Residential Investments in Germany – March 2022

Dear Reader,

Germany’s “traffic light” coalition (SPD, FDP and the Greens) is now just under two months old, and for the first time the ability of the German government and the real estate industry to engage in meaningful dialogue appears to be under serious scrutiny. Across the industry, everyone is talking about the abrupt end to KfW subsidies for energy-efficient new-build properties, a topic that is also the focus of our current newsletter. This non-transparent procedure not only ensures that many individual projects are having to be recalculated – it also slows down the long overdue, and much heralded, new construction offensive. It is therefore appropriate for the real estate industry to take a clear position, because honest criticism is also an important component of a dialogue between equal partners.

At the same time, the real estate industry can’t afford to go into a state of shock or decide to restrict its sustainability measures to the bare minimum. The trend towards more environmental and socially responsible real estate is irrevocable. The best possible response is therefore most likely a resounding “the time is now!”

Read on to find out more,

Your Jürgen Michael Schick & Holger Friedrichs

Why prices don’t tell the whole story

Every day, we are bombarded with the latest reports about record property price increases. There is a tangible price hysteria, and not only in the media, but also among professionals within the real estate industry. The impact of this hype can be seen, for example, in Leipzig – where price increases seem to magically entice more and more investors, who drive the price rally ever higher. And, as the financial viability of a large proportion of new residential construction is calculated on the basis of projected asking rents, investors’ expectations are accordingly ambitious – and optimistic.

The problem is that these forecasts assume an increasing shortage of available housing. However, it is questionable whether this will be the case, especially as a growing number of families are already migrating to the exurbs around Leipzig, and the number of young adults has been rising more slowly of late. In addition, the volume of new apartments being approved and completed over the last few years is higher now than it was just a few years ago. This could mean that the existing demand is more than being met and the market is becoming increasingly saturated.

This in turn creates added investment risks, although on paper the Leipzig market has been growing faster than most cities. Dresden offers a more cautionary tale: Asking rents are no longer rising, and the number of households is constant. New construction, however, continues at a high level.

It is now high time for a new way of thinking: The real estate market should be analysed on the basis of truly relevant data – not just prices.

The latest price data doesn’t really tell us anything
This is because current prices say very little about future developments. They have more in common with taking a glance in the rear-view mirror. All they do is reflect the averages of the past. Whether purchase prices or rental prices, they are only ever based on past transactions and leases.

Tomorrow’s supply and demand, however, are rooted in today’s developments. Long-term investment decisions, therefore, should not be based on prices, but trends that can be derived from existing secondary data.

Key point of reference: the development of household figures
“Where and how do I want to invest?” is the crucial question for investors. It is particularly important to look at the right data. The key point of reference for residential real estate investments is an analysis of growth in the number of households. Although cities and communities with growing populations offer the potential for rising demand and property price increases, it is developments in the number of households that will primarily determine the strength of future demand.

Even shrinking cities can experience growing demand. Which is why, in a second analytical step, questions need to be asked about demographic and economic development in order to determine which properties will be in particular demand in the future. If a city’s senior population is set to expand, demand for senior housing and assisted living facilities will also increase. Investors need to ask themselves: Am I investing in a city that offers large numbers of well-paid jobs? Is there likely to be greater demand in certain market segments due to income distribution?

Can any meaningful conclusions be drawn from commuter patterns? And what do these say about (over)dependence on major employers or sectors, and thus about possible cluster risks? Depending on the location, there are different potentials for successful investments – beyond the pure market price consideration and also beyond the much-discussed A and B cities.

Professional investors should do more than simply chase the latest price trends. After all, there is a great deal of relevant data available which, in contrast to property and rental price data, allow investors to reliably analyse and forecast a given market’s true potential. All it takes is for these data to be studied more intensively and used more sensibly.

Where the real value is – the Ruhr region

Germany’s residential real estate investment market set a new record last year. According to the latest analysis from JLL, the transaction volume climbed to €50 billion – almost three times the previous five-year average. This is, of course, largely a result of Vonovia’s takeover of Deutsche Wohnen, but even excluding this €23.5 billion transaction, the volume was significantly higher than in previous years.

Residential investments in Germany are popular among both private and institutional investors from Germany and abroad because, on the one hand, they are regarded as a safe haven and, on the other, they generate relatively stable and predictable returns. It is still remarkable how strongly transaction activity is concentrated in Germany’s Big Seven cities. Last year, the seven largest cities accounted for 69 percent of transactions (41 percent when Vonovia/Deutsche Wohnen is excluded), even though they are home to only 12 percent of the population.

