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DES - Online Annual Report 2008

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Individual risks

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Presentation of material individual risks

Cyclical and macroeconomic risks

Based on the US real estate markets, as of summer 2007 the attention of banks and insurance companies initially focused on extensive write-downs on mortgage-backed securities. Ultimately, it was the general climate of diminishing confidence in the financial markets took its toll on the banks in particular, since liquidity supplies for short-term funding were no longer assured due to the interbank markets drying up, thus posing a threat to the banks’ existence. We are all experiencing the direct effects of this at present. Since September 2008, state rescue packages for financial institutions have been launched around the world to contain the effects of the financial crisis, which has now also intensified in Germany. No one is able to predict further developments with any certainty.

The German economy grew by 1.3% in the period under review, although the downturn gained significant momentum in the second half of the year. The German government is expecting negative economic performance of 2.3% for 2009.

Deutsche EuroShop is not as strongly affected by economic developments as other sectors are in terms of its business model - longterm, inflation-proofed letting of retail space - and the associated risks. Past experience has demonstrated that by locating our shopping centers in prime inner city locations and by ensuring broad diversification within the centers, we can achieve commercial success even during periods of stagnation.

Market and sector risks

Structural changes have taken place in the retail sector in recent years and these must also be included in a differentiated approach to risk management issues. Deutsche EuroShop’s business model enables it to benefit from a general shift of the market share away from the traditional specialist retailers in favour of larger retail parks and well-managed shopping centers.

This development is more of an opportunity for us, as a decline in consumer behaviour in macroeconomic terms would not necessarily have a negative impact on retailers’ revenue in our shopping centers. The circumstances described are leading to a divergence of the various retail segments in terms of their success.

In 2008, the retail sector increased its revenue by 2.1% in nominal terms compared with a decline of 1.3% in the previous year due to the rise in value added tax. It must be assumed that retailers will face a difficult year in 2009.

We minimise market and sector risks through in-depth market intelligence and by concluding long-term contracts with tenants of all sectors with strong credit ratings.

Risk of rent loss

It is possible that tenants may be unable to meet their obligations under existing leases or that the previous rents may no longer be obtained in the case of new and follow-on rentals. As a result, income would turn out to be less than budgeted, and distributions to shareholders might have to be reduced. If the rental income for a property holding company is no longer sufficient to meet the interest and repayment obligations, this could lead to the loss of the entire property. Tenants’ revenue trends and the accounts receivable trends are regularly analysed in this respect, and measures to find new tenants are initiated at an early stage if there are signs of any negative developments.

The tenants furnish security deposits against the risk of default. Additionally, write-downs are recognised in individual cases.

Cost risk

Expenditure on current maintenance or investment projects can turn out higher than expected on the basis of experience. We minimise risks from cost overruns in current investment projects by costing in all identifiable risks in the planning stage as a precautionary measure. In addition, construction contracts are only awarded on a fixed-price basis to prime contractors with strong credit ratings. During the building phase, professional project management is performed by the companies we commission. However, it is impossible in principle to completely avoid cost overruns in ongoing construction projects in individual cases.

Valuation risk

The value of a property is essentially determined by its capitalised earnings value, which in turn depends on factors such as the level of annual rental income, the underlying location risk used, the evolution of long-term interest rates and the general condition of the property. A reduction in rental income or a deterioration of the location risk necessarily involves a lower capitalised earnings value. Thus the appreciation of the properties is also significantly influenced by a variety of macroeconomic or regional factors as well as developments specific to the property that can neither be foreseen nor influenced. The factors described are taken into account in the annual market valuations of our portfolio properties by independent appraisers. Changes in value are recognised in the income statement of the consolidated financial statements in accordance with the requirements of IAS 40 and may thus lead to increased volatility of the consolidated profit. However, as a rule this has no effect on the Group’s solvency.

Currency risk

Deutsche EuroShop’s activities are limited exclusively to the European economic area. Manageable currency risks arise in the case of the Eastern European investees. Because of the translation of the annual financial statements at the reporting date, the Group’s income statement is affected by unrealised translation gains and losses, and is thus exposed to an incalculable volatility. These risks are not hedged because this is purely an issue of translation at the reporting date and therefore does not expose the Company to cash flow risks. The currency risk from operations is largely hedged by linking rents and loan liabilities to the euro. A risk could arise if the Hungarian forint or the Polish zloty were to plummet against the euro and the tenants were no longer able to pay what would then be considerably higher rents denominated in foreign currency.

Financing and interest rate risks

We minimise the interest rate risk for new property financing as far as possible by entering into long-term loans with fixed-interest periods of up to 20 years. It cannot be ruled out that refinancing is only possible at higher interest rates than before. The interest rate level is materially determined by the underlying macroeconomic conditions and is thus not predictable by us.

The possibility cannot be completely excluded that – for example owing to deterioration of the Company’s results of operations – banks may not be prepared to provide refinancing or to extend credit lines. We monitor the interest rate environment closely so as to be able to react appropriately to interest rate changes with alternative financing concepts or hedging if necessary. At an average interest rate of 5.33%, this does not currently represent a significant risk within the Group, particularly as the most recent refinancing was concluded at lower interest rates than the original financing and the present average interest rate.

Deutsche EuroShop uses derivatives that qualify for hedge accounting to hedge interest rate risks. An interest rate swap is an effective hedge if the principal amounts, maturities, repricing or repayment dates, the dates for interest payments and principal repayments, and the basis of calculation used to determine the interest rates for the hedge are identical to those of the underlying transaction and the party to the contract fulfils the contract. Consequently, the ongoing changes in value of these items in the consolidated financial statements are recognised directly in equity. A test of effectiveness for the hedges described is regularly implemented.

Risk of damage

The individual property holding companies bear the risk of total or partial destruction of the properties. The insurance payouts due in such a case might be insufficient to compensate fully for the damage. It is conceivable that sufficient insurance cover for all theoretically possible losses does not exist or that the insurers may refuse to provide compensation.

IT risk

Deutsche EuroShop’s information system is based on a centrally managed network solution. Corrective and preventive maintenance of the system is carried out by an external service provider. A virus protection concept and permanent monitoring of data traffic with respect to hidden and dangerous content are designed to protect against external attacks. All data relevant to operations is backed up on a daily basis. In the event of a hardware or software failure in the system, all data can be reproduced at short notice.

Personnel risk

In respect of the low number of employees of Deutsche EuroShop, the Company is dependent upon individual persons in key positions. The loss of the key staff would lead to a loss of expertise and the recruitment of replacement personnel and their induction could temporarily impair ongoing day-to-day business.

Legal risk

The concept for our business model is based on the current legal situation, administrative opinion and court decisions, all of which can change at any time.

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