I OVERVIEW OF THE MARKET
The German real estate M&A market has been growing continually since the financial crisis from 2008 to 2010. According to the EY Trend Barometer, the total volume of transactions reached a peak of about €80 billion in 2015. 2016 has shown a slight decrease in market activity, with a total transaction volume of about €66 billion, and in 2017 the volume increased to €72 billion. Investors still see Germany as a ‘safe haven’ for real estate investments. As a result, Germany has become the top market for real estate investment in Europe about the same as the UK, which led the ranks for years, and France. The ‘big 7’ cities in Germany (Berlin, Frankfurt, Hamburg, Munich, Cologne, Düsseldorf, Stuttgart) attract the biggest share in volume. Demand from national and international investors is still strong, but cannot be met with an appropriate supply.
As recent market activity shows, significant activity has shifted to stock exchange-oriented transactions. Several significant transactions have been executed by Germany’s largest housing companies, with the single biggest transaction being Vonovia SE trying to take over Deutsche Wohnen AG for €14 billion, which was, however, ultimately not executed.
Past years had been dominated by special funds, real estate funds and real estate operating companies (REOCs). However, private equity investors profiting from the continuous low interest rates have shifted their focus back to real estate.
II RECENT MARKET ACTIVITY
i M&A transactions
In 2016 and 2017, the market was no longer dominated by large housing REOCs. Whereas in 2015, Vonovia SE, Gagfah SA and PATRIZIA Immobilien AG accounted for some of the largest housing deals, the overall volume of housing deals decreased from a record €23.5 billion in 2015 to €13.2 billion in 2016. However, Vonovia SE accounted for the biggest housing transaction by taking over Conwert through a friendly takeover in 2016. In 2017, the trend turned to the takeover of entire platform provider. Main examples are the takeovers of Rockspring by PATRIZIA, of Triuva by PATRIZIA, the acquisition of GLL by Macquarie and the takeover of WCM by TLG.
In 2017, one of the trends in the market was a shift to large-scale portfolio transactions by way of share deals in the logistics sector. Three of the top 10 transactions by volume in 2017 were such in the logistics: takeover of the logicor portfolio by China Investment Corporation (CIC) from Blackstone (€12.25 billion value of which €2.2 billion is said to pertain to German assets), purchase of the Hansteen portfolio by a JV between Blackstone and M7 (€1.1 billion) and the takeover of Gazeley by Brookfield (€800 million).
The biggest single asset transactions in 2017 were the purchase of the Sony Center in Berlin (€1.1 billion) by Oxford Properties/Madison and the purchase of Tower 185 in Frankfurt by Deka (€775 million).
In terms of volume, investment in office space remains the dominant asset class accounting for about 70 per cent of the investment into commercial real estate, whereas there is a slight shift away from retail to multi-family residential properties. Former niche asset classes such as hotel and logistics have become strong asset classes.
ii Private equity transactions
Generally, transactions into pure real estate have not been as attractive for private equity investors in recent years. Strong demand and the corresponding competition between investors have led to rising prices and falling yields. Thus, market activity has generally shifted to asset management companies and funds investing in real estate as they typically are not as demanding as private equity investors when it comes to rates of return. However, recent market activity shows the growing interest of private equity investors.
One by volume the highest in 2017 was the takeover of the Logicor logistics portfolio by CIC (€12.25 billion). The transaction shows that Chinese investors have taken a key position as player of European private equity exits. At the same time, a JV of Blackstone and M7 has invested in a large portfolio of logistic properties. Apart from that, Blackstone accounted for the single biggest transaction back in 2016 by acquiring Officefirst with almost 100 commercial objects for €3.3 billion.
III REAL ESTATE COMPANIES AND FIRMS
i Publicly traded REITs and REOCs – structure and role in the market
Under German law, REITs have to be organised as stock companies: 75 per cent of their income has to originate from real estate, they have to distribute 90 per cent of their profit and their equity ratio has to amount to at least 45 per cent. Moreover, German REITs cannot invest in apartments that were built before 31 December 2006. Finally, to allow small investors to invest in real estate assets, a certain number of shares must be free floating (15 per cent; by the time of the IPO, 25 per cent),2 and a single shareholder cannot hold more than 10 per cent of the total shares. If a stock company fulfils these requirements, neither corporate nor trade tax are invoked by the REIT’s activities. Only the shareholders’ income is assessed. These strict requirements have led to only a small number of REIT AGs being formed. Currently, only a handful REITs are listed on the stock exchange. They have been growing steadily, and currently aggregate a market value of €2.72 billion, while the biggest German REIT, Alstria Office AG, has a stock market value of around €2.25 billion.3 The other German REITs, such as Fair Value REIT AG and Hamborner REIT AG, play a smaller role in the market.
