I INTRODUCTION TO THE LEGAL FRAMEWORK

i Ownership of real estate

Under German law, two main types of ownership of real estate exist. The most important type is absolute ownership, sometimes also referred to as freehold, which extends, by operation of law, to land and to any buildings or other structures erected on and firmly affixed to the land, as well as to (immovable) fixtures and fittings and (movable) appurtenances.

The other type of ownership is the hereditary building right, sometimes also referred to as leasehold. It entitles its owner to erect and own a building or other structure on or under a certain piece of land owned by a third party against payment of a fee, most often paid in regular instalments over the term of the hereditary building right. Historically, the term of a hereditary building right was commonly 99 years, but it can be agreed for any other period; nowadays, the term is usually shorter. The hereditary building right can be sold and transferred, but the underlying contract with the owner of the land will very often provide for a consent requirement and a pre-emptive right in the landowner's favour. Upon expiry of the hereditary building right, the building will be transferred back to the landowner against payment of compensation to the right holder, which is either pre-agreed or corresponds to the current market value of the building.

Real property can also be co-owned in typically two ways. The co-owners may hold an agreed co-ownership share in the land and building, or – more commonly, pursuant to the provisions of the Condominium Act – they may hold co-ownership shares in the land and structural parts of the building, and enjoy exclusive ownership or exclusive rights of use to the interior parts of residential apartments, or offices or other commercial space.

Real property or a hereditary building right can be made subject to in rem easements or encumbrances in favour of a third party or the owner from time to time of another property, such as rights of way in favour of an adjacent property, or the right of a public utility company regarding electric lines or water pipes, etc.

ii Registration of real estate and in rem rights

Cadastral offices, operated locally by municipalities, keep property cadastres in which any piece of land within the boundaries of the municipality is registered according to situs, use and size, and cadastral maps depicting the situs, size and shape of such a piece of land. As a result, any piece of land can be clearly identified.

With certain exceptions for properties owned by public or quasi-public entities, any piece of land is also registered in land registers that are kept by land registry offices at the local courts. The land register contains information about the identity of the property (in accordance with that in the property cadastres), the owner, in rem encumbrances, and mortgages and land charges. The system is highly developed and extremely reliable. The land register can generally be accessed electronically. It can be reasonably assumed that the contents of the registrations are correct, and so one can generally in good faith legally acquire the property or rights in the property as registered. As a result, title insurance is generally unnecessary for real estate transactions relating to German properties. Priority of title to and rights in a property with regard to third parties is determined in accordance with the point in time at which a filing for registration is received by the land registry office. The German land registers are not available for public inspection. Rather, only a person who can establish a 'legitimate interest', a term defined rather narrowly, can inspect and obtain a copy of the land register and of documents filed with the land registry office.

iii Choice of law for contracts for the sale and purchase of real estate

German law makes a strict distinction between the obligatory contract in which the parties agree on the obligation to transfer title to an asset against consideration in accordance with certain terms as agreed in the contract, and the contractual agreement on the transfer of title to the asset as such. While contract parties are free in their choice of the law applicable to the obligatory contract (including representations and warranties and other covenants), the agreement on transfer of title as such of a real property situated in Germany is, in accordance with the principle of lex rei sitae, mandatorily governed by German law.

Contracts for the sale and purchase of real estate, or for the creation of a land charge regarding real estate, must be notarised before a German notary and are very technical instruments with provisions specific to German law; the notary plays an important role in the implementation and registration of the transaction. For this reason, it is well-established practice to choose German law and have the documentation notarised by a German notary in case real property located in Germany is sold or transferred.

II OVERVIEW OF REAL ESTATE ACTIVITY

In 2018, the German real estate market continued to be boosted by a combination of the unceasingly low interest rate policy of the European Central Bank and the volatility of financial markets, generally maintaining the appetite of investors for investments in safe, stable assets such as real estate, and safe, stable countries such as Germany.

The main focus of investors has remained on the metropolitan areas of Berlin, Düsseldorf, Frankfurt, Hamburg, Munich and Stuttgart. Because of a lack of available assets in prime cities and prime locations, certain second-tier cities and locations are still receiving increasing level of interest.