Germany’s “largest city” is often overlooked
In particular, what could be classed as Germany’s “largest city” is often overlooked: the Ruhr region. In North Rhine-Westphalia, supra-regional investors largely tend to focus on the Rhine region. The band of cities to the northeast, which are home to five million inhabitants, six DAX and MDAX corporations, five universities and one of the largest inland ports and logistics hubs in Europe, on the other hand, is predominantly left to more local portfolio holders.

The causes lie more in the image of the former coal mining region and the fact that many market participants are simply unaware of the region’s attractive investment opportunities. There is no question that the major challenges facing the region are undisputed: Ongoing structural change, above-average unemployment, people moving away, indebted municipalities. A number of Ruhr cities have become regular fixtures in the lowest places in city rankings.

But first, this is not representative of the entire Ruhr region. In many places, “it’s better, much better, than you think”, as Herbert Grönemeyer once sang about his hometown of Bochum. As everyone must know by now, many years have passed since the sky over Bochum was last clouded by coal dust. And second, there are less attractive locations and neighbourhoods in other major cities, too – with the difference being that an individual district in Berlin is equivalent to an entire independent municipality in the Ruhr region.

A heterogeneous agglomeration calls for local knowledge
The Ruhr region is an extremely heterogeneous agglomeration – with both attractive and less attractive residential locations. Yes, there is Duisburg-Marxloh. But there are also the southern districts of Essen, the “secret capital” of the Ruhr, which have little or nothing in common with the usual Ruhr clichés. Incidentally, property and rental prices have also risen sharply in Essen over the last few years – with no sign of migration or vacancies.

The Ruhr region is not Munich. If you want to be successful here, you have to carefully analyse the individual districts and know your way around. But that’s exactly where the charm lies. While investors in Berlin and other A-cities are lining up to buy existing properties at 30 times the annual net rent or more, resourceful investors between the Ruhr and Lippe rivers can discover residential properties in stable, decidedly middle-class neighbourhoods that are available at 15 times the annual rent – and without investors from Germany and abroad doing their best to outbid one another. Thus, acquisition yields are not three percent, but six to seven percent.

This is also confirmed by Schick Immobilien’s German Residential Investment Market Report 2020/2021, according to which, the average price-to-rent ratio for a multi-family building in the largest cities in the Ruhr region was between 11.7 (Gelsenkirchen) and 16.8 (Essen) in 2020. These are average values, mind you, which can vary considerably from district to district. By way of comparison, the average price-to-rent ratio in Berlin and Frankfurt is 29, and in Munich it is a high as 43. So, if you do your due diligence, know your way around a bit and don’t let yourself be blinded by established bias, you will find the kind of high-performance investments “deep in the West” that simply do not exist in Germany’s A-cities.

Incidental costs are by no means an incidental matter

Rising rents are a major social time bomb, especially as a growing number of Germans feel they can no longer afford adequate housing. “Affordable housing” is, therefore, among the key planks of the coalition agreement between Germany’s three governing parties.

In the discussion about housing costs, people tend to focus on the “cold rent”, while charges for services and utilities are relegated to a subordinate role. Yet these ancillary costs represent a significant portion of a household’s total housing costs, as a recent study confirms. According to research conducted by the Cologne Institute for Economic Research (IW) on behalf of d.i.i. Deutsche Invest Immobilien AG, ancillary costs amount to just under a third of the cold rent on average in Germany, and as much as half in some regions.

Reducing the “second rent”
Thankfully, there is significant potential to reduce these ancillary costs, in particular in relation to what are commonly referred to as “warm operating costs”, which include expenses for heating and hot water. According to the IW report, these account for more than a third of total ancillary costs. At the same time, the study reveals that these costs are almost nine percent lower in apartments built after 2000 than in older buildings. Better insulation and more modern building technology have a positive impact on both the environmental footprint of an apartment and the costs for its occupants.

Savings can also be achieved in “cold operating costs”. In terms of items such as building cleaning and garden maintenance, savings can be generated by optimising existing utility and service contracts. It can be well worth checking whether certain contracted-out services are needed at all and, in some circumstances, concluding contracts with new providers can lead to lower costs.

A win-win situation for owners, tenants and the environment
Oil and gas prices rose sharply in 2021. What’s more, this trend looks likely to continue over the next few years. Carbon pricing will also cause heating costs to rise. As a result, it will be increasingly important to make sure that older buildings are retrofitted with the latest and most energy-efficient equipment. This is because energy-efficient refurbishment can significantly reduce ancillary costs. Owners can partially refinance the investment via various federal, state and local subsidy programmes. Lower ancillary costs also create potential for increasing cold rents without increasing the burden on tenants. Last but not least, renovations increase the resale value of the building. And they improve its rentability, as potential tenants are increasingly focusing on ancillary costs in addition to the basic rent.

