Residential Investments in Germany – December 2023

Dear Readers,

As the year draws to a close, it is time to look back, but also to look ahead. One thing is clear: 2023 was not an easy year for many companies in the real estate sector. Valuation adjustments, insolvencies and cancellations frequently set the tone. The impact of interest rate hikes has clearly been felt.

However, we have also seen the federal government and federal states seize the political initiative – most recently in an ambitious 14-point programme that brought together many important ideas to sustainably boost the construction of new housing in Germany.

The bottom line is this: there is still reason enough to take an optimistic view of the future. Despite all the shortcomings, there are still opportunities: How is the European residential property market developing? What impact will inflation have on investments? Where could new residential property projects be developed? And finally: Why will things pick up again in 2024? Our experts address all of these questions and more in the latest WID newsletter.

We wish you an informative read and a happy and healthy Christmas and New Year!

JMS and HFR

European residential markets continue to offer plenty of opportunities

While the situation on the capital markets may have largely calmed down in the wake of the central banks’ rapid interest rate hikes, the economic environment nevertheless remains challenging. The dramatic increase in geopolitical conflicts, including military confrontations, is fuelling economic uncertainty, weighing on growth and affecting the investment behaviour of institutional investors. In addition, inflation remains too high and monetary policy has become much more restrictive. All of this is also having an impact on residential property markets. Higher construction and financing costs, competing asset classes with more attractive yields, and uncertainties regarding asset valuations are weighing on new construction and transaction activity. However, from a fundamental perspective, there is still a lot to be said in favour of residential property.

Globally, transactions in the residential property sector have declined by around 50 per cent this year, in Europe by as much as 60 per cent. The transaction market is cautious and restrained, waiting for an interest rate plateau – which now seems to be materialising. Beyond the headline declines, it is well worth taking a look at the transactions that did take place: they were more specialised, more informed. In the EMEA region, cross-border transactions only declined by just under 40 per cent, and Europe remains the number one destination for cross-border residential investors, accounting for around 70 per cent of transactions.

Rented residential market not expected to ease anytime soon
The decline in transactions highlights which residential subsectors in Europe remain relatively interesting to investors. The transaction volume in the student housing sector, for example, has only declined by just under 14 per cent. This supports the case for the resilience of the residential market in general and of niche uses in particular, as anti-cyclical purchases continue to take place in segments that are in constant demand. Even more relevant than the decline in transaction volumes, however, is the low level of construction activity, which is unlikely to lead to an easing of the market any time soon, particularly in urban centres. As rising demand due to ongoing urbanisation and demographic change cannot be met by a larger supply, this will tend to lead to further increases in prices and rents. In the current environment of rising financing and material costs, new construction starts are being further delayed.

The undersupply of housing has created a fairly comfortable situation for institutional investors. Despite the shrinking yield gap to bonds, institutional investors can benefit from the stable cash flows and attractive risk-adjusted returns of residential property, especially if the inflationary environment is considered. Consequently, investors will focus less on achieving the lowest possible purchase price and more on long-term positive rental growth, which is fundamentally supported by sustained strong demand, high construction and financing costs, and thus a decline in construction activity, coupled with increasing requirements for the incorporation of ESG criteria.

The housing market is undergoing a structural shift
Fulfilling ESG criteria involves coming up with answers to a social question that inevitably arises in supply-constrained environments. As, with the exception of Ireland, completions and project pipelines are currently shrinking, it is lower and medium income households in particular that are feeling the impact of the lack of supply. This presents the property industry with the task of implementing ESG criteria while also placing responsibility on investors. Above all, experienced market players benefit from their expertise in planning and management.

One opportunity is to look at the rising number of single-person households. Between 2010 and 2020, the number of single adult households grew at an above-average rate of almost 20 per cent in Europe. Single-person households tend to show greater demand for rental accommodation than other groups. Young, urban and single professionals in particular prefer to rent for a longer portion of their working life so that they can react more flexibly to job changes and changes within their private environment.

Europe remains resilient
It is this structurally strong demand in the rented residential segment that is bolstering the entire European residential market. The effects of war, inflation, interest rates and rising material costs do not change the fact that the imbalance between supply and demand is fuelling further rental inflation. Declining transaction volumes are only of limited significance, as investors continue to appreciate the attractive fundamentals of the housing sector as an asset class. Despite a lower yield spread towards government bonds, the residential property sector remains an inflation-proof and stable investment opportunity, provided the location and quality are right. On this score, cities such as Malmö, Vienna, Helsinki, Paris, the Randstad region and the Top-7 cities in Germany are particularly relevant. And it is important not to forget that single-person households are particularly widespread in Barcelona and Dublin.

