among financial institutes around the world by means of international trade with collateralised loans. Since the extent of the necessary write-offs remained unclear, a crisis of trust resulted, causing negative effects on the refinancing markets.

The subprime crisis remains unresolved. As a consequence, global economic growth in the larger national economies, especially in the USA, slowed down further during the first months of 2008, and there has been a weakening of corporate and consumer confidence. As the conditions on the credit markets have become increasingly worse, pension and stock markets have experienced an unusually high degree of volatility and extensive reappraisals of asset values. The loan and mortgage markets have revealed especially serious weakness. Activities in the sector of investment banking slowed down significantly during the first months of 2008, including an industry-wide, significant decline in the number of concluded mergers and takeovers and of stock issues. Owing to the ongoing upheaval, the international financing markets remain extremely erratic. In addition, the current market conditions have shut down completely or severely limited the functioning of the international financial markets in certain areas.

Source: Nord/LB

The advantages for the US mezzanine and opportunity market resulting from the subprime crisis have had extremely positive effects on the "König & Cie. US Real Estate Opportunity GmbH & Co. KG" fund. The demand for mezzanine capital has risen because banks are reluctant to grant loans, approving them only under restrictive conditions and with high margins. The demand for rental residences continues without change as the population structure of the USA alone is adequate to maintain its level. Moreover, the high number of residences being auctioned has triggered additional demand.

As a consequence of the subprime crisis, many US citizens have once again become more realistic in appraising their financial prospects and are renting apartments rather than taking on unmanageable debt to buy a house.

The scenario of a bargain dollar, declines in prices and benefits from the demographic development are an incentive to entering the USA market.

Johannes Bitter-Suermann
Johannes Bitter-Suermann, 37, has been a managing partner of König & Cie. Real Estate GmbH since February 2006 and of König & Cie. GmbH & Co. KG since June 2008. Before taking this position, he was active in the real estate business for the HSH Nordbank in sales and international business among other areas. Johannes Bitter-Suermann studied law and was admitted to the bar in 2000.
jbitter-suermann@emissionshaus.com