Pension funds, international private equity funds, (listed) real estate corporations, real estate investment trusts (REITs) and sovereign wealth funds, private investors, family offices and insurance companies are all important market participants.

Market activity has been strong across most asset classes, including in particular residential portfolios, office and logistics properties. As a result of continuing yield compression, prices have still been rising.

While the interest in residential properties in the top cities has boomed significantly and further price increases are expected for 2019, new federal legislation and municipal initiatives limit the potential of rent increases and reliability of deals (see Section VII).

III FOREIGN INVESTMENT

Generally, no restrictions apply to the acquisition and holding of real estate by foreign investors. This is true for acquisitions by foreign individuals or legal entities, as well as indirect acquisitions through the formation by foreign individuals or legal entities of purchasing vehicles in the form of legal entities governed by German law. The acquisition of land by a non-EU entity may be subject to review by the Federal Ministry for Economic Affairs and Energy if it is part of an investment in a German company that may raise public order- or security-related concerns in certain sectors, e.g. critical infrastructure.

Further, there are no restrictions on the free transferability of funds in relation to providing equity or debt for the acquisition of real estate or repatriation of profits. Foreign investors are naturally subject to generally applicable money-laundering laws. Cross-border money transfers must be reported under the provisions of the Foreign Trade Act and Foreign Trade Regulation for statistical purposes only.

Recent developments regarding the taxation of foreign investment in real estate located in Germany are the introduction of 'real estate corporations' and the waiver of loans relating to German real estate as a taxable event in Germany (see Section VII.iii). Foreign investors should carefully note these developments but not consider them as an obstacle for investment.

IV STRUCTURING THE INVESTMENT

Depending on whether the property is owned by an individual or a holding vehicle in the form of a legal entity, the acquisition of real estate can be structured as an asset deal, acquiring the asset from the individual or the holding vehicle, or as a share deal, acquiring the shares in the holding vehicle from the shareholders.

As the acquisition of – currently – 95 per cent or more of the shares in a legal entity that owns German-situs property (the relevant threshold will quite likely be lowered to 90 per cent according to most recent legislative initiatives (see Section VII.i)) triggers real estate transfer tax (RETT), structures are being used under which the seller retains more than 5 per cent (in the future likely 10 per cent, cf. comment above) of the shareholding in the holding vehicle. Under the current RETT regime, the remaining more than 5 per cent of the shares in a property owning corporation may be acquired RETT-free by an independent third party (which may be a separate fund managed by the same asset manager), but such structures allowing the RETT free transfer of 100 per cent of the shares in a corporation will no longer be feasible under the proposed new RETT regime.

Apart from RETT considerations, share deals are widely used in large portfolio transactions to simplify the transfer of the properties and to avoid the application of statutory pre-emption rights.

On the buyer's side, a foreign investor may structure the acquisition either directly (as an individual or existing legal entity) or through a foreign or German acquisition vehicle.

If a German property is owned and let by a foreign investor (or a foreign acquisition vehicle), the rental income is subject to German income tax, but no trade tax applies unless a German permanent establishment exists. The property as such does not constitute a permanent establishment.

If the foreign investor wishes to create an acquisition vehicle governed by German law (which is often the case if the investor is a foreign investment fund), the full range of legal entities under German law is available, and the issues of limitation of liability and tax treatment of the acquisition vehicle and the investors are often relevant factors in deciding which form of legal entity is chosen.

One option is to incorporate the acquisition vehicle in the form of a stock corporation (AG) or limited liability company (GmbH), which both provide for limitation of liability. The AG and the GmbH have, however, the disadvantages of not being transparent for income tax purposes and, by virtue of legal form, of being in principle subject to trade tax. Profit repatriations from such corporations are generally subject to German withholding tax, although certain relief may be available if further requirements are met.

