Author: | Published: 3 Apr 2003
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Commercial leasing

The letting of commercial property in Germany is almost exclusively by lease contracts. German law does provide for other legal means of granting possession of parts of real property for a business operation, such as easements, registered leases (Dauernutzungsrechte) and leasehold rights (Erbbaurechte), however these options are used scarcely. Contrary to other European jurisdictions, German law provides a complete set of rules regulating the relationship between landlord and tenant which is mainly found in Sections 535 to 597 of the German Civil Code (Bürgerliches Gesetzbuch, abbreviated: BGB) which were recently completely revised with effect as of September 1 2001. The BGB is federal law enacted by the Federal Parliament (Deutscher Bundestag). Under German law, human rights legislation does not affect the relationship of landlord and commercial tenant.

The provisions in the BGB are largely unsuitable for commercial leasing. The statutory provisions generally benefit the tenant and do not reflect specific needs of commercial leasing such as the allocation of maintenance duties, ancillary costs and their allocation. Therefore commercial lease contracts generally include an extensive number of detailed provisions to cover specific aspects of commercial leasing, which often deviate substantially from the statutory regulations. In contrast to residential leasing commercial leasing is subject to only a few mandatory provisions of BGB so the parties are free to agree on terms suiting their needs. However, standard lease agreements for more than one lease relationship are subject to the law of general terms and conditions, meaning that deviation from the statutory regulations is only possible to a limited extent.

Details of normal lease agreements do not have to be disclosed to any formal registry. However, if the right to use the premises is granted by a leasehold agreement which constitutes a right similar to freehold (see below) particular details such as the existence of the leasehold and its term must be disclosed and registered for the leasehold to be valid.

Tenant's insolvency
The opening of insolvency proceedings against the tenant's assets does not automatically affect the landlord-tenant relationship. The liquidator is entitled to terminate even lease agreements with a fixed period, which is generally not possible except in insolvency proceedings. However, the landlord is not entitled to terminate the lease for non-payment of rent before the insolvency proceedings have been commenced. Also, the deterioration of the tenant's financial situation is not a valid basis for termination. The landlord may, however, terminate for delayed rental payments due after the opening of the insolvency proceedings or for fraudulent misrepresentation of the tenant regarding its financial situation.

Effect of accounting issues on lease structures
Generally, leased premises are allocated for balance sheet purposes to the landlord, the lease itself is not regarded as an asset of the tenant. However, premises of finance leases are for tax balance sheet purposes allocated to the tenant if certain conditions set forth in regulations issued by the Ministry of Finance are fulfilled. Leases can be structured differently in order to meet or not to meet these requirements depending on what balance sheets results are sought. Thus, changes to those regulations would presumably lead to different lease structures.

Lease renewal
At the end of the term, there is no statutory right for commercial tenants to ask the landlord for renewal of the lease. Commonly, termination and renewal options are dealt with entirely by the lease agreement. However, if the agreement does not deal with these issues the lease is regarded as renewed if the tenant continues to use the premises unless objected by either party within two weeks.

Assignment or alienation of the lease
Under German law, rights and obligations relating to the lease relationship are regarded as purely contractual. Thus any assignment of the lease agreement to a third party by the tenant requires the landlord's consent and vice versa. Therefore, tenants cannot divest themselves of a lease without the landlord's cooperation.

Securitization of real estate assets

Traditionally, German mortgage banks employ as a refinancing tool a particular mortgage based bond, the pfandbrief, which has been known to German banking institutes and investors for over 200 years now. A number of statutory regulations give high security standards. Consequently, the pfandbrief is widely accepted as a low risk bond with advantages such as its listing by the European Central Bank as a tier I bond and adequate collateral in Eurosystem credit operations. However, the pfandbrief model also has a number of inherent restrictions, and as the securitization market for other assets (such as leases, loans and trade receivables) has become increasingly sophisticated in the past few years, many institutions are starting to look more closely at asset-backed securities and, in particular, mortgage-backed securities (MBS) structures which do not involve the issuance of pfandbriefe.

MBS transactions in Germany in 2002
Transaction Originator Value
Provide Comfort 2002-1 HVB Real Estate €3,0 billon
Provide Home 2002-1 Aareal Bank €1,8 billon
Provide Residence 2002-1 Commerzbank €1,5 billon
Provide Blue 2002-2 BHW €1,5 billon
Provide Residence 2002-2 Commerzbank €1,5 billon
Global Commercial One Aareal Bank €1,5 billon
Provide Blue 2002-1 BHW €1,3 billon
Rheinhyp Gems II Rheinhyp €1,1 billon
Provide Gems 2002-1 Rheinhyp €1,0 billon
Provide VR 2002-1 DG Hyp; DZ Bank €0,6 billon
Source: Immobilien Manager

The role of rating agencies
Due to the long history of pfandbriefe, its structure, advantages and disadvantages are widely known to potential investors in Germany. Thus, a professional assessment by rating agencies is not required. However, since issuers of pfandbriefe aim to attract foreign investors, pfandbriefe too, are subject to general rating procedures. Nowadays, almost all credit institutes issuing pfandbriefe can offer ratings. Asset- and in particular mortgage-backed securities are subject to rating just as in other jurisdictions. Since these securities refer to particular portfolios of securities, and their structure and value may vary considerably, potential investors rely to a large extent on the rating agencies' statements. Thus a good rating is a crucial factor for a MBS transaction to be placed successfully. In this respect, uninsured risks that lead to payment obligations of the landlord or set-off rights of the tenant will affect the rating of MBS using rent receivables as security.

