Why forward deals make sense in the residential real estate market
Take a glance at the latest market forecasts and you are in for a fairly big surprise: For the first time in seven years, it looks as if there will be a decline in the number of apartment buildings that change hands in 2016 compared with the previous year. This is not because demand has weakened, it is because real estate that generates attractive yields has become something of a rarity. Investors on the lookout for attractive properties right now are being forced to widen their investment horizons beyond the stock of buildings that do make it to market, and are increasingly turning to the newbuild segment. In order to secure the best properties early, a growing number of investors are buying before the first hole has even been dug – taking advantage of what are known as forward deals.
A chance to shape the development
The benefits of forward deals for investors are not limited to the prospect of achieving higher total returns than from investments in existing properties. In many cases, a forward deal also allows an investor to shape the development of a newbuild property, either at the planning stages, or even once construction is underway, aligning it more closely to the investor’s own real estate investment strategy. For example, if an investor already has a defined category of tenants in mind, a forward deal means that it is possible to integrate specific floor plans, where technically possible, and the investor can set their own accent on the property. Admittedly, this may involve additional planning, and will certainly require the efficient collaboration of the project developer and asset manager, but it’s ultimately worth the extra effort. In return, the investor takes ownership of a property that has been perfectly designed and constructed to suit the requirements of the investor’s specific tenant group.
Security for buyers and sellers
Forward deal properties are particularly suitable for residential real estate funds, especially as fund managers are under considerable investment pressure in the midst of this era of ultra-low interest rates and excess liquidity. They are able to gain a foothold in ABBA locations, i.e. those that are already technically overheated and in which existing properties do not generate high enough yields – thereby allocating their investments more broadly and avoiding any potential concentration risks. But it is not just investors who stand to benefit from this type of deal. An early sale means that a property developer or construction company can benefit from greater planning security. They can take advantage of current market conditions and don’t have to bear all of the development risk on their own. As it is not possible to remove residual risk entirely, it is important that any forward deal is agreed between competent contractual partners, namely those with a strong basis of professional expertise and mutual trust.
“Tenants do know their rights”
On June 1, 2015, Berlin became the first German state to introduce the Mietpreisbremse (rental price brake). An increasing number of towns, cities and municipalities have since followed the capital’s example. At the same time, only six tenants have so far challenged their landlords in court for alleged violations of the rent controls – and only one of those has been successful (as of early October 2016). We spoke with Dr. Henrik Baumunk, Managing Director and Head of Residential Valuation with CBRE, about the positive and negative aspects of this recently introduced legislation.
Dr. Baumunk, the rental price brake was described as a “milestone in tenancy law” by the Federal Justice Minister, Heiko Maas, just over a year ago. From the bare figures, however, it doesn’t like the Mietpreisbremse has achieved much of anything at all – neither in terms of rental prices or for tenants.
Why is this? Is it that most tenants don’t understand their rights, or are they more interested in avoiding potential conflicts with their landlords?
Given the widespread presence of the topic in the media, every tenant should be know about the Mietpreisbremse. It is also true that the strength of an individual tenant’s negotiating position is largely determined by the levels of supply and demand in their local housing market. Especially in large urban centres, where demand far outstrips supply, tenants find themselves in a comparatively weaker. Let’s just take Berlin as an example: In 2015 alone, rents in the city rose by an average of 5.1 percent. This places Berlin ahead of Frankfurt, Munich and Cologne in terms of rental price growth, although rental prices in the other three cities have already reached a high level. So, this tells us that anyone who is looking for an apartment, and finds one that they can afford, will take it. It is not possible to “regulate this problem away”. Lawmakers can try to restrict rental prices for new leases – but this does little to relieve the pressure in sections of our housing market.
Nevertheless: Just recently, local courts came down on the side of three tenants in Berlin. The court in Lichtenberg ruled that they are now entitled to refunds for the excess rent they have paid.
We should be careful not to over-exaggerate the importance of this case. Let’s remember, just six legal challenges have been launched in Berlin so far, and only one has actually been successful. Across the rest of Germany, as far as I know, not a single relevant complaint has been lodged. Of course, the governing coalition is going to be less than impressed by the limited success of its legislative measures. In fact, the opposite is true: In response to the recent cases, The Federal Justice Ministry has just announced that it intends to launch an official enquiry into the effectiveness of the Mietpreisbremse. The SPD then wants to use the enquiry’s findings as the basis for future discussions on tightening the legislation.
And rents will rise strongly until then?