Single-person households and demographic trends also point to two particularly interesting types of use: both senior and student living in Europe are benefiting from the structural social transformation caused by persistent urbanisation. Paris, London and Madrid in particular attract large numbers of international students, while Vienna and Stockholm are more focused on domestic student bases. The European residential property market therefore continues to offer opportunities; it is simply a matter of adopting a city-level approach to identify the best individual opportunities.

Inflation does little to ease the German housing crisis – or does it?

Rising interest rates are a cause for concern. Inflation data continues to show inflation stubbornly higher than the ECB’s two per cent target.

However, as inflation is likely to remain above two per cent for the foreseeable future, the ECB signalled that it is still too early to cut interest rates when it decided to put a hold on further interest rate adjustments at the end of October. Inflation would have to fall further for this to happen, the bank explained. Seen in this light, it is not surprising that many institutional investors have adopted a wait-and-see approach to investing in the residential market. In addition to inflation-driven construction cost spikes, financing has also become more problematic, with failed project developments and an increasing reluctance on the part of banks to provide construction financing only making matters worse. As a result, the number of completed units in the new-build sector in Germany has declined over the past three years.

The German government’s construction targets are dead in the water
The German government’s construction targets are now redundant, according to the unanimous assessment on the market. The German Housing Industry Association (GdW) expects that a third of the units that were due to be completed in 2023 and 2024 will no longer be built. According to estimates, the housing shortage is currently greater than ever before, with a deficit of 700,000 units.

Taken together, these developments mean that everyone in Germany who was already affected by the acute housing shortage will now also have to adjust to chronic excess demand in over the next few years. More and more people are therefore competing for less newly built living space and rents are rising as a result.

Great opportunities for institutional investors
And this is precisely where the opportunity lies for institutional investors looking to invest in residential property. However, in view of the gap between purchasing power and current rents in the new-build segment in Germany’s top cities, this group of investors is aware that unaffordable new-builds will neither eliminate the housing shortage in the rental segment nor represent an attractive investment from a risk/return perspective.

Properties with a maintenance backlog present opportunities
The only practicable solution is therefore to refurbish the numerous well-situated but vacant existing apartments in Germany’s towns and cities and make them habitable again. In smaller cities in particular, there are still countless properties with maintenance backlogs that have tended to be neglected by the professional property industry to date, as most players have focused on markets in the Top 7 cities or classic B-cities such as Hanover and Dresden.

Fund managers with development expertise
Against the current backdrop of declining residential property prices, it is therefore possible for fund managers with development expertise to purchase properties at favourable conditions and upgrade them with the right measures, resulting in a significant increase in value, which can be passed on to investors while maintaining rents at “affordable” levels. Thanks to this positive return on capital appreciation, institutional investors can achieve returns above those of fixed-interest investments in the current market without – as mentioned – having to raise rents excessively. This ensures affordable housing that costs only around half the construction costs per square metre compared to new builds.

My assessment: In the current market, with declining residential property prices, it is possible for fund managers with development expertise to acquire existing properties at favourable conditions and upgrade them with the right measures to increase the value of the properties while rents remain “affordable”. Institutional investors have the opportunity to invest in residential property in a market segment that combines steady cash flow and stable high demand for the product.

Investors need a transparent location analysis

There is no shortage of challenges on the property market. Which is why it is absolutely essential for investors to conduct a thorough location analysis before investing in a property. However, this is not so easy, as most studies on the impact of location factors on property values tend to focus on municipal or district level features. As a result, many investors are forced to fight their way through a multitude of analyses, which then need to be weighed against one another.

What investors actually need is an analysis of property locations that covers as many localities in Germany as possible – from micro-location to city level – and balances the full spectrum of relevant factors, including demographic trends, for example. This is the only way they can clearly understand the potential returns of a property in a particular location.

The valuation platform PropRate evaluated more than 106,000 property listings in Germany’s 80 largest towns and cities, including their districts, harvesting data from all major property listing platforms.

Striking north-south divide
The results are interesting: there is a striking north-south divide in German investment property markets. The city of Gelsenkirchen in the Ruhr region is, reportedly, one of the best destinations for investors, who can expect strong returns, especially in locations where properties are offered at low purchase prices and where rents are expected to develop dynamically.

