The backdoor route to Germany's undervalued property market

Bombed-out prices and record high yields make Germany the best property buy in Europe. But how can you get exposure without actually having to buy a flat 600 miles away?

Bombed-out prices and record high yields make Germany the best property buy in Europe. But not everyone likes the idea of looking after tenants 600 miles across the Channel. High transaction costs when buying or selling a property pose further entry hurdles. Here, Sven Lorenz tells you all you need to know to avoid these problems.

German property: Low valuations, but a market that is tricky to get into

Half the world's literature on taxes is printed in German, and unless you have lived and done business in the country, the chances are you won't be able to deal in German property efficiently. The bureaucracy is a nightmare, and despite English being widely spoken in Germany, there remains a language barrier, particularly when dealing with contracts and legal correspondence. And while the frequently quoted example of German council estates being sold off en masse may be good news for private equity firms and other large investors, unless you have the financial firepower to buy hundreds, or even thousands, of flats, these deals won't be open to you.

So, how best to get exposure to this market of seemingly low-hanging fruit? Property shares would be the obvious answer, if only there were as many attractively valued German property shares as one would expect. Surprisingly, there aren't. Germany never developed a sophisticated market for property shares. The market cap of all German property companies amounts to just e7bn, compared to the e85bn that Europe's 50 largest property companies are worth. To find any worthwhile investments, investors generally need to sift through the German small and mid-cap sector.

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Buying actual property in Germany is no easy solution either. You'll be faced with average transaction costs of 10%-12%. That doesn't mean your investment won't pay off in the long term if you get in at a low price, as you currently can, your capital gains should cover it. But when transaction costs immediately take up more than a tenth of your invested capital, you do begin to wonder if there isn't a better way in. The good news is that there is.

German property: the most direct routes are not always the best ones

One of the reasons that private equity firms expect a higher valuation of German property is the impending liberalisation of the German mortgage market. German property buyers currently have to deal with a hugely restrictive lending system. Once mortgages become easier to get, additional liquidity will rush into the market and lift property prices.

Thus, the same bullish arguments that hold true for German property investments also hold true for German mortgage lenders. Their market is set to expand rapidly because of the general market recovery and because of the expansion of the property market as a whole thanks to new products aimed at potential clients who were unable to take out mortgages in the past.

The best value is usually found in the least obvious places. Such was the case with BHW, Germany's second-largest mortgage lender. The German market is comparable to the UK market during the 1970s. But with EU legislation to liberalise the German mortgage market already on the horizon, product innovation and thus considerable market growth is merely a question of time.

That makes BHW's extensive, country-wide distribution network for mortgages look like a nice asset to have. So when it was announced that the union that owned the majority of shares was putting them up for sale, all those who remembered Britain in the 1970s took a look. There are now more than ten bidders in the market and the shares are up 60%. BHW is likely to be delisted after the takeover, hence you won't be able to profit from its longer-term potential. That means that we need to look for the next BHW.

One likely candidate might be Eurohypo (EHY, e26.90). This is a company few have even heard of, but it has a credit portfolio of e103bn, putting it at No. 315 on the Fortune Global 500 list. Eurohypo was formed just three years ago, when Commerzbank, Deutsche Bank and Allianz merged their respective mortgage divisions in an attempt to get the mortgage business off their books.Just 2% of Eurohypo shares have been in free float since then. Originally, the idea was that the banks would sell down some of their stakes, but there was little interest from buyers so the move was postponed. It's still being held back today, but for different reasons: Eurohypo is getting more valuable every day, so selling doesn't seem so attractive any more.

During the first six months of 2005, earnings before tax rose 30.9% to e254m and that's even before the German property market has properly turned around. Given its economies of scale and the fact that Eurohypo has cleaned up its portfolio during recent years, this could become one of the biggest indirect winners of a newly revived and broadened German mortgage market. The shares are thinly traded, but anyone buying now can rest assured that the major shareholders are going to start a flurry of marketing activity before reducing their stake via a public offering. They'll want to achieve the maximum price for their shares. It has also emerged during the last few days that the bank might be sold in its entirety, which means there's a good chance of a bid offer too.