Not necessarily. If you take a look at Hamburg, you’ll see that rents have almost reached a ceiling. In central districts, asking rents are hardly rising at all. In the most expensive parts of Berlin the same is true, and rental prices are more-or-less static. But we would have seen this anyway, even without the Mietpreisbremse. For large numbers of households, especially those on average incomes, the limit of their willingness and ability to pay higher rents will be reached. Households are also limited in their choices of where to live. There aren’t that many vacant apartments, particularly in central neighbourhoods, and rents have already risen to relatively high levels in many places. As a result, people are moving less frequently and fluctuation rates have bottomed out. Sooner or later this will feed through into a slowdown in rental price increases. Moreover, this process will soon be offset by growing numbers of households moving out of the cities and into more rural areas, and by an expansion of specific market categories, such as serviced apartments. These are completely natural market developments. It didn’t need a law to achieve any of this.
But what doesn’t work in Berlin might work elsewhere…
Without a comprehensive national study, it’s very difficult to judge one way or the other. Having said this, it is already clear that in many cities, given the significance of pre-existing local conditions, rent control legislation will be very difficult to implement. As of June 2016, the city states of Berlin, Bremen and Hamburg, as well as more than 260 other towns, cities and municipalities, had introduced the Mietpreisbremse. And this is despite the fact that Bremen and 207 of the towns, cities and municipalities have no form of rent index, whether qualified or not. In a huge number of regions it is therefore impossible to reliably and scientifically determine local comparable rents, which should be the basis for determining whether a rental increase for a new tenant breaches the law or not. The fact that politicians introduced the Mietpreisbremse legislation while neglecting to reform the methodology behind the country’s rent indexes is what makes it so difficult for landlords to reliably set rental prices. If the federal government is serious about improving their rental price brake, this would certainly be a good place to start.
Tax relief for the housing construction industry
Now more than ever, too few apartments are being built in Germany. In absolute terms, the number of newbuild apartments may be on the rise, but completions are running far behind the 500,000 apartments that are needed each year if current levels of demand are to be satisfied. One thing there is no shortage of: Ambitious goals and loud calls for housing construction to be given a boost. There have been a number of demands for red tape to be cut in order to accelerate building permit processes and the zoning of building land by municipal authorities. This is all well and good, but doesn’t go anywhere near far enough.
It’s true: Without building land, or the possibility of adding floors to existing buildings, investors won’t be able to build new rental apartments. And without certain incentives, many investors aren’t interested anyway. Which is exactly why tax incentives will be needed if politicians are serious about accelerating housing construction. And there are a number of effective, but less well-known instruments, in the tax relief toolbox.
1. Tax credits via income tax. The reintroduction of accelerated depreciation for the construction of new housing is certainly one option. For a more targeted approach, it would be possible to limit depreciation allowances, for example focussing solely on the regions experiencing the fastest population growth. It would also be possible to restrict tax deductions to specific housing sectors, such as affordable housing, or to couple an extra tax benefits to a rental ceiling of, say, € 8 to € 9 per square metre, in order to promote the targeted construction of more affordable rental housing.
2. Raising standard depreciation rates. Increasing straight-line depreciation from its current two percent to 3 or 4 percent per year would more accurately reflect the front-loaded loss of value of modern buildings. After all, a large proportion of construction costs nowadays are attributable to technical installations, which lose value at a more accelerated rate than a building’s structural elements.
3. Reforming real estate transfer taxes. One option would be to stop charging real estate transfer taxes on land, provided the land is used for the construction of rental housing within a five year period and this housing is rented at no more than € 9 per square metre. It would also make sense to introduce an exemption for owner-occupiers, who could be freed from real estate transfer taxes for a period of seven years – limited to the newbuild sector. Overall, real estate transfer tax rates need to be reduced. Just ten years ago, every state in Germany was operating with a tax rate of 3.5 percent. Some states are now levying 6.5 percent. Such tax changes wouldn’t directly encourage the construction of new housing. But it would certainly be easier to buy and sell apartments, which would represent a significant incentive for investors.
4. Reform of real estate taxes. Owner-occupied homes should be exempted from real estate taxes for a period of ten years. Current proposals for the reform of real estate taxes would disadvantage housing construction as, logically, the construction costs of new buildings are higher than they were for older buildings, which means that the cost valuation method used for future tax assessments will be higher. But this will only become an issue ten years from now, which is when the new valuations are scheduled to become the basis of tax assessments.
5. Adjustments to value added tax rates. The German government levies a lower level of value added tax on everyday essentials. This reduced rate is currently set at 7 percent. Why doesn’t the construction of housing count as one of these essentials? As landlords do not enjoy the right to deduct input taxes, the rate of the value added tax they pay is of direct relevance.
6. Simplifying energy-efficiency refurbishments. A range of different tax regulations currently apply to apartment modernisations, depending on whether construction and material costs are counted as manufacturing costs. This is potentially case, when modernisation costs exceed a certain level. Where the purpose of a refurbishment is to increase the energy-efficiency of a building or apartment, it should be possible to deduct these costs immediately as income-related expenses, irrespective of how high the actual costs are, and provided the refurbishment is carried out within three years of the materials’ purchase.