There are also major differences between Germany’s top cities, with Berlin achieving the highest rating among the A-cities. The Munich metropolitan region, on the other hand, is considered unattractive, while Stuttgart also scores poorly. This result can be attributed to the fact that property prices are comparatively high in these economically strong cities, but are not proportionate to rents – comparatively low returns are to be expected.

Be sure to consider the microlocation
One aspect that investors should definitely consider is a property’s microlocation. Depending on the neighbourhood, they can expect very different returns, even within the same city. In Berlin, for example, ratings vary greatly: Wartenberg (a neighbourhood in the district of Lichtenberg) achieves a score of 3.41 out of a possible five stars, while Niederschönweide (a neighbourhood in the district of Treptow-Köpenick) only rates 1.79 stars. Anyone familiar with the diversity of the German capital will hardly be surprised by this – even within the same districts, neighbourhoods are sometimes so different from one another that you can feel as if you are in a different city when you turn a corner onto a new street.

So, what information do investors need to make an informed decision? Well, nothing beats an on-site inspection, and this should take place whenever possible. In order to pre-filter a range of offers or to make a post-viewing decision, investors should use an evaluation platform that uses as much data as possible to analyse the location. At a glance, this will allow them to see, for example, which cities and neighbourhoods have a particularly large number of properties for sale – because this provides a fairly reliable indication that buyer demand is subdued and sellers will need to be more flexible in terms of their price expectations. Analysing the data, a clear ranking of Germany’s top 8 cities emerges – the listed properties are distributed as follows: Berlin (16,528), Hamburg (6,635), Munich (5,821), Leipzig (4,093), Cologne (3,616), Düsseldorf (2,881), Frankfurt (2,571), and Stuttgart (2,138). However, within the cities, a majority of listings are not in the most populous districts, they are in the most popular ones – in Berlin, for example, this is Friedrichshain. Anyone using a rating platform should therefore make sure that it assesses as many factors as possible – because not all of Berlin’s districts are the same.

PropRate uses a proprietary algorithm that analyses all relevant factors, such as price trends, location features, asking prices, rental prices, property-specific data, and yields. The results are used to create a comprehensive location rating to compare the potentials of locations and properties. Investors can use a search engine to evaluate the properties based on this data.  And this is possible in real time – because those who can make quick decisions have a clear advantage.

Where there is shadow, there is also light

A time of crisis – a time of optimism? What at first glance appears to be a contradiction in terms is, at second glance, an accurate description of the current state of the property sector. Because despite all the negative reports, there is also good news that also needs to be given due attention.

But first, let’s take a step back. Any description of the current state of the sector must indeed begin with the crisis, which is primarily a crisis in residential construction and project development. According to forecasts, only around 245,000 units are likely to be completed this year; last year’s figure was already far too low to satisfy demand for housing – and miles away from the government’s target of 400,000 units per year.

What’s more, project cancellations are on the rise. According to a survey by the ifo Institute, 22.2 per cent of property development companies reported cancelled projects in October. One month earlier, this figure was 21.4 per cent. It is clear that a struggling construction and property sector represents a significant issue for the domestic economy on a number of fronts. And the housing shortage is fuelling rent increases and exacerbating the burden on households, especially in big cities – all of which is undoubtedly part of the harsh reality.

However, looking beyond our industry’s own backyard and often self-referential reporting that tends to outdo itself with negative headlines, there is still good news to provide us all with hope.

Construction costs are stabilising. As demand for construction weakens, experts are forecasting that construction prices will start to fall next year at the latest. In addition, federal and state governments are looking to simplify building regulations and building authorisation processes – and coordinate them more closely across state borders – which could also reduce costs.

Residential property prices are not in free fall. According to a new study from the Kiel Institute for the World Economy (IfW), prices for owner-occupied flats fell by an average of 1.5 per cent between July and September compared to the previous quarter, with strong regional differences and outliers. In A-cities such as Cologne and Berlin, prices are relatively stable.

The gap between purchase prices and rents is narrowing. While prices for owner-occupied homes and apartments have risen continuously in recent years, rental prices have stagnated. This trend has increasingly slowed down, and in some markets even reversed. For example, asking rents in Berlin rose by almost 19 per cent from 2022 to 2023, while rental prices also increased in other major cities. At the same time, demand is set to remain high in the long term due as the German population continues to grow. This trend suggests that investments in residential property will become more attractive again, both for owner-occupiers and buy-to-let investors – which will stimulate the property market as a whole.