German property: a gold-gilded former mining company from the Ruhr area

For those who believe in holding actual assets for safety and steady capital growth, there is one particularly suitable play on German property available.Few follow the fortunes of the firm, mostly because its free float is worth a mere e80m. But once you start to look at it properly, it looks very exciting indeed. Next time you walk through the centre of a German city, the chances are you will pass a property owned by Hamborner (HAB, e27.90).

Formerly a coal mining company, Hamborner has been relaunched as an efficient manager of part of the fortune of the mega-wealthy Thyssen family. The billionaire family's stewardship makes this a company that remains largely untouched by the short-term pressures that other listed companies have to deal with. This state of affairs has enabled Hamborner to use their money to pick up top-quality retail and commercial property whenever it comes across a tempting opportunity. Just 1.3% of the company's space remained unrented at the last count, testament to its extremely careful selection of investment properties. This is a recession-proof portfolio from which Hamborner receives a substantial cash flow, which means it has never taken on much debt. The portfolio is gradually expanding and there has always been a steady series of dividend payments.

With German property prices now at 1975 level in real terms, even Hamborner's largely unleveraged portfolio could yield ample profits in years to come. In the meantime, with an investment in Hamborner you will have nothing to worry about in terms of risk. The share's net asset value is e32.50, compared to a current share price of e27.90 (a 14% discount). Last year's dividend amounted to e0.90, giving the share a yield of 3.2%.

German property: an Aim-listed shell company

For some investors, Hamborner will be far too conservative. Instead, they will want to make as high a gain in as little a time as possible. Curiously, it is on the London Aim market that you can find an emerging equity story that is closely tied to the German property market. That this story has a healthy dose of City-style financial engineering thrown in may worry some and certainly adds to the risk, but it could also make this the share that generates the highest returns of all the shares featured in this article.

Speymill Group (SYG.AIM, 33p) is the kind of play we saw a lot of in the late 1990s where a buccaneering investor gets into and restructures a listed shell company. In this case, it is Jim Mellon, number 233 on The Sunday Times Rich List 2004, with a fortune of £175m and an occasional member of the MoneyWeek Roundtable. Mellon controls around 65% of the company's fully diluted share capital of about 50 million shares. Mellon gained notoriety for setting up Charlemagne Capital, a boutique investment firm that after only five years has gained him a reputation for being "one of the most astute managers of emerging market funds", says Funds International.

The firm's assets under management have already surpassed the $3bn mark, leading Finance News recently to speak of the firm's "breath-taking growth". Charlemagne made headlines when one of its private equity funds returned 250% in just three years, largely on the back of well-timedanti-cyclical investments into banks in the Balkan region.

Mellon's latest brainchild, Speymill Group, looks like it's going to step into the footsteps of Charlemagne Capital. It will also focus on looking after other people's money, in exchange for management and performance fees.Asset management doesn't require a lot of capital. Hence, if performance fees start to roll in, then the earnings per share could sky-rocket. Just as Charlemagne had a major theme with its Balkan investments, Speymill has also focused on a particular investment story, at least during the first phase of its development. Speymill's plan is to commit resources to managing German property investments. To this end, it has teamed up with a Berlin-based property entrepreneur.

It is too early properly to value Speymill, given that it only announced its new plans a few weeks ago. But with a fully diluted market cap of just £15m, this is one to watch. The company still owns one of its former operative businesses, an outfitter of hotel rooms. This division currently has £36m in order prospects and, with a cyclical upswing in the hotel-fitting business in sight, it may well turn out that the existing business fully justifies the current market cap. In that case, Mellon's apparent talent for setting up asset-management operations could, for the time being, still be had for free.

Sven Lorenz contributes to the free Profit Hunter Files weekly e-alert, which reports on developing international investment trends. To start receiving it, go to