Such tax measures could provide a real boost to the construction of new housing. And time is of the essence. If no action is taken, the housing shortage will become more and more acute with every passing year. And Germany’s lawmakers are fully aware of this; they are full of talk, appeals and demands – what they are short of is action. Of course, solving this problem will require courage and creativity. Unfortunately, these are qualities that not everyone possesses. But if the problem is not tackled, and tackled soon, we will sleepwalk into a serious, full-on housing crisis.
Hamburg: Investments are being made all over the city
As in every major German city, Hamburg’s property developers are also complaining about massive increases in land prices. The reaction: Investors are increasingly turning their attention to the city’s outlying districts. Only a small number of very forward-looking developers anticipated this market shift to the city limits. And it is these developers, the ones who took early action and preemptively secured development land all over Hamburg, that are now being praised for their foresight.
Otto Wulff is Top Dog
During a recent “Real Estate Roundtable” event in Hamburg, Andreas Schulten from bulwiengesa revealed that Otto Wulff is, by some distance, now the top property developer in Hamburg. This alpha developer has almost 200,000 sqm either under construction or in the pipeline, followed by Behrendt (just under 120,000 sqm) and Bonovia (formerly NCC) with roughly 110,000 sqm. Wulff believes that warnings of a property price bubble in Hamburg are unfounded. Even if between 8,000 and 9,000 new apartments are built in Hamburg every year, natural shrinkage of the city’s housing stock means that there is a net gain of just 1,500 to 2,000 apartments.
It is still difficult to make small-scale projects pay off
The bulwiengesa study shows that a vast majority of property developments still involve between 20 and 30 apartments, while experienced property developers are skeptical as to whether such projects will be worth developing in future given the escalating price of land. Peter Jorzik from “Hamburg Team” has directed his company to focus on projects involving at least 100 apartments. He has identified the greatest potentials in the City North office district, where he is currently developing more than 500 new apartments together with Otto Wulff. The same pattern can be seen all over Hamburg – a mix of one third subsidised housing, one third condominiums and one third free-market rental units.
Hamburg’s property developers are unanimous: The government-subsidised housing sector makes little economic sense, even if some investors are willing to pay price-to-rent ratios of 30. Government-subsidised housing is cross-subsidised by the development of free-market rental housing and, primarily, by the construction and sale of condominiums.
Price-to-rent ratios of 23 to 25 dominate
What price-to-rent ratios are rental housing investors willing to pay in Hamburg? According to the city’s property developers, prices for forward deals have solidified at price-to-rent ratios of around 23 to 25. Even in the city’s peripheral locations, namely those where investors would drawn the line at buying at price-to-rent ratios of above 20 just a couple of years ago, developers are achieving ratios of 22.
The fact that investors are willing to pay such prices just goes to show the extent to which demand from institutional investors is outstripping the supply of new properties. At the same time, property developers need to achieve such price-to-rent ratios in the face of massive land price increases, even in peripheral locations. Even in a district such as Langenhorn – a long way outside the city centre, almost at the border with Schleswig-Holstein, land prices have now climbed to EUR 600/sqm. The big winners are the forward-looking investors, including Patrizia, who bought land at less than half the current going rate and is now developing roughly 450 apartments.
Apartments are shrinking
Fabian von Köppen from Garbe Immobilien outlined two further trends in Hamburg: Year for year, apartments are becoming progressively smaller. He used four projects in Hamburg’s Hafencity, developed between 2006 and 2016, to support his claim. Project by project, the average size of an apartment has fallen from an initial 160 sqm to 80 sqm. The number of 2-room apartments in the projects he cited rose from 0 percent in 2006’s “La Taille Vent” development, to 45 percent in the new “Creative Blocks” project. This is a further consequence of rising land and construction costs.
Bulwiengesa also confirmed the strength of this trend in Hamburg. In 2008, the average size of a rental apartment was 95 sqm, whereas today’s average has fallen to 82 sqm. Average sizes have also shrunk in the condominium segment, dropping from 115 to 94 sqm.
Another trend: Fewer car parking spaces are being built, with more space being provided for bicycles instead. When “La Taille Vent” was developed, the parking space ratio was set at 1.6 parking spaces per apartment, whereas for “Creative Blocks” the figure stands at just 0.4. Von Köppen explained that the change is due to the fact that younger people are less likely to own a car. Square-metre prices for the four projects had risen from EUR 4,500 in 2006-2008 to EUR 7,500 today. Similar developments can be seen all over Hamburg. Bulwiengesa reported that the average sale price of a condominium in the Elbe/City sub-market surged from EUR 3,800/sqm in 2010 to more than EUR 5,500/sqm in 2014, and has now reached EUR 6,700/sqm.