Existing property is experiencing a renaissance. Existing properties – especially multi-family blocks – have been the subject of growing interest from investors in recent months. This is because investments in the segment offer a unique combination of advantages. Prices for existing properties have fallen in all Top 7 cities; in Munich and Stuttgart by almost ten per cent, to name just two. At the same time, existing properties cost around half as much as new-builds, proving ample reason to take a closer look at this asset class. Because:

The buyer’s market is an opportunity. It is a simple fact that rarely in recent years has the opportunity to invest in existing properties been as favourable as it is today. New opportunities are coming up all the time, especially for wealthy private an commercial investors, as long as institutional investors remain cautious. There is a significant supply of product coming to market again, which has not been the case for some while now. You could say that there is currently an opportunity to acquire existing properties at yesterday’s prices – with tomorrow’s rents.

Finally, it is important to look at the direction the key interest rate is heading, as this will sooner or later have an impact on building interest rates. The European Central Bank (ECB) has so far been successful in combating inflation and recently refrained from raising interest rates again. It remains to be seen whether this will be enough to reverse the trend in building interest rates. Nevertheless, the same applies here: cautious optimism is not out of place.

The bottom line is that there is not a crisis everywhere, and if you want to look for positive trends, you will find them. Or to put it another way: Where there is shadow, there is also light.

News

German Chancellor calls for more new development areas

Federal Chancellor Olaf Scholz (SPD) called for a radical shift in housing construction policy at an event organised by the Heilbronner Stimme on Sunday evening, reports FAZ. Scholz attributed the lack of affordable housing to a shortage of building land, rather than high interest rates. He proposed a solution: “Across Germany as a whole, we probably need twenty or so new city districts in the most sought-after cities and regions – just like those built in the1970s”. This represents a significant departure from traditional policies, which were, in part, designed to seal less land. Reiner Braun, CEO of the analysis company Empirica, offered a critical assessment: “We have been telling politicians for more than a decade that we urgently need more building land – so far largely without success”. Braun is by no means alone in recognising that the key lies not only in making increased use of previously developed and sealed areas (densification), but also in the development of entirely new areas. As densification is comparatively expensive, Braun explained, and the development of greenfield sites is less disruptive and less complex, modular construction could realistically be expected to deliver more affordable housing at rents of EUR 16.00-17.00 per square metre, rather than the standard EUR 20.00. Other industry representatives took up the Chancellor’s call and pointed to the new Seestadt Aspern district in Vienna as a positive example.

Signa halts work on all Berlin construction projects

According to Rundfunk Berlin-Brandenburg (rbb), the Austrian property group Signa has suspended all of its construction projects in Berlin, adding a new dimension to the crisis engulfing the company founded by René Benko. A range of prestigious projects, including the planned upgrade of the Karstadt store on Hermannplatz and infrastructure projects such as the redevelopment of the Bremsenwerk at Ostkreuz are all affected. The construction freeze applies to all projects in Berlin, regardless of whether they are still in the planning phase or construction is already underway, as is the case on Passauer Strasse and Nürnberger Strasse (City West). Since the summer, the financial crisis engulfing Signa has prompted an exodus of investors. For example, Commerzbank subsidiary Commerz Real pulled out of a contract for the construction of a 32-storey tower block on Alexanderplatz. As the scale of the crisis escalated, Benko relinquished control of the Signa Group at the beginning of the month and is said to have transferred his voting rights to the restructuring expert Arndt Geiwitz, who has been entrusted with getting the group back on track. There a number of factors driving the financial turbulence within the Signa Group, including rising interest rates, which triggered EUR 1.17 billion of devaluations to the SIGNA Prime Selection AG portfolio.

Residential property prices continue to fall in the third quarter

In mid-November, the Kiel Institute for the World Economy (IfW) reported continued price declines for German residential property in the third quarter. The latest update of the German Real Estate Index (GREIX), compiled in collaboration between IfW and ECONtribute, shows declining valuations in all housing segments. Compared to the previous quarter, prices for apartments fell by 1.5 per cent, prices for single-family homes by 3.2 per cent. and prices for multi-family homes by 5.9 per cent. Compared to the same quarter of the previous year, GREIX indicates even sharper corrections in valuations (prices for apartments down by 10.5 per cent; single-family homes down 12.1 per cent; and multi-family homes down 24.0 per cent). The number of properties sold also fell significantly, with around a third fewer sales across all market segments compared to the same quarter of the previous year. However, there are strong regional differences and outliers. For example, prices for apartments fell across the board in all of Germany’s Top-7 cities with the exception of Cologne, where they rose by 1.1 per cent. Berlin registered a moderate decline of 0.8 per cent.