Some of the biggest German REOCs under German law are UnionInvestment, Deka Investment, Deutsche Bank AG and the fast-growing PATRIZIA Immobilien AG. Often, REOCs with their business focus in Germany are not constituted under German law. Driven by tax considerations, real estate companies are generally constituted as funds under Luxembourg or Dutch law. Open-ended funds are a common form of investment. Most foreign investors prefer investments via Luxembourg structures, followed by Dutch law structures. German open-ended funds held around €80 billion-worth of property worldwide. They are very attractive for investors, especially for German pensions funds and small and midcap insurance companies.
Activities of open-ended funds have been subject to a shift in regulation in recent years. After the financial crisis, the EU adopted the Directive on Alternative Investment Fund Managers in 2011. Germany implemented the regulations in 2013 by issuing the Code on Capital Investments (KAGB). In the KAGB, a network of detailed provisions was established as it applies to all forms of investment funds and brings change to multiple regulatory aspects. The most significant changes for directors of REOCs operating investment funds are the duties of conduct and the obligation to implement organisation of risk management separate from portfolio management. Various distribution regulations were also implemented, and now also apply to private placements and not only to public distribution. Significant changes have been brought to the minimum holding as well as termination periods: thus, new funds can be managed with considerably lower liquidity ratios.
With regards to the business strategy and the types of property transferred by German REOCs, commercial property, such as offices and shops, makes up about 70 per cent of the transactions. Being commercial property, hotels have been increasingly focused on by REOCs. Recent studies predict, however, that as residential construction is currently, and may in the future potentially be more heavily subsidised by the government, residential property will increase its market share significantly in the coming years.
ii Real estate PE firms – footprint and structure
As stated above, private equity firms investing heavily in the German market had been rare in recent years; however, in 2017, market players like Blackstone have at the same time have disposed main stakes at their share of Logicor logistics and invested jointly with joint venture partner M7 into the Hansteen logistic portfolio. Cerberus has invested in large-scale shopping centre Rhein Ruhr Zentrum. However, generally it seems to be fair to state that PE investors who are typically looking for higher yields will in the current market rather be selling than investing to investors who are generally willing to sacrifice high yields for lower risks (the German market as a safe harbour). However, given that Germany is one of the top three markets for investments into real estate in Europe being, together with North America and Europe, the main focus of interest for investment, bigger players such as Blackstone, Cerberus, Apollo and Patron Capital will have Germany on their watchlists. With regard to their structure, the same principles apply: choosing a company structure is highly tax-driven, with most private equity firms being offshore firms or founded under Luxembourg or Dutch law.
i Legal frameworks and deal structures
Typically, negotiations begin with structured tender offers. Parties often agree on exclusive or co-exclusive periods after an initial offer to conduct due diligence. Exclusive periods last for around six to eight weeks, after which the seller has to accept one of the offers from the prospective buyers before the final negotiations on the sale and purchase agreement begin.
It is common for the seller to determine the manner in which the object of purchase – either a single property or a portfolio – is transferred to the buyer. Under German law, this can either be done by an asset deal or a share deal. When transferring real estate in an asset deal, one company directly sells the property to another company, while in a share deal, the company owning the property is sold. Both structures are equally common, as they both offer certain advantages and disadvantages.
An asset deal will achieve a step up to the fair market value of the real estate but will usually result in higher exit taxes for sellers. An asset deal will always invoke real estate transfer tax (RETT) (see Section IV.v), while a share deal might mitigate it if properly structured. The rate of RETT depends on the location of the real estate, with rates in the 16 German federal states currently differing between 3.5 and 6.5 per cent.4 However, a share deal will require more comprehensive due diligence as not only the property itself but also the company has to be assessed extensively. Moreover, depending on the company structure, there might be a liability for contributions under company law. When it comes to formal requirements, an asset deal has to be notarised, while in a share deal the formal requirements depend on the company structure – a notarisation is only necessary if one of the companies sold is a limited liability company (GmbH). Common share deal structures that mitigate RETT are selling no more than 94.9 per cent of the interest of a propco to one single investor (or a group of affiliated investors) or, particularly if the propco is established in the legal form of a partnership, the seller remaining a minority shareholder of 5.1 per cent for at least five years.
