The German property market is a sleeping giant. After years of poor performance punctuated by high vacancy rates and low growth, investors across the world are beginning to see value.

The much anticipated introduction of REIT legislation this year, which effectively halves capital gains tax on commercial property, is expected to create an instant market worth billions.

Unlike more developed markets across Europe, such as the United Kingdom and France, German listed property trusts are almost non-existent. Over 70 per cent of all property in Germany remains privately owned by companies and unlisted open-ended funds.

And it is this fact that has investors across the world licking their lips. Some have estimated that within the next five to 10 years a market worth a staggering €140 billion ($229.5 billion) could open up.

"Germany is the most interesting market at the moment because the Government and public corporations own a huge amount of the real estate and they are selling it to pay down debt," Joe Harvey, senior portfolio manager at Cohen and Steers, the largest REIT manager in the US, says.

Research from Citigroup backs this up. It has estimated the German REIT market could be worth €57 billion ($87.4 billion) within three years. It also stressed that in a fragmented property market like Germany there would be greater opportunities to find value because of regional mis-pricing.

"(German) corporates are seeking to realise value through disposal of their property portfolios. Many public authorities are running large deficits and are under pressure to raise funds through the sale of properties," the research says.

For Chris Reich, who sits on fund manager ING Investment Management's investment committee, German REIT legislation will open up tremendous opportunities. 

"Over the next three years between 80 and 100 German REITs could come to the market . it will go from being one of the smallest markets in the world to one of the biggest," Reich says.

The move to invest in German property, however, has already started. Investment houses across the world, and in particular in Australia, have been jockeying for position in anticipation of huge potential growth. Playing catch-up
"Germany has been bumping along the bottom really since 1992," Robert Orr, a UK-based director of global property research company Jones Lang LaSalle, says.

"The market has been falling or flat since then - 2004/05 was the first sign of a tentative bottoming out of the property market."

Few places are more keenly aware of Germany's potential than Australia. With $55 billion worth of uninvested cash pouring into the Australian funds management industry on an annual basis, and fewer opportunities at home, it is hardly surprising investors are looking beyond their own borders in search of returns.

Whereas once it was the US that attracted Australian dollars, a weak housing market and a recent crisis in sub-prime lending has scared off investors.

"Australians invested heavily in the United States in 2004/05 but there has been a definite shift to Europe in 2006," Orr says.

"The total amount of offshore capital invested by Australians in 2006 was US$12 billion of which US$6 billion went to Europe. Over half of that, US$3.5 billion, went to Germany."

By the late 1990s there was virtually no international ownership of German commercial and residential property, he says.

"There is a huge catch up to be done. Just two years ago the total transaction value for commercial property deals in Germany was between €5 billion and €7 billion; by 2006 transaction values stood at €50 billion," he says.

Fund manager Pengana Capital is one such firm positioning itself for a potential assault on Germany. Its executive chairman, Russell Pillemer, is optimistic, but at the same time urges caution.

"The German economy has been flat for a number of years. We are focusing on value.

In the office market, for example, you can find pockets of value where vacancy rates are lower," Pillemer says.

Pengana now owns 29 individual assets in Europe, 95 per cent of which were built up in the past six years.

Only last month Pengana splashed out $158.5 million on three German properties to seed its proposed Pengana Credo European Property Trust. It has also established a London office. The firm said it expects its new European trust to grow to a billion-dollar fund within a few years.

It is not alone. Competition is set to be fierce and Pengana is one of a myriad of Australian investment houses with its eyes set firmly on European, and in particular, German property.

"There is a lot of competition at the moment. The Americans have a high degree of interest as do the Australians and the Europeans. Competition is fierce, even today, but going forward it will increase," Pillemer says.

Pengana joins such names as Macquarie Bank, Stockland, GPT, Rubicon Asset Management, APN Property Group, Valad Property Group, Lend Lease, Multiplex and Westfield, which have all established a German presence in the past few years.

Pillemer, however, urges caution. "Germany does present opportunities for investors, but you need to be selective. Our view is people should be careful about direct exposure to a different currency. You are exposed not only to property but also to currency fluctuations," he says.

Perennial Investment Partners chief Stephen Hayes is also sceptical. Hayes says the German economy is improving but there is still a long way to go.

"In the past most German real estate markets have been poorly performing. Retail sales have been flat for many, many years. Occupancy costs are high in shopping centres and cash-flow growth is poor compared to other markets," he says.