Civil law partnerships (GbR) and limited partnerships (KG) have the advantage of being transparent for income tax purposes, and profit repatriations are per se not subject to withholding tax. The GbR, however, has the disadvantage of full liability for all of its partners. Because in a limited partnership only the general partner of the limited partnership is fully liable, the legal form of choice is a combination of both elements: a GmbH & Co. KG is a limited partnership where the general partner is itself a GmbH, i.e. a limited liability company.

As, however, a limited partnership whose general partner is a GmbH, which manages the business of the limited partnership, is by virtue of legal form – like the GmbH – subject to trade tax, additional structures are used to minimise the trade tax liability. In particular, if a German tax-resident acquisition vehicle derives income from trade or business solely because of its legal form, but in fact generates no income other than rental income from its property, trade tax may be avoided by properly structuring the leases. Because in such a case only rental income from the letting of land and buildings is exempt from trade tax, whereas the letting of office or other commercial space often includes fixtures and fittings or appurtenances that may qualify as business equipment of the tenant, the rental income relating to business equipment is not exempt from trade tax and may render the rental income from the letting of the space subject to trade tax as well. It is, therefore, common practice to use a separate vehicle for the acquisition and subsequent letting of business equipment. As this rental income is subject to trade tax in any case, a GmbH is most often used for this purpose. Other structures – such as the use of German limited partnerships where the only general partner is a foreign corporation – which have been quite widely used in the past have come under intense scrutiny especially by German banks and are currently no longer best practice because of uncertainties under German corporate law.

A widely used form for structuring investments in real estate by several investors has been the civil law partnership (GbR). It is expected that its significance will decrease, as it is no longer a permitted legal form for a closed-ended investment fund within the meaning of the KAGB (see Section V.v). It will, however, likely remain important for use by family offices and similar privately organised groups of investors, as investment vehicles set up for such predetermined groups do not fall under the scope of the KAGB.

Since the civil law partnership is generally not registered in any public register, the partners can only be identified from the GbR constitutional documents and through the partnership's authorised representatives – unless the GbR including its partners and the natural persons benefitting from the GbR have to be registered in the 2017 newly established transparency register in case the GbR holds shares of another legal entity. In the past, this often led to difficulties in the land register registration process. The Federal Supreme Court held that if the partners state in a real estate sale and purchase agreement that they are in fact all partners of, and are authorised to represent, the partnership, the land registry is not required or entitled to request further evidence as to the existence, identity and authority of representation of the partnership. The GbR is entitled to be the owner of rights and obligations, be party to legal proceedings and be registered in the land register. The partners of the GbR have to be added in the land register as well.

V REAL ESTATE OWNERSHIP

i Planning

The legal framework for planning and zoning is essentially set out in the Federal Building Act, the Federal Building Use Regulation and building regulations of the individual states.

Planning and zoning is usually based on a large-scale regional plan for the use of land, which the competent municipality then specifies authoritatively and in greater detail for particular areas within that municipality. The planning process will involve extensive consultation with other competent authorities, such as environment, safety, water, nature or monument conservation, and participation by the general public. The land-use plans regularly contain restrictions on development and use. Municipalities also enjoy some statutory pre-emptive rights applicable to the sale of land that they can exercise to protect inter alia certain planning requirements. While such statutory pre-emptive rights have historically been rarely exercised, certain cities with significant housing or office shortages like Berlin and Munich have recently started to use these rights much more aggressively.

Individual building projects as well as changes of use generally require a building permit to be issued by the competent building authority stating if the project or change is in accordance with planning law and the state's respective Building Code. The admissibility of a building project outside the area of a land-use plan will generally be judged by its surroundings.

ii Environment

Under public law, if soil or groundwater contamination of a property presents a danger, significant detriment or disturbance to individuals or the public, the competent authority may issue an order for decontamination, remediation, investigation or monitoring addressed to the current owner of a property, any previous owner thereof, any party who is responsible under corporate or commercial law for the owner, any party holding actual possession of the property or the party actually responsible for the contamination or the polluter's universal successor. Usually, the authorities will select the party that it can most effectively hold responsible to undertake the necessary measures, which is normally the present owner or – in particular in case of industrial or business premises – the tenant of the property. Along with public law liability, there is civil law liability for clean-up or damages with regard to neighbours or other third parties affected by the contamination.

