Guest column: Challenges and opportunities of the German residential real estate market

Despite the still tense environment with rising interest rates, high inflation and consequently high construction and financing costs, the fundamentals of the German residential real estate market are stable. Residential real estate has already proven itself as a robust asset class in the past due to its low volatility and resistance to crises. Especially now, further attractive investment potential is emerging from unbroken and increasing demand for living space with a simultaneous growing supply deficit.

Supply cannot keep pace with demand

The rental market in particular is characterized by an increasing demand, which leads to rising rents and high occupancy rates. Germany already has a record housing shortage of more than 700,000 flats, according to a study by the Pestel Institute (Hanover) and the construction research institute ARGE (Kiel). According to the Federal Statistical Office (Destatis), the number of new flats completed in 2022 was only 258,800 units; including construction measures on existing buildings, the figure was 295,300. The federal government's target of 400,000 new flats per year was thus clearly missed.

Declining construction activity increases housing shortage

The situation is accelerated and multiplied by declining construction activity and strong population growth. According to Destatis, the population in Germany grew to a new high of 84.4 million in 2022. In 2022, almost 1.5 million more in-migrants to Germany were recorded than out-migrants from Germany. This is the highest net immigration recorded so far within one year since the beginning of the time series in 1950 and more than four times as high as in 2021, mainly due to the influx of people from Ukraine as a result of the Russian war of aggression.

According to Immobilienscout24's housing report, demand for existing flats in the second quarter of 2023 was 30 percent above the pre-Corona level across Germany and for new-built rental flats 90 percent above. Existing flats became 7.2 percent more expensive across Germany compared to the same quarter of the previous year, while new-built flats rose by 6.3 percent. Especially in the metropolitan areas, the high demand and thus the pressure on the rental market continues. Some large cities even recorded double-digit growth rates in rents. The strongest increase in existing flats was in Berlin with 15.6 percent, rents for new flats increased the most in Stuttgart with 18.1 percent. Other major cities such as Düsseldorf, Cologne and Munich also saw rent increases of more than ten percent for flats in existing and new buildings.

Risks put business models to the test

As there is no relief in sight in the rental market due to the large demand and low supply, there is a risk of stronger regulation in the form of an extended rent control.

Risks also exist in connection with a refurbishment obligation without funding opportunities around the topic of ESG as well as with the Building Energy Act (GEG) and the associated investments. Disproportionate discounts on valuations and purchase prices of existing buildings with a maintenance backlog in the area of energy refurbishments are the consequence. Subsidy programs for the refurbishment of existing buildings could counteract this effect and at the same time contribute to faster achievement of shared climate targets.

The price trend is also supported by Immobilienscout24 studies of flats and single-family homes advertised in the first quarter of 2023: The worse the energy condition of a property, the greater the price reductions - more so in the countryside than in metropolises and large cities. In the metropolitan core, the price reduction for properties with energy class B compared to energy class A is on average five percent and for energy class C already 19 percent. In rural areas, the asking prices for properties with energy efficiency classes F, G and H are 41 to 51 percent below the prices for properties with energy class A.

Refinancing pressure can lead to distressed sales

The refinancing pressure on some portfolio holders could also lead to selling pressure, which could increase the supply on the investment market and put pressure on prices and portfolio valuations. In addition, there is a risk for some market participants to slip into a shrinking or even negative cash flow model due to sharp increased interest rates or to no longer be able to deliver attractive returns compared to alternative investments. Investors or shareholders might shift to alternative investments. This could force some participants into distressed sales for liquidity reasons, which is likely to further decrease market prices.

Conclusion

Providers whose business models were based primarily on valuation gains or excessive debt financing (leverage effect) will now have to prove whether their operating business is still competitive. Income return and a cost-effective management of real estate is increasingly coming into focus and is becoming a question of existence. Optimization on the income and cost side is the natural consequence.

Effective management and solid rental growth can over time counteract the potential declining property values caused by the sharp interest hikes of the past 18 months.

Despite the challenges, the current market situation also offers enormous opportunities for investors with strong capital structure. Investors will profit from the creation of new products in the fund sector with increased returns as well as from transactions at attractive entry prices, also in the course of M&A processes. However, a precise market selection and market understanding with a sharp eye on financing structures are prerequisites for a successful long-term investment.

The crisis resilience of the residential asset class will prove its worth in the medium to long term compared to other asset classes.

About the Author

Hans-Peter Hesse is the Chief Investment Officer of ZBI Zentral Boden Immobilien Group.