A typical share deal structure consists of a direct acquisition, for example, if a subsidiary operating the property that the parties want to transfer is sold. Usually, sold companies are held by propcos, which are structured as German limited partnerships (GmbH & Co KGs), GmbHs, Luxembourg limited liability companies (Sàrls) or Dutch limited liability companies (BVs).
However, the transactions in the housing sector mentioned in Section II.i, were direct mergers, whereas the transactions planned but not executed would have been share purchases (for hostile takeovers, see Section IV.iii).
Another common form of investment is a forward transaction in which undeveloped real estate is purchased, then developed and afterwards resold to a third party. This form of investment is quickly becoming more and more attractive for investors: as supply cannot match demand, investors look for options to lock up attractive properties in an early phase of development. They are willing to tackle the risks connected with forward transactions by calling for careful drafting of agreements.
ii Acquisition agreement terms
German real estate is listed in the land register. The person registered as owner in the land register is deemed the owner except where the purchaser has positive knowledge to the contrary. Accordingly, the review of title and title guarantees does not play a significant role in German asset deal transactions. This is different in share deal acquisitions, where there is no such good faith with regards to the shares; however, even in these cases an integral part of the due diligence is that the propco must have purchased the real property from the registered owner. Accordingly, the typical agreement starts with a detailed summary of the entries in the land register or – especially in bigger transactions – by making reference to land register excerpts. This is associated with the most important part of the purchase agreement: guarantees and warranties, typically including that the property is not encumbered (neither easements nor mortgages).
Under current market conditions, the model for dispositions of real estate is that they are sold ‘as is’, and only few warranties and representations, mostly knowledge-based, are given. Typical warranties and representations include that there are no outstanding administrative orders with regards to the property; there are no written complaints by authorities that the current development does not comply with the building laws; and the seller has no knowledge that the construction has not been carried out in accordance with the building permit.
Liability for hazardous materials or Second World War munitions, for example, tends to be excluded, whereas German judgments require that any such known defects need to be disclosed for the purchaser to avoid fraud.
German law provides for an automatic transfer of the lease agreements concluded for the corresponding real property from the seller to the purchaser, and also for transactions by way of an asset deal. Given the importance of the lease agreement and its cash flow, the most important warranties and representations are very often those connected with the lease agreements. Typical warranties and representations include the completeness and correctness of a list of lease agreements; the payments thereunder within the months or years before signing; and the absence of disputes or counterclaims made within a certain period before signing.
Another peculiarity of German law is that lease agreements for real estate with a term of more than one year need to be in writing. This generally includes all agreements between lessors and lessees, and also all amendments. Any oral or tacit change therefore could form a breach of the written form requirements. A breach of the written form does not mean that a lease agreement would become invalid, but both parties would be in a position to terminate the agreement becoming effective within six to nine months from the notice of termination. This can potentially cause major issues for investors (as well as for lessees), and can bring the bankability of a transaction into question. The most frequent breaches of the written form requirement are the incompleteness of annexes or later oral changes. Accordingly, the absence of oral or tacit changes to the lease agreement is one of the typical warranties in German acquisition agreements.
Another aspect requiring careful drafting is the purchase price, its calculation and the date of its becoming due. Asset deal transactions need – as laid out above – to be notarised to be valid. The execution of an agreement for the acquisition of real estate by way of an asset deal is usually in the hands of the notary public, who also controls the fulfilment of the conditions for the purchase price to become due. The notary public is therefore not only required to notarise the asset purchase agreement, but is also responsible for bringing about maturity, inter alia, by gathering waivers of statutory or pre-emption rights, registering a priority notice to secure the transfer of property, and ensuring he or she has all the documents necessary to remove encumbrances in the land register that will not be taken over by the purchaser.
When drafting a share purchase agreement, inclusion of a specification of the company’s assets and their description is recommended to determine the seller’s liability. The catalogue of guarantees and warranties is more extensive than when conducting an asset deal, as not only guarantees with regards to property itself but also to the shares that are transferred have to be included. Typical guarantees include that:
- the shares exist;
- they are not encumbered;
- the share capital is fully paid;
- the current shareholders’ agreement is complete and correct;
- the company is not bankrupt;
- there are no intercompany agreements in place; and
- the list of shareholders is complete and correct.
The purchase price falling due cannot be decided by a notary public as a notary public is not required in all such cases. Thus, the parties have to take measures (especially the purchaser, who typically wants to ensure that it gets a good deal for the purchase price) to bring about maturity. Typical prerequisite requirements are a release from encumbrances and negative clearance (as no priority notice can be registered).
