From Gerd Kommer and Felix Großmann
In Germany, open real estate funds have been a popular investment product for over 60 years because, according to the providers, they combine “the limited risk of investing in real estate” with “solid long-term returns”. In this article we show that in reality, open-ended real estate funds certainly do not have “limited risk” and their returns are rather unattractive. In addition, we examine the question of why open real estate funds are so popular with German private investors, despite their unpresentable returns.
Open real estate funds (hereinafter “OIFs” for the sake of brevity) are investment funds that are marketed to private investors and which invest investor money in real estate. The properties are mostly in Germany or Western Europe. These are predominantly commercial properties (offices, retail, logistics, hotels, clinics, parking garages), with a few OIFs also being residential properties. The typical OIF real estate portfolio is only slightly diversified in terms of locations, tenants and types of use. OIFs are allowed to finance up to 40% of their real estate portfolio through debt (loans) (30% long-term plus 10% short-term).
There are currently 31 OIFs in Germany, which together accounted for an astonishing 9% of the market value of all 9,000 mutual funds (including ETFs) sold in Germany at the end of September 2021. [1]
From an investor perspective, what are the main alternatives to OIFs?
Direct investments in individual properties are often mentioned in this context. This idea is probably unrealistic. A direct investment turns the corresponding private household into a landlord and property manager - with far-reaching consequences in terms of skills, time, tax and legal consequences. The difference to a “passive” OIF investment is big.
So-called closed real estate funds are also considered an alternative to OIFs in the real estate world. Closed real estate funds have been a total return disaster over the past 30 years, only surpassed by closed ship, aircraft and film funds. We will address the closed-end fund investor fiasco in a future blog post.
A real and realistic alternative to OIFs are real estate equity ETFs. With them, investor funds flow into the shares of listed real estate companies, such as Vonovia SE (Düsseldorf), the largest owner of rental apartments in Europe.
But normal, broadly diversified stock ETFs also contain real estate exposure, as the real estate industry accounts for around 5% of the listed stock market globally. In this respect, every sufficiently diversified, passive equity investor is automatically also a real estate investor.
Let us now look at the historical data on the return and risk of OIFs compared to two relevant alternatives. The following table contains figures for the past 25 years. We focus on the three largest OIFs with pan-European real estate portfolios. The investment volume of the three funds is between 14 and 18 billion euros per fund. This makes you one of the largest mutual funds in Germany.
Table: Comparison of return and risk of the three largest open-ended real estate funds investing across Europe with two ETF alternatives (nominal returns in euros)
► Data sources: Comdirect, fondsprofessional.de, MSCI. ► Returns including distributions. ► The available return data for the iShares European Property Yield ETF only goes back to 08/2004. ► For the three open-ended real estate funds, the current issuing premium was deducted at the beginning of the period. This is particularly effective for short investment periods, e.g. B. one year or five years has a noticeable impact on the return. ► The MSCI World Index took into account ongoing costs that were normal for ETFs/index funds in the period shown here (higher costs in earlier years, lower costs in later years, in accordance with the actual market development). ► Volatility = annualized standard deviation of monthly returns. For the three OIFs, this number should not be taken seriously for the reasons stated below. ► Maximum drawdown = maximum cumulative loss in the observation period. For the three OIFs, this number should not be taken seriously for the reasons stated below. ► Taxes are not taken into account anywhere.
What can be gleaned from the table?
Compared to the real estate equity ETF and the general equity ETF, the three OIFs have performed dismally poorly over the past 25 years. If you had a euro in your wallet 25 years ago house investment-OIF, this euro would have grown nominally to a modest 2.29 euros by today. The same initial investment in the global equity ETF would have produced a final value of 7.48 euros - 3.3 times the OIF value (all figures exclusive of taxes).
The fact that the OIF poor performance has little to do with real estate as a sector, but is solely due to the specific financial product OIF, is shown by the shorter return comparisons with the real estate ETF over the three periods of 1 year, 10 years and 17.4 years. (Note: Over the “20 year” period not shown in the table, the global real estate equity sector outperformed the broader equity market in the form of the MSCI World Index.)
Would one instead of the three largest OIFs all Evaluating the 31 German OIFs that exist today, the return figures over the past two and a half decades have been almost identical to those for the average of the three individual OIFs in our table. However, the important fact to keep in mind is that the available historical long-term returns for the OIF fund sector contain a drastic upward bias. This results from the so-called survivorship bias, the “distortion in favor of survivors”. Without this “error” in the available databases, the OIF sector return over the last 15+ years would be far lower. The data problem is that the 31 OIFs that exist today do not include the poor returns of the almost 20 OIFs that de facto “went bankrupt” between 2004 and 2017. We will go into the background of these historic OIF crashes in more detail below. However, the returns of the funds in the “OIF cemetery” are no longer publicly available.
If an investment A has noticeably worse long-term returns than an investment B, then the question naturally arises about the respective risk levels. If A were significantly less risky, his shortfall in returns could possibly be justified by this. At first glance, it looks like this was exactly the case with the three OIFs. According to the two risk indicators in the table, the three OIFs are not only far, far lower risk than the real estate equity fund and the general equity fund, they are even almost risk-free. Can this be?
It can't be. The reported risk metrics for the three OIFs are not worth the proverbial paper they were printed on. They are the result of a structurally deficient risk measurement method in the form of return smoothing. This measurement method is tolerated by the supervisory authority (BaFin) despite its obvious shortcomings.
