Germany has a gross domestic product of approximately €2.7trn (£1.8trn) and is the third-largest real estate market in the world, making it the largest and economically most powerful member of the European Union (EU). In recent years, UK investors have purchased £4.5bn-worth of German real estate and this, together with the constant smattering of reports in the property press about the expansion into Germany of UK property companies, are a telling indicator of the attractiveness of the German real estate market to UK and international investors. The introduction of the German real estate investment trust (G-REIT) has the potential to open up the German real estate market and capture the attention of more UK investors.

The Bundesrat (Higher Chamber of the German Parliament) passed the German Public REIT Act on 30 March, 2007, and from 1 June, 2007, G-REITs came into existence retrospectively from 1 January, 2007. G-REITs aim to create a significant listed German real estate market and offer the opportunity for existing companies to restructure. Each investor holds a small share in a real estate portfolio that offers the investor the chance to achieve returns at the same level as if real estate is held directly, without the costs of doing so.

What are G-REITs?

A G-REIT can be either a new company or an existing company that is transformed and listed on a recognised European stock exchange. A G-REIT must:

• have headquarters and management in Germany;
• have a minimum stated capital of €15m (£10m);
• have a single class of shares with voting rights;
• have at least 15% – and when listed, 25% – of the available shares as free float, which means those shares are freely available to the investing public (of which no individual participation can be more than 3%);
• not permit any one shareholder to hold more than 10% of shares;
• not trade. A G-REIT will be assumed to trade if it sells more than 50% of the aggregate value of its real estate portfolio within a five-year period; and
• generate at least 75% of its total profits from real estate and at least 75% of its total assets must consist of real estate.

A yearly review by a certified public accountant will determine whether the G-REIT has met the necessary criteria and conditions and can take advantage of the tax benefits. Administrative fines (1%-3% on assets breaching the 75% limit, 10%-20% on gross profits exceeding the 75% limit and 20%-30% on the amount by which the minimum distribution rule (see below) is breached) will be imposed in case of default, and repeated infringement can result in the loss of G-REIT status.

The main tax benefit for companies thinking about converting to G-REITs is the total exemption from corporate and trade tax (Koerperschaftsteuer and Gewerbesteuer). In contrast to the UK REIT, there is no price to pay to enjoy this benefit as there is no 2% conversion charge.

Each year, the G-REIT is required to distribute at least 90% of its profits within the 12 months after the end of its financial year, save where a proportion of up to 50% can be retained for up to two years only as a reserve. This is known as the minimum distribution rule. The dividend distributions to resident and non-resident shareholders are fully taxable.

So how will G-REITs open up the German real estate market? Figures for 2005 indicate that a German real estate reservoir of E7.2trn (£4.8trn) exists, with only E390bn (£262bn) held by institutional real estate investors. Traditionally, commercial property has been owner-occupied and the G-REIT aims to encourage these hidden assets to be released, freeing equity that can be used for other business operations. The legislation offers further encouragement to release hidden assets, held at least for five years, with a 50% allowance on capital gains if these businesses sell or sell and leaseback these assets before 1 January, 2010.

Some of the biggest names in Germany are considering converting to G-REITs and the opportunity G-REITs provide for such companies to restructure their portfolios and provide an exit for existing open-ended and closed-ended funds makes them more attractive. Expansion is also encouraged by the German banks' favourable low interest rates on borrowing compared with the rest of the EU.

What does it mean for the UK investor?

It is estimated that only 0.5% of German commercial real estate is available to investors via the stock market and an influx of G-REITs will increase access to part of the potential E7.2trn German real estate reservoir through the listed market.

UK resident shareholders will be subject to 25% withholding tax on the dividends, which (where such dividends are subject to tax in the UK) may be reduced to 15% under the current double taxation treaty between Germany and the UK. As single shareholdings can be no more than 10%, the advantage of the European Parent-Subsidiary Directive that reduces withholding tax to 0% is not available to foreign corporate investors.

As with all new products, the advantages for UK investors are dependent on whether the G-REITs will really bear the promised fruit.

In a late decision, the legislation dealt a blow to the possible success of G-REITs by excluding investment in the residential market, subject to the exception mentioned below. Only 42% of Germans (12% in cities such as Berlin and Frankfurt) are owner-occupiers. This, together with the recent revival in the economy, increased movement to urban areas and a short supply of apartments, has led many to believe in the great potential of investment in German residential real estate. This is despite the constant shadow created by the social welfare policies of the German legislature that restricts and limits the rent levels and movement in the residential rental market, which has and may continue to deter investors.

However, all may not be lost as the residential market exclusion does not apply to apartments built after 1 January, 2007. The potential shortage of residential stock and single-occupancy trends increasing demand may lead to more apartments being built after 1 January, 2007. In addition, there may be a potential market in increasing housing stock for the increasingly aged population. This may offer some future opportunities to investors and the shortage in supply may inspire the German legislature to review its strict stance on rent levels, movement and the G-REIT residential exclusion.

All these considerations aside, the success of G-REITs will depend on who takes advantage of this new vehicle and if the money will flow as hoped for. If the third-largest real estate market in the world uses G-REITs to open up as predicted and with the reported enthusiasm from banks and investors, UK investors would be wise to take note and consider their participation.

Leena Mistry and Carsten Kociok are Olswang real estate associates in London and Berlin respectively.