When it comes to the calculation of the purchase price, several forms of purchase price adjustments can be considered. Parties only seldom agree on a locked-box calculation, but rather agree on a potential adjustment of the purchase price with the help of projections.
Usually, sellers seek to limit their liability. Typically, there are several limitations such as a combination of thresholds for single breaches, minimum amounts of claims for multiple breaches and overall caps. Whereas the amounts for the thresholds mainly depend on the overall deal volume, the overall cap very often is equivalent to a percentage of the purchase price. Whereas for some years, caps of 15 to 20 per cent were very often agreed upon, in recent months and years, caps of 5 to 10 per cent have become more frequent.
Terms for the prescription of claims vary mostly between 12 and 24 months after the closing of a transaction. Other typical provisions to limit liability are the exclusion of any claims for facts disclosed before signing or for those claims for which the purchaser can seek indemnities against third parties, such as insurances.
Regardless of the acquisition structure and term, parties focus more and more on warranty insurances, especially in distressed M&A situations but in the past 36 months the market share of transactions involving a W&I insurer has significantly increased. By this, financial pressure is lifted off the distressed seller. This is of special interest to distressed sellers, and also sellers who intend to dissolve the selling entity shortly after closing.
iii Hostile transactions
There are not many hostile transactions in the market in the past in the German market. The planned transaction by Vonovia SE to take over Deutsche Wohnen AG would have been a hostile transaction. After LEG Immobilien and Deutsche Wohnen AG published plans to merge in October 2015, Vonovia SE resolved a capital increase to offer to purchase the shares from the shareholders of Deutsche Wohnen AG. The offer had a volume of €14 billion. As of February 2016, the required acceptance rate of 50 per cent had not been reached. Thus, the attempt hostile takeover failed. Since then, no major hostile takeover has become public in the German real estate market.
iv Financing considerations
Recent years show more equity-oriented transactions. Typically, deals are nowadays only financed by borrowed capital up to a level of around 40 to 60 per cent. Moreover, finance by insurance has become more and more attractive, whereas the number of transactions being mezzanine or bridge-financed has decreased.
Market players for the bank financing of real estate acquisitions are typically mortgage banks. Their regulations provide for a maximum loan-to-value ratio of 60 per cent if they want to issue credit notes. Since the margins are comparable and low in the long term for these kinds of mortgage loans, the equity proportion is very often no less than 40 per cent. The German funds are restricted by regulation and are not allowed to finance higher than 50 per cent of the asset value: they typically do not finance higher than around 45 per cent.
Another impact bank financing by mortgage banks has on real estate investment relates to the need for the mortgages to rank prior to any encumbrances in the land register that may have an impact on the enforceability of the mortgage or the value of the property. This can very often be the case in relation to easements in favour of tenants. Mortgages banks have developed a standard for tenant easements that they usually accept. If these requirements are not met, the costs for financing are typically slightly higher.
v Tax considerations
Under German law, two major tax issues have to be tackled in almost every transaction: RETT and trade tax.
RETT is generally triggered on both the purchase of real estate in an asset deal and the purchase of at least 95 per cent of shares in a company owning German real estate.5 The rate of RETT depends on the location of the real estate, as rates differ in the different federal states. An asset deal always invokes RETT, and even the indirect purchase of property in a share deal can be liable for RETT. As a general rule, RETT is invoked when 95 per cent or more of the interest in a property company organised as a partnership (KG) is transferred to new shareholders.6 The same applies when 95 per cent or more of the shares in a GmbH are purchased by one purchaser (or related parties). To avoid RETT in this situation, the parties can implement a ‘RETT-blocker structure’, usually involving an unrelated third party acquiring at least 5.1 per cent of a German propco. Real estate investments made by a group of unrelated investors enhance the opportunities to mitigate RETT in many transactions. However, under all circumstances, even blocker structures are considered taxable, which is why, in each case, a tax lawyer should advise on the transaction.
