UPDATE 1-Hypo Real privatisation eyed in 2013/14 -source

* Berlin to start mulling privatisation in 2013/2014 -source

* EU approval of Hypo Real Estate bailout seen in Q4 -source

* HRE seen passing stress tests thanks to bailout -sources

* Manuela Better now seen remaining CEO of HRE -sources

(Adds stress tests and CEO Manuela Better, more details, background)

FRANKFURT, July 6 (Reuters) - Germany will start looking into privatising property lender Hypo Real Estate (HRE) [HRXGe.DE] in 2013 or 2014, a financial source told Reuters, as the firm continues to work on recovering from its near-collapse.

HRE, whose business model combined investment banking with real estate finance, was nationalised last year after it became Germany's highest-profile casualty of the credit crunch.

"In 2013 or 2014, Germany will actively tackle the topic and prepare the privatisation," the source said, adding the government was hoping markets would improve by then.

"The discussions (on privisatisation) with the German Finance Ministry and rescue fund Soffin are very productive," the person said.

The bank received a 110 billion euro ($147.6 billion) German government bailout, for which the source said the lender hopes to get European Union approval as early as the start of the fourth quarter.

The European Commission is expected to ask the bank to set a fixed date for the privatisation as well as drastically shrink its balance sheet and map out a stable business model in exchange for the approval.

"The EU will not allow 10 years (for HRE to be privatised), but will set a very ambitious schedule," the source said.

HRE, the Commission and the German finance ministry declined to comment.

When the credit crunch hit HRE, the lender was deemed too important to fail given its weight in Germany's covered bond market, a major source of refinancing for the banking sector in Europe's biggest economy.

Now it is restructuring and has bundled into Deutsche Pfandbriefbank its property and public-sector financing businesses, which have a volume of around 130 billion euros -- a third of the bank's former size.

TARGETS 2012 PROFIT

To rid itself of toxic assets, HRE plans to shift about 210 billion euros of assets into what will be Germany's biggest "bad bank". Once the bad bank is set up -- likly by the end of this year -- HRE will no longer have to pay for state guarantee. In 2009, the bank paid 125 million euros per quarter in these fees.

The bank targets a profit in 2012 at the earliest and aims for a sustainable pretax return on equity of 9 to 11 percent per year. It lags the goal of rival Deutsche Bank (DBKGn.DE), which aims for at least 25 percent annually.

The interim chief executive of HRE, Manuela Better, Axel Wieandt's replacement who has been at the helm of the lender for 100 days, is now expected to stay in the role, company sources said.

Thanks to billions of state support, HRE is expected to pass a European stress test despite its huge exposure to the so-called PIIGS countries -- Portugal, Italy, Ireland, Greece and Spain -- the sources said.

HRE holds 39.2 billion euros in sovereign bonds from the PIIGS states and has loaned roughly an additional 40 billion to local authorities, financial institutions and government-regulated companies in these countries.

Europe's banking watchdogs have been holding stress tests to see how lenders would be affected by a sharp downturn in the economy or other shocks, aiming to boost confidence and bring a a negative spiral in financial markets to a halt.

They are working ahead of an end-of-July deadline to publish the test results. (Reporting by Arno Schuetze and Christian Kraemer; editing by Karen Foster) ($1=.7453 Euro)