Since the properties in an OIF are not listed investments with an official, objective market price on each trading day, but the OIF fund manager still has to publish a daily value of the portfolio (and therefore of each individual property in the portfolio) at the end of each working day, he uses expert valuations as an alternative. However, expert valuations are not market prices that result from real purchases/sales, as is the case with stock or bond funds. Appraisers' valuations are simply very approximate estimates that vary little from estimate to estimate and - like all property price estimates - are often incorrect. In the context of the assessment of the actual Given the risk that an OIF investor bears, this approach (rough estimates rather than real market prices) can be called “Deficit #1”. But that's not enough. The reports are only updated every three months. There are therefore only four fundamentally different data points per year for the value of an individual object, compared to around 250 different data points for each share in an ETF (the closing prices on each of the around 250 working days per year). The OIF generates 250 pseudo data points from the four real data points, since it has to publish a “new” price in the evening of every working day. Here we have deficit number 2. And last but not least, the experts are also paid by the OIF. We probably don't need to go into detail about what this means in terms of freedom from conflicts of interest and objectivity for these reports - deficit number 3. The whole process is structurally broken.
The following figure shows for the 36-month period from January 1, 2019 to December 31, 2021 what these three deficits lead to in reality. These 36 months include the severe stock market crisis due to Corona in the first half of 2020.
Figure: Indexed price development of the ETF iShares European Property Yield and the OIF Deka Real Estate Europe from January 1st, 2019 to December 31st, 2021 (36 months)
► Data source: Comdirect Informer. ► The price development shown includes any distributions. ► Issue premium of 5.3% taken into account for the OIF. This results in the downward bend at the beginning of the blue curve.
When interpreting the figure, it should be taken into account that the underlying economic reality for the performance of the two funds is almost identical: in both cases it is a diversified investment in European commercial real estate. The only really relevant differences are that the real estate portfolio in the ETF is more diversified (which reduces risk) and that the investments in the ETF are slightly more “credit leveraged” (which increases risk). [2] However, both together can never cause the exorbitant difference in volatility that is visually expressed in the figure and quantified in the table. What actually causes it is the flawed mechanism described above by which an OIF generates the 250 individual data points (the daily closing prices) per year that underlie the almost completely straight blue curve in the figure.
Now an OIF investor might argue, “I don’t care as long as I can redeem my shares every day at the (obviously smoothed) share prices.” [3] This objection is on shaky ground. In a severe market crisis, the return at the “declared market rate” will most likely only be possible to a limited extent or no longer possible at all. This is exactly when the option to return the item at the stated, apparently stable rate would be most important.
Evidence of this occurred not long ago, namely with individual OIFs from 2004 and with even more numerous from the beginning of the Great Financial Crisis at the beginning of 2008. The overall stagnating or falling commercial rental income since 2004 and the global real estate crisis from 2008 led to the eventual “death” of around half of the 40 or so OIFs in Germany at the time. These funds were wound up between 2009 and 2018 after several years of failure, often with double-digit losses for investors. Other, non-liquidated OIFs were “closed” for years, i.e. they allowed no or only limited share returns before they “opened” again. Shareholders who still wanted their money during the “freeze” were forced to laboriously sell their shares on the unregulated, gray secondary market, often at dramatic discounts. For some funds these discounts temporarily amounted to over 80%.
When it comes to real consumer protection in the financial industry, the German state has been in a vegetative state for decades. But the OIF disaster from 2008 was so severe that Berlin briefly woke up from its coma. The result was a regulatory OIF mini-reform in 2013. Since then, an OIF share cannot be returned for the first 24 months after purchase and thereafter only with a notice period of 12 months.
However, the reform did not actually cure the OIF genetic defect. It consists in OIFs dishonestly claiming to their private investors that they are transforming an illiquid asset class - direct real estate investments - into a highly liquid investment that is available on a quasi-daily basis. It doesn't seem too far-fetched to view this as horse-trading.
The illusion theater has been continuing since 2013. OIFs publish prices every evening that suggest the fiction of price stability and low risk.
On the basis of this apparent stability, OIFs have even been viewed by many private investors and numerous business journalists since the beginning of the “zero interest rate era” around 2015 as a replacement for savings accounts, overnight money and money market fund investments, i.e. as a substitute for investments that are actually highly liquid, that actually hardly fluctuate in value and that actually have little risk of default (at least in the case of bank deposits, within the state deposit insurance of 100,000 euros per bank-customer combination).
In the two most modern capital markets in the world - the USA and Great Britain - OIF horse-trading does not exist. There, OIFs are not permitted for distribution to private investors for the reasons set out here. If the logic presented here and the historical data shown are not convincing, then the OIF ban in the USA and Great Britain should at least give you something to think about.
Conclusion
Open-ended real estate funds consistently deliver poor returns. They market their anemic returns to a gullible audience through the illusion of a supposedly almost fluctuation-free “real asset investment” with daily price determination. OIFs are therefore – as we have shown here – “risk dishonest” financial products. In the next severe real estate market crisis, the OIF risk illusion will with a certain probability be killed again by reality. On a long-term average, such crises happen every 15 to 25 years.
Endnotes
[1] “Public funds” are investment funds that are marketed to private investors (“consumers”). Many other fund types may only be marketed to professional or institutional investors.
[2] A real estate stock corporation like Vonovia SE mentioned above typically has between 20% and 50% debt capital on its balance sheet.
[3] OIFs are funds in a conventional (“classic”) fund format. The sale of a share takes place by returning it to the fund company, not by selling it on the stock exchange like with an ETF or a share.