German rent-reversion index shows lower potential ahead

Every year since its inauguration six years ago we have reported faithfully here at REFIRE on the annual DMX German Office Rent Reversion Index study, produced annually by IPD Germany and Alstria Office REIT AG, Germany’s first and still largest REIT.

We have had our quibbles over the years with particularly IPD over the methodology used to arrive at the annual readings. We don’t dispute the findings – our issues have always been over the usefulness of the index in helping decision-making – but we beleive that the nature of the index means that its true value will always be only provable one there is sufficient date to look back at forecasts, and establish whether, with the benefit of later data, the original indices had merit.

The DMX Index, in essence, shows the theoretical rent adjustment potential of office leases in Germany by comparing the contract rents of existing leases with the sustainable rents from valuation certificates for office space. This measure is called rent reversion. In short, it provides an indication of the likelihood of further rent rises ahead for investors.

This year’s reading shows a slightly negative potential for rent adjustment on German office leases of 0.6% (on average) for the reporting year to May 2014. By contrast, last year’s index pointed to a “catch-up” potential of 2.5%. To be specific: the sustainable rent from valuation certs of €13.38 per sqm per month is marginally below the average contract rent of €13.45 per sqm/month – largely due to the rise of 3% in contract rents since May 2013, while sustainable market rent remained stable at 0.1%.

In other words, investors need to accept the idea that for contract extensions they will have difficulty pushing through rent increases. That is this year’s take-home message, from what we can see.

As usual, there are wide regional differences. The highest potential for rental growth for leases was measured in Cologne at 5.3%, followed by Dusseldorf with 2.2%, Berlin 1.9% and Munich at 1.0%. Negative potential for rental growth of office leases was determined for Stuttgart and several B-cities at 3.2% each, as well as Frankfurt with 2.4% and Hamburg at 0.7%.

The strong growth of contract rents did not include all markets. Berlin, Frankfurt, Stuttgart and Munich have seen increases of 6%-8%, whereas Cologne or the B-cities saw reductions of 6% and 2% respectively for the year to May 2014. However, not all of the leading cities achieved sustainable market rental growth, e.g. Frankfurt has a rather strong growth of contract rents with 7.6% but featured a slight decline of 0.5% in rental value growth, leading to negative potential for rent adjustment of 2.4%.

Closer scrutiny of lease structures demonstrates (for the overall market, as well as individual locations) an under-rent for expiring leases on the one hand, but also for concluded contracts.

Daniel Piazolo, Vice President and Geschäftsführer of IPD Germany, commented: “It seems that investors are not able to enforce rental growth or an adjustment to market level in many cases when negotiating new leases or renewing running contracts. This is a crucial indication as rental income is the main driver for real estate performance, even in the office sector.”