Environmental issues, therefore, are an important consideration in the due diligence of a real estate transaction, and in the representations and warranties, indemnity provisions or other covenants of a real property-related sale and purchase agreement.

iii Tax

Any sale and comparable conveyance of real estate is subject to RETT. If the real estate is held by a legal entity, the purchase of 95 per cent (in the near future likely the change of ownership of 90 per cent, see above) or more of the shares in such a legal entity is likewise subject to RETT (see Section IV and Section VII.i). The RETT tax rates depend on the location of the real estate and differ from state to state, from 3.5 to 6.5 per cent of the purchase price.

In addition, fees for the notarisation of the sale and purchase agreement, and land charges required for the financing, will accrue, as will registration fees for the land registry office for the registration of the priority notice securing transfer of title, the transfer of title, any land charges and the deregistration of existing land charges. Such fees are fixed by law and amount to regularly less than around 0.5 per cent of the transaction value with a decreasing percentage figure applying the higher the transaction value is.

Generally, the sale and letting of real property is exempt from VAT; however, under certain circumstances it is possible to opt for its application at the normal rate of 19 per cent. The seller of a property that has accepted the previous seller's option for VAT upon purchase in the past may want to sell the property not exempt from VAT; otherwise, the seller may be required to repay previously deducted input VAT to the tax office. The purchaser will have to pay the VAT in addition to the purchase price (reverse charge) which may commercially be acceptable if such VAT can be deducted as input VAT (i.e., when the property is used by the purchaser for supplies and services that are not exempt from VAT, including, but not limited, to letting with an option to VAT). Lettings can only be made subject to VAT if and to the extent the tenants are enterprises within the meaning of the VAT Act and render VAT-able and not VAT-exempt supplies or services (see Section VI.iv) – that is, use the premises for a business involving the delivery of goods and services subject to VAT. The issue of whether an input VAT deduction has been applied in the past should be carefully addressed in the due diligence procedure, particularly when acquiring multi-tenant commercial buildings, as the seller may have let space to non-professionals or professionals who render VAT-exempt services (such as banks, doctors, etc.) in the past, or the purchaser may want to do so in the future. As a result of such changes in circumstances, the purchaser may be required to repay input VAT to the tax office.

Real estate is subject to real property tax, which is a municipal tax and is presently calculated on the basis of certain tax values of 1964 and 1935, respectively. Because of a recent ruling of the Federal Constitutional Court, legislative activity is underway to change the historically low tax base to represent current values of the real properties (see Section VII.ii).

iv Finance and security

Real estate transactions will usually be financed by banks or other providers of debt financing such as insurance companies. Security can be created by way of a land charge over a property, a hereditary building right and a co-ownership share or, in the event of a share transaction, by a pledge or security transfer of the shares of the holding company to be acquired. In case of a share transaction involving a German GmbH or AG, because of applicable capital preservation rules, the availability of the property as security for the financing of the share purchase price is limited. Senior and junior debt financing can be secured with different ranking. Land charges are registered in the land register and, if no other agreement is made, the time of receipt by the land registry office of the filing for registration will generally determine the ranking of the land charge with regard to all other registered rights.

v Real estate investment funds

In line with the AIFMD, the German Capital Investment Code (KAGB) takes an all-encompassing approach and regulates all types of investment funds, including, for the first time in 2013, closed-ended investment funds. The regulation entails a licence requirement for managers of investment funds, requirements as to the eligibility and acting of depositaries and product regulation, as to the permitted legal form of investment funds and limitations as to the investment policy.