The developments outlined above will increasingly sharpen the focus on ancillary costs over the next few years. Energy-efficiency refurbishments are therefore the best response to the growing pressure exerted by both markets and regulators. They ensure a win-win situation for all stakeholders: owners, tenants and, last but not least, the environment.

Promote what needs promoting

The real estate year started with a slap in the face for many private and professional property developers. The completely unexpected halt to applications for the KfW programmes for energy-efficient building refurbishment and new construction funding caused quite a stir. 24,000 applications that had been submitted but not yet approved were left hanging in the balance. More than 20,000 new buildings to efficiency standard 55, around 3,000 new buildings to the EH40 standard and around 700 conversions were affected. The response from the real estate industry was unanimous. This was no way to achieve the ambitious housing construction targets on the one hand, or the new German coalition government’s climate protection targets on the other. As a result of the great public and media pressure, Economics and Climate Protection Minister Robert Habeck was forced into a U-turn and withdrew the sudden funding freeze.

However, Habeck’s plans for a stripped-down programme, which have subsequently come to light, are no less serious. Based on what we know so far, the Green Party’s former leader is planning to cut subsidies under the Efficient House 40 (EH40) new-build programme in half. He also wants to introduce a cap of one billion euros. A subsidy program with a one-billion-euro cap is likely to be exhausted after little more than a year.

With these announcements, the German government’s goal of creating 1.6 million new apartments in this legislative period is becoming a distant prospect. Many developers are already forecasting significant cost increases, which will drive rents up accordingly. Various calculations show that without EH40 subsidies, rents for social housing would rise by €3.00 per square metre and more. If the subsidy were halved, as Habeck is now planning, rents would rise by at least €1.50 per square metre. The result of slashing subsidy programmes for affordable housing couldn’t be more obvious: If housing is to be built – and built in an environmentally-friendly way – developers need a permanent and adequate funding framework. Policymakers must promote what needs promoting. During the first weeks of the new year, a great deal of trust has been squandered. In terms of housing policy, the most important task facing the new government is to quickly regain that trust. Otherwise, by the end of the current legislative period 1.6 million new homes will be little more than a pipe dream – and the legislative period has only just begun. The chaotic funding freeze, the halving of the EH40 programme, and the unrealistic cap must all be taken off the table as quickly as possible.

News

Geisel calls for rent freeze in Berlin

Berlin’s housing market remains tense. Affordable housing is in short supply. In response, the “Alliance for New Housing Construction and Affordable Housing” met for the first time in late January. The Berlin Senate wants to create more affordable housing and boost new construction in cooperation with the district authorities and the housing and construction industries. Andreas Geisel, Senator for Urban Development, Construction and Housing, has called for a voluntary, five-year rent “freeze” on the part of the housing companies. However, he wants rent increases to be linked to the rate of inflation, rather than a complete freeze. In return, he will make it easier for developers to get new construction projects up and running by guaranteeing faster building permits. The IVD Berlin-Brandenburg is keeping a close eye on the proposals and has already warned against embarking on the wrong path of too much regulation, especially in the wake of the failed rent cap.

Right of first refusal – a common concern in Berlin, Hamburg and Munich

It was only in November that Germany’s Federal Administrative Court instructed state authorities to stop exercising their right of first refusal as an instrument against potential speculation – a success for property owners. Now the mayors of Germany’s largest cities are following suit: In response to the Federal Administrative Court’s ruling, Berlin, Hamburg and Munich have launched an initiative to strengthen municipalities’ rights of first refusal. The mayors say they want to safeguard the supply of affordable rental housing and protect social preservation areas from speculative real estate companies. Together, the three mayors have called for an expeditious solution and a new regulation governing their rights of first refusal from the federal government. According to the IVD, such a reaction was to be expected. But the efforts to secure new legislation comes at the expense of urgently needed new construction.

Berlin increases housing benefits

The housing benefit reform of 2020 calls for the regular adjustment of housing benefit. This provision is intended to ensure that housing benefit recipients do not suffer a decline in household purchasing power. Adjustments are calculated in relation to the date the housing benefit reform was passed (January 1, 2020). As a result, low-income households who might otherwise lose their entitlements as their incomes increase can continue to receive housing benefit. From January 1, 2022, housing benefit recipients in Berlin will receive an average of €10.00 more per month. Almost 19,500 households in Berlin are affected by this regulation, including many pensioner households – almost half – and families. Clearly, as an alternative to stronger regulatory measures, targeted financial support can effectively mitigate the increasing burden of rising housing prices.