Reasons to be cheerful
Opinions on the appeal of Germany’s real estate market vary considerably, views reflected in some highly disparate trends. Exaggerated pessimism has just as little foundation as blanket euphoria. Looking at the market as a whole, we can discern two key arguments in favour of a forthcoming upturn. German real estate is, on the whole, under-represented in the portfolios of international investors. As a result, for reasons of diversification alone, growing interest in German real estate is to be expected in the future.
And if an economic upturn were to materialise and the necessary structural reforms in Germany were to be implemented, this would improve growth prospects, thereby benefiting commercial real estate in particular.
Germany’s markets for office real estate have been in deep crisis in recent years. The vacancy rates reached record levels by European standards, at the same time rents declined substantially.
Since then, however, rental revenues have increased perceptibly. According to Jones Lang LaSalle, rental take-up was 1.7m m2 in the principal metropolitan areas, (Berlin, Düsseldorf, Frankfurt, Hamburg and Munich) in the first three quarters of 2005, up almost 19% on the corresponding period in 2004.
A particularly sharp year-on-year increase in rental revenues was recorded in Munich (78%) and Frankfurt (63%).
Despite the persistently high degree of company relocations in tandem with economies on space, positive net absorption can once again be observed on the rental markets in specific areas.
Additional relief to the market has come from a decline in construction work in recent years. Today, speculative construction of new office buildings only takes place in exceptional cases. Office stock has grown by only 1.3% within the past year. Sub-letting of office space is on the decline as well. With the exception of Hamburg, these trends on the rental market have not so far prompted a rise in rents. A large supply of vacant space is to be expected – in tandem with high vacancy rates.
Residential real estate market deserves a particular mention. Despite rental yields barely reach more than 4-5% and a highly regulated marketplace, many financial investors have acquired major German residential real estate portfolios over the past two years. Here, too, the excess amount of money available for investment and the pressure on initial net returns on international markets is likely to have been one of the main reasons for the growing interest. The majority of residential units promise stable rental income, which means that any investments in this field entail only limited downside risk. Of the 700,000 residential units being bought and sold as part of larger transactions since 1997, 500,000 have changed hands since the end of 2003 alone. Price levels have since risen substantially.
Despite the long-term decline in Germany’s population, the number of households and thus the demand for residential floor space can be expected to increase for the next decade and beyond. Although the market can therefore be expected to show a stable performance overall, we can discern considerable differences between individual regions and locations.
The German housing market is also of interest to investors focusing on earnings potential in the event of privatisation of the housing market. Germany currently has a low ownership ratio in comparison with its European neighbours. The potential for this type of privatisation is, however, limited at locations expected to record poor performance.
Diametrically opposed trends can be observed in the retail market. Whereas the generally weak state of the economy has exerted a negative impact on consumer sentiment and thus on the retail sector, selected top locations and the large-store retail segment have defied expectations.
In the wake of the structural shift in the retail sector, department stores and small specialist stores are losing importance. By contrast, chain stores and large specialist stores are gaining in importance, often expanding through shopping malls. As far as the retail trade and demand for space is concerned, we can observe that the life cycles of trading concepts are becoming increasingly short. This means that the requirements for retail real estate will continue to undergo major changes.
The German REIT debate has focused too much on the appeal of such a vehicle to private investors rather than institutional investors. REITs in Germany are likely to be of far greater importance to the institutions. The demand by risk-averse private investors for real estate investments that are as liquid as possible and offer a relatively steady performance and low volatility is met by the open-ended real estate funds.
A recent Nordbank study estimated the potential market capitalisation of German REITs up to 2010 at between e30bn and e60bn. Of this, about two-thirds will be accounted for by German and foreign institutional investors and only one-third by private individuals.
The potential in the institutional investor segment can be explained by the fact that German real estate is currently substantially underweight in the portfolios of international investors considering the size and importance of the market.
Yields on the German real estate market have been below those on other markets, substantially so in some cases. In recent years, however, this gap has shrunk. Secondly, the particularities of the German market have played an important role for indirect real estate investments. The types of indirect real estate investments that predominate in Germany are either largely unknown to foreign investors or of little appeal to them.
For instance, many German institutional investors consider Spezialfonds (a type of investment fund peculiar to Germany) that invest in real estate to be an attractive type of investment, while foreign investors use this vehicle only occasionally and it has remained largely alien to them.
Given this situation, German REITs would provide an alternative that is familiar to international investors, and an investment vehicle that has successfully established itself in several European countries. Assuming their asset composition and management teams are acceptable, German REITs will only meet with broad acceptance on the international capital markets if their legal set-up is not overly complicated and if they are not subject to excessive regulation.
Herein lies one of the critical challenges for the political decision-makers. The failure of this project or the introduction of a REIT construct that is not in line with the market would have serious consequences for the German real estate market. It would make REITs less attractive to foreign investors, and other countries will be happy to fill the gap – if they haven’t already done so.
Moreover, German investors would increasingly withdraw their funds from the domestic market and invest them internationally.