The KAGB confirms the changes to the legal regime applicable to open-ended public real estate funds that had already been introduced by the Investor Protection and Functionality Improvement Act in 2011. Most importantly to investors, the Act provides for a lock-up provision prohibiting investors from redeeming units in an open-ended public real estate investment fund for a period of at least 24 months. Further, investors are only entitled to redemptions of fund units once a year. In line with the AIFMD, the KAGB requires with respect to the expert committee responsible for the valuation of the properties that an independent expert or, if the previously determined value of the property exceeds €50 million, two independent experts must value the property. In addition, in the case of an acquisition of a property, one or two experts, as the case may be, who are different from the experts that are responsible for the regular valuation, must value the property proposed to be acquired. To enable a fund to meet certain redemption requests, it is required to maintain liquidity of 5 per cent of its net asset value.

The above-described restrictions do not apply to special open-ended real estate investment funds, which are only open to professional and semi-professional investors within the meaning of the KAGB. The only mandatory restrictions applicable are a limitation of leverage of up to 50 per cent of the value of the real estate assets held in the fund, and a prohibition to invest more than 20 per cent of the fund's assets in private equity (excluding real estate companies).

On 1 January 2018, the tax regime applying to open-ended public real estate funds significantly changed. Before, these funds were generally tax-exempt and their investors were (only) taxed on distributions and certain deemed distributions resulting from rental income and capital gains realised at the level of the fund (the concept of 'semi-tax transparency'). Contrary thereto, under the new regime, the funds themselves will become subject to tax with certain items of German-source income (including rental income and capital gains resulting from German-situs real property). At investor level, a second layer of taxes applies; to mitigate the resulting 'double taxation', the investors may enjoy a (partial) tax exemption depending on the investment strategy of the fund.

Following the legislative changes, the KAGB nowadays subjects public and special closed-ended real estate funds to a regulatory regime broadly comparable with the one applicable to open-ended real estate funds. Hence, the fund rules for public closed-ended real estate investment funds must be approved by the German Federal Financial Supervisory Authority (BaFin). Closed-ended investment funds may only be established in the legal form of an investment limited partnership or an investment stock corporation with fixed capital. Public closed-ended real estate investment funds may only take up leverage of up to 60 per cent of the gross value of the fund. If the fund is not risk diversified (which is deemed to be the case if it holds less than three properties, unless the risk diversification is commercially present with a view of the type of property), it may only be acquired by investors committing to invest at least €20,000 and passing a suitability test.

The above-described investment limitations do not apply to a special closed-ended real estate investment fund.

To obtain marketing approval for public real estate investment funds as well as special real estate investment funds from another EU member state or a country outside the EU, the management company must prepare and submit to BaFin a sales prospectus and key information document.

VI LEASES OF BUSINESS PREMISES

Leases of business premises usually contain provisions concerning the following.

i Use and public permits

The intended use by the tenant of the premises is usually precisely defined. Any change of use will be forbidden or subject to the consent of the landlord. The landlord usually does not guarantee that the premises are fit for the use intended by the tenant, and the tenant is responsible for any public permits required for the conduct of its business on the premises.

ii Term and termination

Leases are generally for fixed periods (five, 10 or 15 years) with options in favour of the tenant to extend the term for consecutive periods (often one or several five-year periods). A lease for a fixed term exceeding one year must be in writing. Failing compliance with this requirement, the contract can be terminated in compliance with statutory termination periods. The same termination right applies after the expiry of 30 years if a lease contract was concluded for a rental period exceeding 30 years (through initial fixed term or by means of exercise of extension options). Both are critical issues with many pitfalls, and require careful attention in the due diligence of multi-tenant commercial real estate.

Tenants also have an extraordinary termination right if modernisations will result in an increase of the rent payable by the tenant. The law applies to commercial as well as residential leases. Therefore, landlords will have to guard against exploitation of this right by tenants seeking to terminate their long-term lease early for other reasons.

iii Rent and service charges

Rent for commercial leases with a term of more than 10 years is often linked to inflation by way of an index clause linked to the German consumer price index that needs to work upwards and downwards to be effective. Rent reviews at the time of the exercise of an extension option are still rather the exception than the rule, but have become more widely used in the last few years. It is usually agreed that the tenant must pay in addition to the rent any service charges, other ancillary costs as well as taxes and duties.