Property outsourcing

Lately, the German property market has recognized property outsourcing as an interesting and potentially profitable business opportunity. Public communities and entities are increasingly in debt while there is also a considerable need for maintenance, renovation and new construction of public buildings. At the same time, the construction and engineering industry is experiencing a dramatic decrease in investment. Public entities and private enterprises in the construction industry are therefore increasingly interested in joint projects of public-private-partnerships (PPP). Also, finance institutes consider PPP projects as an opportunity to extend their credit business.

The PPP model usually includes the following structure: A private investor plans the project according to guidelines issued by the respective public entity. The engagement of the private investor commonly includes financing, constructing and letting the property to the public entity or as the case may be operating the property itself to be used by the general public. Often the private investor will operate the property at his own risk. In this case the investor has to provide services either from his own service departments and employees or from third parties.

Private sector property owners that do not specialize in the property business are also increasingly interested in outsourcing their real estate, often including related activities such as maintaining and operating their business places. The outsourcing company may and often does divest itself of a large number of its real estate assets and leases back what is needed for operating the company's core business. Outsourcing property turns illiquid assets of the outsourcing entity into funds that can be invested and relieves pressure on capital. As an effect of Enron and other recent accounting scandals, schemes providing for off-balance sheet property outsourcing are difficult to carry out. Preferred schemes include true sales of assets.

Often companies or public entities that outsource real estate also aim to outsource their IT and even sometimes their HR departments. The development of a branch offering services for the management, maintenance and operation of real estate together with IT and HR services as a one-stop-shop may seem possible. However, this does not appear to be market practice yet.

Presently the German market shows a great and increasing interest in property outsourcing projects, both in the public and private sector. However, since the outsourcing market in Germany is still young and developing it is too early to predict what lessons regarding structure and performance can be learnt. However, the German property outsourcing market can reasonably be expected to grow considerably in the future and become more sophisticated.

Financing real estate transactions

Traditionally the purchaser of real estate uses the property as security for financing, granting mortgages (Hypotheken) or land charges (Grundschulden) against the property which are commonly limited to 60% to 80% of the loan to value ratio. Mortgages and land charges are not binding against third parties until they have been entered in the land register. These liens are enforced by compulsory auction in which the property is sold to the highest bidder. The creditors' claims are then satisfied by the proceeds of this sale. To instigate the auction, the creditor must first obtain a court order. Alternatively, the debtor can and often does undertake in advance by a statement in a legal document recorded by a notary public or a German court to submit to immediate execution. In this case, such a statement suffices to initiate an enforced auction. Under German law the owner of property retains legal title to the property even if this is mortgaged. There is no debate as to this legal position.

Even for high value real estate transactions such as portfolio purchases, investors choose this classic method of financing by granting land charges and mortgages. However, alternative means of financing are becoming more and more popular giving investors and the financing institutes more flexibility, in particular, as to the amount of equity needed. Such alternative means include, for example, the use of sale and lease back structures or as mentioned above PPP models and securitization of receivables from property.

Transaction costs
In contrast to Anglo-American jurisdictions there is no stamp duty. The German equivalent is a land transfer tax (Grunderwerbssteuer) which amounts to 3.5% of the property value. Notarial and registration fees have to be added. However, property transactions can be structured in different ways to optimise tax and costs implications.

In the course of a property sale there are relatively few obligations on the parties to disclose the terms of the purchase and its financing to formal registries. In order to transfer the property the conveyance needs to be registered with the land register (Grundbuch). For this the parties have to hand in the notarised purchase agreement. However, since the land register is only interested in the sale, only the relevant part of the agreement need to be handed over. Although collateral agreements between the parties need to be notarised as part of the overall agreement, generally they do not have to be disclosed. However, the land charge and its amount must be registered with the land register in order to provide the real estate as security. This may allow conclusions to be drawn as to the amount of debt financing. Disclosure obligations might also arise from antitrust and competition law.

Conveyancing issues

Under German law there are two fundamental types of property rights, rights in rem (dingliche Rechte), and rights in personam (obligatorische Rechte), also called relative rights. The main difference between the two is that a right in rem is a right that one can enforce with regard to anyone, whereas a relative right only affects the contractual partners involved. Rights in rem must therefore be recorded officially and publicly. They are subject to special safeguards and must all be entered in the land register. This is a must for rights in rem; but it is not required for relative rights.

