Why you should follow the banks into German offices

With the UK commercial property market looking pretty toppy, the smart money is heading overseas for better returns. The favoured destination? Germany. We pick two of the best ways to get involved.

With its £1.1bn purchase of HSBC's headquarters in Canary Wharf last month, Spanish company Metrovesca might just have called the top of the UK commercial property market. The building's yield (the amount of rent paid compared with the purchase price) will be just 3.8%, well below the current UK base rate. It's not the only sign. Land Securities CEO Francis Salway last week said that some of the group's properties had fallen in value compared with 2006. "This is a big deal. We have had four years when everything was going up." So it's no surprise that "the smart money is now seeking better returns overseas", says David Budworth in The Sunday Times.

German commercial property: where the banks are heading

So where's it headed? Germany. Commercial property in Germany has lagged behind its continental neighbours for years. German commercial property was the worst, or second-worst, performer of 12 Western European countries measured by Investment Property Databank (IPD), in five of the six years between 2001 and 2006. Last year, the total return (rental income plus capital growth) from the sector was 1.3%, compared with 21.7% in France and 17.4% in Spain, according to the IPD.

But this also means that the market looks incredibly cheap, particularly compared with the UK. As Roger Dossett of New Star International Property tells The Sunday Times, one of his fund's first investments was an office block in Berlin's equivalent of Knightsbridge, where the rent is £9 per square foot. That compares with the £65 per square foot you would have to pay in Knightsbridge itself. Prime Berlin warehouses achieve a typical rental yield of 6.8%, says property consultant Jones Lang LaSalle. In London, comparable properties yield 5%.

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Returns on UK commercial property have largely been driven by capital gains rather than rental growth, an unsustainable situation, says Henk Potts in The Independent. Conversely, in Germany commercial property prices have fallen 3.1% a year since 2003.

So property's cheap, but it won't be for long. The German economy is recovering, already growing at its fastest rate since 2000. The IFW research institute upgraded its economic growth forecast by a third to 2.8% last month. The country is enjoying a surge in exports (Germany's share of global trade is 10%, the highest in the world), which has reduced unemployment to a six-year low of 9.3%. How is this affecting commercial property? Demand for office space, already in short supply, is closely linked to the economic cycle, says Potts. That means offices should fill as business confidence grows. The retail property sector will also prosper when Germans finally open their wallets again, while global demand for German exports should bolster industrial property.

Germany looks to be one of the property investments of the decade, says Merrill Lynch's Ian Stewart. Banks are already buying in. Morgan Stanley and IVG Immobillien have forked out $3.6bn on 53 properties and an office development in the Rhine-Main and Berlin regions, while Morgan Stanley spent e4bn on German commercial property last year, note Simon Packard and Peter Woodifield on Bloomberg. We look at the best ways to follow their lead in the box below.

German commercial property: two ways to buy into Berlin

Eurocastle Investment Limited (Euronext:ECT) is practically a pure play on German commerical property. The company completed a e2.2bn purchase of office buildings largely occupied by Dresdner Bank at the turn of the year, establishing itself as the dominant player in the sector. The shares trade on a forward p/e of 11.7. Mick Gilligan of Killik tips the Invista European Real Estate Trust (IERE), which listed in London last December, and also Develica Deutschland (DDE) as good ways in.

The Invista fund has e743m worth of commercial real estate across Europe, mainly in France and Germany, and aims to pay out income of 6% a year. Aim-listed Develica recently announced the acquisition of ten retail properties in Germany, bringing its exposure to the market to e700m. The company aims to create a portfolio containing 50% offices, 25% retail and 25% logistics. Its managers are confident that they can find deals that offer a 7% yield.

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