iv VAT

If the lessor (or, as the case may be, the sublessor) has opted for VAT, it will be charged in addition to the rent. The lessor will only be entitled to opt for VAT and to deduct input VAT if and to the extent that the tenant is an enterprise within the meaning of the VAT Act and renders VAT-able and not VAT-exempt supplies or services. This requirement must be carefully addressed in the due diligence procedure for the purchase of commercial properties (see Section V.iii).

v Maintenance and repair, insurance

While German statutory law is quite tenant-friendly and imposes most of the maintenance and repair obligations on the landlord, rental contracts for commercial properties generally are more landlord-friendly and shift most of the maintenance and repair obligations to the tenant. It should be noted, however, that triple net leases where the tenant is also responsible for the maintenance and repair of the roof and of the structural parts of a building are problematic under German law.

vi Subletting, transfer of the lease

Subletting will normally require the consent of the landlord (not to be unreasonably withheld). Transfer of the lease by the tenant is generally not possible, but tenants may wish to be allowed to transfer the lease within their group of companies or as a result of a corporate reorganisation.

VII DEVELOPMENTS IN PRACTICE

i Expected extensions for RETT applicability to share deals

As the current regime for exempting certain share deals on companies holding real property has become for quite a while a sensitive political issue (see Section IV), different proposals have been discussed to restrict such RETT exemptions.

According to a proposal by the majority of state finance ministers of late 2018, the threshold for the applicability of RETT to share deals shall be lowered from currently 95 per cent to 90 per cent of the transferred interest. Such lower threshold shall apply to both partnerships and corporations. Additionally, there shall be a shift in focus for corporations (mirroring the existing concept for partnerships): at the moment, only the acquisition of shares in a corporation above a certain threshold is subject to RETT (focus on acquisition). According to the new proposal, RETT is triggered if ownership interest is transferred above a certain threshold (focus on change of ownership), now 90 per cent. As a consequence, future RETT blockers in corporations can only be existing shareholders of the corporation. RETT may no longer be avoided by 'bringing along' a new, independent minority shareholder. Finally, time limits for RETT exemption to hold the shares shall be prolonged from five to ten years (some possibly even 15 years).

The state finance ministers asked the Federal Ministry of Finance to introduce their proposals into federal legislation. The federal government coalition had already agreed in early 2018 to restrict RETT exemptions for certain share deals. First discussions with the public on new rules for real estate share deals shall be held in the Federal Parliament in early 2019. While the direction appears to be relatively clear, the exact changes – and likely new models for real estate transfers – as well as the exact timetable cannot be foreseen yet.

The European Court of Justice decided on the non-state aid character of certain RETT exemptions in December 2018. According to the clear opinion of the Advocate General, exemptions are not to be considered state aid when they are non-selective, i.e. in general applicable to all sectors and companies (e.g., RETT exemptions for mergers within a group structure). The European Court of Justice did not follow key aspects of the Advocate General's reasoning, but also held that the German RETT exemption for mergers within a group structure does not constitute state aid, because it is not selective.

ii Outstanding reform of the real property tax

In a recent case, the Federal Constitutional Court has declared the current system of Real Property Tax unconstitutional to the extent it is still based on the perpetuated values of real properties in 1964 and 1935, respectively. It considered the current method to infringe the principle of equal treatment as property values have developed at different rates over the last decades. The court declared the law to remain valid until the end of 2019, to give parliament time to enact new legislation. Further, the current law may still be applied until 2024 once a new law has passed but is not applicable yet.

The federal finance minister proposed two different approaches for reform in late 2018, one based on the size of the real property and existing buildings alone, the other – favoured by the minister – based on the real value of the property. According to his proposal, the value shall be established in a simplified procedure every seven years mainly based on the actual net rents of existing buildings on the property.

Some states have opposed this model because of its complexity. The federal and state ministers are expected to discuss and shall initiate reform in 2019. As reforms of the real property tax have repeatedly failed in the past, an outcome or timeline can hardly be predicted yet.

