How would German companies react to a possible rate rise?

German real estate investors are unlikely to be fazed by a moderate rise in interest rates imposed by the European Central Bank, and would not radically alter their medium-term strategies, according to a recent study by Catella Research.

Catella questioned 100 German asset managers (investing in all classes) as to their likely reactions to an imminent ECB rate rise. The majority would view a rate rise somewhat even-handedly – 33% would leave their portfolio unchanged, 22% would consider a change to their strategy only after at least two years, while 30% said they would react within six to twelve months.

86% of the surveyed asset managers said they are actually planning more direct investment in real estate, while 14% plan to counter any interest rate rises by increasing their exposure to indirecty-held real estate.

Catella says it sees a trend among most of the 100 surveyed managers to increase their tactical allocation to "alternative assets" or real estate since 2013, to an average of 9.5% of total AUM.

Based on a more detailed analysis of respondents' feedback, Catella envisages that, in the case of a rate rise, niche assets would continue to be in demand, but with lower weightings. The trend to investment in logistics and hotels would continue, albeit at an ongoing lower allocation than for the other core categories of residential, office and retail. Residential and office would also see a lower weighting, with office not recovering for about five years.

Peter Finkbeiner, the CFO at listed Berlin-heaquartered TLG Immobilien, pointed out in a thoughtful article published recently in trade magazine Immobilien Manager, that we've actually been experiencing an effective change in interest rates, with the yield on ten-year Bunds more than doubling since December last year. While not expecting the ECB to alter its expansive monetary policy in the short term, he says the increasing uncertainty on the capital markets is palpable.

He notes that several listed commercial property companies issued bonds last autumn paying coupons of 1.5% and less, helping to pay down old debt and reducing their interest payable on longer-term debt to often under 2%. Should they not have taken on more debt while the going was favourable, thus improving their IRRs and, by extension, their earnings per share?

While theoretically this should benefit shareholders, in practice this is often not the case. Real estate companies with relatively high degrees of indebtedness often have lower share price valuations in relation to their NAVs, and experience higher costs of capital (both on equity and borrowings) as a result of the capital markets viewing their high debt levels disapprovingly.

Additionally, too much borrowing has a negative effect on their ratings, making refinancing more expensive. On top of this, borrowed funds need to be invested very rapidly to generate decent returns, while there may not be suitable assets to invest in that meet the criteria. Too much liquidity sitting around while searching for suitable assets also has a dampening effect on the company's IRR.

Several listed companies, says Finkbeiner, are currently favouring an LTV ratio of no more than 45%, and in looking to raise fresh capital are trying to abide by this ratio. Such companies are reasonably well protected against even sudden rate rise shocks, which in any event appear unlikely in the current climate. It would be more realistic to assume a scenario of successive moderate rate rises in the eurozone to still low, in real inflationary terms probably still negative interest rates – or even to yet further rate falls, which could be used for further lower refinancing, he says.

Finkbeiner says that even if a mild rate increase were to exert pressure on German real estate prices, companies' LTVs should be well able to absorb these. Companies adopting a cautious approach to their balance sheets would barely notice new valuation pressures, he says, as interest rates and rental yields on commercial property are further apart than they were ten years ago, offering a certain safety margin against any imminent rate rise.