The income of a German corporation is generally subject to German corporate income tax and a solidarity surcharge at a combined rate of 15.825 per cent, and a municipal trade tax of between approximately seven and 17 per cent (depending on location, but in most cities around 15 per cent). However, companies exclusively generating income from the lease of real estate can usually apply for an exemption from trade tax:7 this requires that only real estate is leased. If the lessor lets fixtures or supplies services to the lessee that are needed for the operation of the business itself, this could lead to trade tax liability under German tax law. Typical examples are the furniture, fixtures and equipment (FF&E) of hotels. To avoid trade tax, propcos are usually separated from opcos, or the beneficial ownership of detrimental assets is transferred to the tenant.
vi Cross-border complications and solutions
Non-German resident investors are generally limited to tax liability in Germany on income from a lease, resulting only in corporate income tax of 15.825 per cent. It is important to avoid the creation of a permanent establishment in Germany, for example, by not maintaining the place of management or services, or employees, in Germany. Should this not be the case, income may be additionally subject to trade tax unless the specific exemption applies. It is, therefore, common to use foreign corporations for the acquisition of German real estate having their place of management outside Germany.
It may also be possible to shift the place of management of a propco that was incorporated under German law (GmbH (limited) or GmbH & Co KG (limited partnership)) to a location outside Germany to have a more robust trade tax structure. However, in this context there are discussions whether limited partnerships under German law can have their seat outside Germany. Having a liable partner with seat outside Germany, therefore, bears the risk of having the limited partnership dissolved or never properly set into force. Given the number of follow-up questions such as who is the right owner, even if the limited partnership has been registered as owner (potentially a (non limited) partnership under civil law), and how this ‘toxic’ limited partnership registered as owner in the land register is being properly represented, etc., structuring acquisition vehicles with limited partnership or the acquisition from such vehicles will take more diligence. The issue is currently not yet well known in the market, but the‘toxic acquisition vehicle is expected to be one of the future hotter topics in transactions.
Foreign investors should observe the strict German ‘anti-treaty shopping rules’, which require foreign investors, broadly speaking, to satisfy certain substance and economic reason tests to benefit from the exemption from or reduction of German withholding tax on dividends under the Parent–Subsidiary Directive8 or applicable double tax treaties.9 Therefore, investors in German real estate usually structure acquisitions to avoid the need for cash repatriations by way of dividends to be distributed by German-resident corporations. Preferred structures to repatriate cash are shareholder loans benefiting from the absence of German withholding tax on regular interest payments and the repayment of debt. However, also as a result of the global BEPS discussions and its upcoming implementation into German law, financing structures need to be carefully structured and monitored to ensure exemption from withholding tax of interest payments and their tax deductibility. Hybrid financing instruments (e.g., profit participating loans) into Germany can create negative tax effects.
V CORPORATE REAL ESTATE
As mentioned above, to avoid trade tax, the company owning the property should be separated from the company operating the property. This tax issue can be tackled by implementing propco or opco structures. Moreover, it is easier to transfer the property by selling the opco to another propco. Most propcos avoid German taxation by being structured as Sàrls or BVs and only holding the opcos.
Particularly when transferring hotels or shopping centres, careful attention has to be paid to the corporate real estate structure. Not only are propcos and opcos involved, but multiple companies provide hotels with their FF&E by way of lease contracts.
The market outlook is positive because of the consistently low interest rate and, therefore, cheap financing, and the positive economic outlook (due to the low unemployment rate and predicted economic growth of 2 per cent). Moreover, demand should be steady, as the consumer climate is positive because of very low oil prices and the growth of the total population from immigration. Therefore, the total volume of transactions will depend on supply, and the rate of return is expected to decline even further.
With the Brexit negotiations ongoing, the greater questions regard its implications on the real estate market. Expected falling investments in the UK and an expected decline in UK property values may lead to the German, and other large developed markets such as France, being regarded as ‘safe harbours’. Investors may also expect rebound opportunities in 2019 depending on the outcome of the Brexit negotiations.
Under legal aspects, the toxic acquisition vehicle issue described above is to be expected to take more room in transactional work and structuring vehicles.
1 Stefan Feuerriegel is a partner at Norton Rose Fulbright LLP and heads the German real estate practice..
2 Article 11(1) of the German REIT Act.
3 All figures as per the third quarter of 2018.
4 Mostly around 5 per cent, but many states have recently increased this or announced increases.
5 Article 11(3) of the German Real Estate Transfer Tax Code (RETT Code).
6 Article 1(2a) of the RETT Code.
7 Article 9, No. 1, Sentence 2 of the German Trade Tax Code.
8 The Directive on the Common System of Taxation Applicable in the Case of Parent Companies and Subsidiaries of Different Member States, first adopted by the European Union on 23 July 1990 (90/435/EC) and later amended on 22 December 2003 (2003/123/EC) and on 20 November 2006 (2006/98/EC).
9 Article 50d(3) of the German Income Tax Code.