It is common ground so far, that the financial outcome of real property tax shall not change overall. Yet it is expected, that in particular real property tax in attractive inner-city locations may rise considerably. Real property tax can be fully levied as service charge to the residential and commercial tenants of a real property. However, such on-charge has come under scrutiny after criticism from the minister of justice in December 2018, although such criticism appears to relate predominantly to residential tenants.

iii Other tax reforms relating to real estate

Capital gains derived by foreign investors from 'real estate corporations' have become subject to taxation as of 1 January 2019. Previously, such capital gains were subject to tax only if (1) the shares were allocated to a German permanent establishment or (2) the foreign investor held more than one per cent in a corporation residing in Germany. Real estate corporations are now defined as corporations whose share value related directly or indirectly to German real estate to an extent of more than 50 per cent at one point in time during the 365 days prior to the sale, irrespective of the place of management of the corporation and without any threshold. The 50 per cent ratio shall be calculated on the basis of the book value of the assets. Such change applies only to the extent that any change in value relates to the period between 1 January 2019 and the sale of the shares. Currently one would foresee a significant tax burden increase only in transparent structures for investors that cannot rely on the 95 per cent tax exemption for corporations as set out in the German participation exemption. Yet, a significant increase in compliance matters has to be expected.

In addition, capital gains resulting from the waiver of debt by foreign companies relating to German real estate has become subject to tax in Germany as of 1 January 2019. If and to the extent a loan that relates to German real estate is waived, the waived amount will be added to the profit of the disposal of such German real estate. The legislation is effectively overriding an investor-friendly decision of the Federal Fiscal Court from December 2016. The change should affect all non-German investors in German real estate irrespective of the extent of their overall involvement into the German real estate market.

Finally, a new provision to incentivise international and domestic market participants to build more affordable housing units was approved by the Federal Parliament and is currently pending before the German Federal Council. Pursuant to this draft legislation, building projects with building costs below €3,000 per m2 and located anywhere in EU/EEA for which the application for permit or notification was filed after August 2018 and before 2022 can benefit from an additional depreciation of 5 per cent for the year of completion (or acquisition) and the following three years, for a tax base of a maximum of €2,000 per m2. The regular depreciation (2 per cent per annum for residential real estate) can be claimed additionally. However, it is expected that such incentive may only appeal to smaller investors, as it is subject to the de-minimis exception that building companies may only receive benefits (being the economic advantage of an earlier depreciation not the depreciation amount itself) of up to €200,000 over a three-year period.

iv Recent reforms of rental regulations for residential units

Overall in Germany, rent increases for residential units are only permissible in limited cases defined by statutory law. With investors increasingly interested in German residential portfolios and rent levels in metropolitan areas rising significantly faster than wages and inflation, federal and state lawmakers have been active in further limiting the possibility of raising the rents for residential units.

Effective beginning 2019, annual rent increases because of modernisation costs will be limited to 8 per cent of the modernisation costs (lowered from previously 11 per cent). In absolute numbers, increases based on modernisation will be newly capped at a maximum of €3 per m2 over a six-year period (and at €2 per m2 in case of a rent of less than €7 per m2). Certain modernisations directed at expelling tenants will be subject to stricter civil – and also criminal – law consequences.

Since 2014, states may additionally set up a limit on rent levels for certain areas with tense housing markets. Such limits have been set up inter alia for all of Berlin, Cologne, Düsseldorf, Hamburg, Munich and Stuttgart, as well as for several medium-sized and smaller municipalities. In such areas, rents may generally not exceed the rent index for comparable apartments in the area by more than 10 per cent or the prior (legal) rent. New apartments and substantially refurbished apartments are exempt from the limit on rent levels. In case of a higher rent than permissible, the tenant may reclaim overpaid rent from the moment the non-permissibility of the rent was declared. Effective beginning 2019, landlords have to provide future tenants with written information on the legal grounds for a rent higher than 10 per cent over the rent index. In case of failure to do so, the landlord cannot claim the higher rent. If the information is provided too late, the higher rent may not be claimed for the next two years.