He points out yields are low and office vacancy rates high - up to 9 per cent in Berlin and 10 per cent in Germany overall.

"There is not much prospect for growth, yields are low and we believe people are paying too much," he says.

"A lot of foreign capital, including Australian capital, has gone into German residential, office and industrial warehousing. The private equity firms have been very aggressive and pushed yields to unrealistic levels." Tax implications
The tax situation for foreign investors is another pitfall many seem to ignore. The new REIT legislation has huge tax benefits, but only to those funds that list in Germany. If investors want to get access to superior returns, then the only real option is to invest with global property securities funds.

Hayes points out that in the past Australian listed property trusts (LPT) have taken advantage of a tax loophole in Germany, which may no longer be open to them because of proposed German tax reform.

As of January 1, 2008, legislation could be introduced that will reduce corporation tax by up to 9 per cent, to 30 per cent, but the new law is also intended to close off the thin capitalisation tax loophole many foreign investors have been taking advantage of.

The proposed legislation effectively puts a limit on how much debt a company can operate on and still be eligible for tax deductions.

"It's a rule against redirecting profits to tax havens via financial structures involving international structures. As a result, funds like Rubicon Europe Trust and the APN European Trust could have smaller returns than those that invest directly in German REITs," Hayes says.

The message is clear. Invest directly in German REITs rather than through an Australian diversified fund. In Hayes' view investing in Germany through an Australian LPT would be a "ridiculous concept".

Pillemer is aware of the tax situation. "Our tax advisers are saying that it is unclear what exactly the German Government will come out with. We will be monitoring the situation and see where they take everyone," he says.

Changing economic fortunes
Despite such concerns there is no doubt that after years of slow growth and high unemployment, the wider German economy is in recovery mode. This can only be good news for the property market.

According to statistics released by German economic research group the Ifo Institute, business confidence is surging. Its April Business Climate Index for German industry and trade showed that the outlook among German firms for the next six months is overwhelmingly positive.

"The German economy is experiencing a very strong economic boom as last observed in 1990," Ifo Institute president Hans-Werner Sinn says.

The Essen-based RWI Economic Research Institute also has encouraging news to spread on the German economic revival.

"The powerful upturn in Germany continued during the second half 2006," it says. "Gross domestic product increased by 2.7 per cent on average during the year - the greatest increase since 2000 . after 10 years in the doldrums, construction activity has picked up again and personal consumption was revitalised as a function of growing employment."

Getting access to the German economic revival through the new REIT market will be at the forefront of many investors' minds, but most in the market urge a healthy dose of caution.

"Investors need to remain disciplined. With this amount of capital involved they could quite easily get caught up in the story of German REITs and ignore the fundamentals," Reich says.

Orr also takes a sober view about the much anticipated explosion in the German REIT market. In his mind investors can expect not so much an explosion but a slow burning fuse.

"Because of the more restricted nature of the German REIT legislation, compared to France and the UK, as well as the scale and size of German property companies, it means there will not be a lot of REIT activity in the early months," he says.

As to Australian investors getting access to the German property market, he says LPTs are likely to be the most popular way at first.

"Australian LPTs are a tried and tested public route for investing in German property. Most will continue to use the LPT vehicle as a flotation route, but I would be very surprised if they didn't create German-domiciled REIT vehicles over time," he says.

"It will be tougher for Australian LPTs to compete for assets in Germany, so it makes sense to float in Frankfurt."

German REIT legislation
On March 23, the German Bundestag adopted the long-awaited German REIT legislation with retroactive effect from January 1. 

It means only half of the capital gain from the sale of commercial property to REITs is subject to tax.

The legislation had been stalled over debate on the required holding period before companies were eligible for the tax break. The Government eventually settled two years for existing listed property trusts and five years for other companies.

Previously, the holding period for both was 10 years. 

The other key issue with the legislation was whether to include residential assets.  These remain effectively excluded, except if the assets have been built after 2007 or are foreign.

Other features of the legislation include:
. 75 per cent of the trust's activities must be real estate related; in Australia, the requirement is 50 per cent;
. The trust is allowed a maximum of 60 per cent leverage; in Australia there are no gearing limits;
. Trusts in Germany must pay out 90 per cent of distributable profits; in Australia they are required to pay out 100 per cent of distributable profits; and
. German REITs must place a minimum 15 per cent of its shares in a free float; in Australia there are no restrictions.