The most important rights in rem regarding property are freehold (Eigentum), leasehold (Erbbaurecht), condominium property relating only to parts of a property, usually a flat (Wohnungs-/Teileigentum). The property can be held by a sole person or company or jointly by several persons or companies.

Freehold includes the owner's right to absolute control of the property (within the limits of the law and third parties' rights). All individuals, including legal entities, are entitled to acquire freehold.

Leasehold refers in contrast to freehold only to buildings on a property: Property owners can encumber the property by granting a third party the saleable and heritable right to erect, maintain and operate a building on or beneath the surface of the property. This right is called Erbbaurecht, that is, leasehold or heritable building right, and must be recorded in the land register. The leasehold title is registered in a separate leasehold register (Erbbaugrundbuch). As an exception to the general rule that ownership of a building follows ownership of land, under the concept of leasehold title to the land remains with the owner of the land whereas title to the building belongs to the beneficiary of the leasehold, the leaseholder (Erbbauberechtigter). It is important to note that this is not permitted for part of a building, such as a single floor but must always apply to the entire building. The leaseholder is entitled to encumber and use the building in the same way as a freeholder subject to the stipulations of the leasehold agreement.

Under the Condominium Property Act (Wohnungseigentumsgesetz, abbreviated: WEG), separate freehold of a self-contained unit in a building may be acquired. Due to the statutory provisions of the WEG, a sole owner of an apartment (or otherwise defined part of the property) only controls this particular apartment. All common premises like stairs, roof and walls are owned by the community of co-owners which decide in regular meetings about these common premises. Such decisions are required for example for reconstruction and modernization measures of the property. For each condominium property a property manager is mandatorily required. They are the caretaker of the entire building and are responsible for carrying-out co-ownership decisions. Furthermore, they often have to consent to the sale of condominium property as trustee for the community of co-owners if such consent is required by the agreement between the co-owners.

The concept of sole or joint proprietorship refers to the number of and the relationship between several owners. A property can be owned by a sole person, partnership or company or jointly by several persons, partners of a partnership, several partnerships or companies.

Purchase of property
Property can be acquired either by way of an asset deal transferring the property as such or, if the owner is a partnership or company, by purchasing the interests in the partnership or the shares of the company. The purchaser of land via a share deal in contrast to an asset deal, will have to take into account all other obligations of the partnership or company not relating to the property.

The asset real estate purchase agreement must be recorded by a notary public. This also applies to share deals if the selling company is a limited liability company (GmbH). Without notarisation the agreement is void. This compulsory legal form includes every transaction connected with the sale and purchase of the property, even if the transaction would not require notarisation if it stood alone. Given the compulsory nature of notarisation, which requires the notary to read aloud the agreement in the presence of the parties, e-conveyancing is not possible at the moment in German practice.

It is important to stress that notarisation of the purchase agreement does not in itself make the buyer the owner of the property. It only gives the buyer the right to request of the seller the conveyance of the property formally by entry of the new owner in the land register. The land registry will record the new owner only upon fulfilment of the following conditions (plus any further contractual conditions if agreed):

  • A statement from the local authorities is required confirming that they waive their possible statutory right of first refusal, or that they do not have a right of first refusal.
  • The fiscal authorities must issue a clearance certificate,
  • and if only part of a property is being sold the buyer must wait until the autonomy of the sold part has been confirmed by the land registry.

In order to secure the buyer's entitlement to the transfer of the ownership, a priority notice (Auflassungsvormerkung) is commonly registered to the buyer's benefit. Provision for such an arrangement can and is usually made in the purchase agreement. By registration of a priority notice the beneficiary receives a right against any other buyer or unregistered creditor of the property. Once the priority notice is registered, the beneficiary's claim overrides any subsequent buyer's claim or other parties' encumbrances.

Purchase agreements
The sale agreement must include a precise description of the property to be sold in the form of an exact citation of the relevant entries in the land register. Any encumbrances, liens and charges on the property must also be included in the agreement, and if not otherwise agreed, they are transferred to the buyer together with the property.

The price is naturally a key element of the agreement: it is normally paid without VAT but it is also possible to provide for a different arrangement if advisable for tax reasons. Sometimes the parties agree on a preliminary price to be adjusted according to agreed criteria such as for example measurement of leased premises or the property itself to be carried out after signing of the purchase agreement. Agreements which pertain to sharing the possible advantages of a development uplift are rather rare. However, it can be achieved by earn-out provisions, for example, granting the seller a share of possible profit made by the buyer with a later development or sale. Also, if the property is owned by a partnership or company the selling partner or shareholder can sell the property via a share deal and retain shares or interests. It will depend on the particular structure if and to what extent the seller participates in profit and/or loss.

Acquisition of property by means other than agreement
The acquisition of a property cannot only be achieved by agreement but also by law such as succession, foreclosure or appropriation. As a general rule such a change of ownership does not require registration in the land register. It takes place as a matter of law upon fulfilment of the particular conditions. Subsequently the land register will be rectified by entering the new owner. It has to be noted that in contrast to objects, under German law real estate cannot be acquired by adverse possession.

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