v Increase of municipal pre-emptive purchases and social preservation areas

According to the Federal Building Code, municipalities may have a general pre-emptive purchase right for real properties. A municipal pre-emptive purchase right exists by law especially in certain particular land-use areas, such as re-allocation areas, formal refurbishment areas, urban development areas and preservation areas. Additionally, municipalities may set up pre-emptive purchase rights by statute, inter alia where urban developments are planned. In case of a pre-emptive purchase right, the municipality has to be informed of the sale and purchase agreement of a real property and may step into the sale and purchase agreement instead of the planned buyer within two months. The agreed purchase price may even be lowered to represent the market value. The municipality may also call the pre-emptive purchase right for third parties, for example, its municipal housing companies. The pre-emptive purchase right does not apply to the sale of shares in a company holding real property.

While several legal aspects of municipal pre-emptive purchase rights remain open and subject to further clarification by case law, some municipalities have become increasingly active in acting on pre-emptive purchase rights in recent years. In particular in areas with tense housing markets, the municipal pre-emptive purchase right is increasingly used with the explicit aim to safeguard tenants from rent increases. For example, in Berlin, the pre-emptive purchase right is therefore used where a social preservation area (i.e., an area for the preservation of the resident population) has been set-up. While these areas are intended to secure the urban infrastructure, the pre-emptive purchase right appears increasingly to be used politically to protect tenants in general. The measures have been criticised for being way more expensive than building new residential units by the municipal housing companies, but are still on the rise.

Besides triggering the municipal pre-emptive purchase right, social preservation areas also limit the landlords' availabilities to modernise buildings as all alterations and changes require a special permit by the social preservation authority. The permit will be denied if the modernisation is considered a threat to the composition of the current resident population, but has to be granted if it does not go beyond the contemporary standard for comparable apartments. In practice, specific criteria have been set up by the municipalities for modernisations that will or will not be permitted. Generally, bigger floor designs of apartments and changes from residential to commercial use will not be permitted in a social preservation area, while permission for elevators and balconies will depend on their size and quality.

vi Energy efficiency

The Energy Savings Ordinance requires the use of energy saving materials for all new buildings and in the event of major refurbishment of existing buildings. Owners are required to prepare energy passports for their buildings, which they have to make available to potential purchasers or tenants of the property. Pursuant to the Renewable Energy Act, renewable energies must constitute part of the energy supply of newly constructed buildings. Further legislative activity is to be expected in this area in particular because of incorporation of the new Energy Performance of Buildings Directive (EU) 2018/844 until 10 March 2020.

Because energy efficiency has also become an important political issue, in particular to reduce climate change, the real estate market is following this trend: real estate owners and tenants such as large corporations wish to use green buildings as part of their corporate identity, demonstrating responsibility for the environment. In the absence of a legal definition of a 'green building', certain systems of certification (e.g., BREEAM, LEED and the German DGNB seal) are being used to arrive at a common understanding of the term, and such certificates are becoming increasingly popular. Therefore, investors will have to look carefully at the energy efficiency rating of a building at the time of acquisition in relation to investments necessary during the holding period and subsequent exit strategies.

VIII OUTLOOK AND CONCLUSIONS

On the legal front and regarding the structure of real estate investments, the new regulations on RETT for share deals (see Section VII.i) will be of particular importance in 2019 and beyond. The changes – if enacted – will likely lead to new purchasing structures that should be carefully advised. Further, the recently proposed valuation methods for the real estate property tax (see Section VII.ii) will undoubtedly be heatedly discussed. Still, the financial burden on property owners by the real estate property tax is comparably low. The recently enacted further limitations on rent increases for residential housing (see Section VII.iv) and the state's raised interest in social preservation areas with their municipal pre-emptive purchase rights and factual restrictions on modernisations (see Section VII.v) will need to be carefully considered when making an investment decision.

Still, the German real estate market will undoubtedly continue to provide very interesting investment opportunities in most asset classes.


Footnotes

1 Jan Bonhage and Thomas Lang are partners at Hengeler Mueller. The authors would like to thank their partner Martin Klein (tax) for his input.