Risk-Reward study helps uncover many of Germany's 'hidden champions'

Osnabrück, Wolfsburg and Worms are Germany's "hidden champions" for investors looking for residential investment in existing property that offers the best risk-return ratios, according to independent property consultant Dr. Lübke & Kelber. For investors in new-built property, the cities to look at are – again this year – Wolfsburg, along with Aschaffenburg and Fürth, both in Bavaria.

The long-established, Frankfurt-based asset manager and broker Dr. Lübke & Kelber has just published its influential annual Risk-Reward Ranking List 2017, which scrutinises 110 German urban locations, including the Top 7 cities. The ranking uses proprietary analytical tools to rank German cities on their attractiveness for attainable return on equity in the light of an associated locational risk factor.

REFIRE sat down recently with Dr. Lübke & Kelber' managing director Ulrich Jacke to examine the implications of this year's survey results. Kicking things off, Jacke reminded us of some basic truths of the German residential market. "Risk and return are only theoretically two equal sides of the same coin. In practice in residential real estate, the optimal investment tries to combine the lowest possible risk with the best possible return. Our analysis therefore weighs the expected return on the asset or the return on equity against the associated locational risk of where the property is situated", he says.

In a parallel ranking for new-build residential buildings, the most attractive conditions for investments are to be found in Wolfsburg, Aschaffenburg and Fürth, say the Dr. Lübke & Kelber researchers. The new-build category was added to the study last year for the first time.

The Risk-Return study works on the assumption that the investor has 55% equity capital and pays a fixed interest rate of 1.2% on borrowings for ten years. For both existing and new-build properties a yield of more than 3% should be achievable in nearly all the 110 cities, says Jacke.

"Mid-market locations in Worms, Trier and Landshut, as well as top locations in Worms, Osnabrück and Wolfsburg, offer investors in second-hand German residential properties the best risk-return relationship," says Jacke. "For those buying new properties, mid-market in Würzburg, Oldenburg and Landshut, as well as top locations in Wolfsburg, Aschaffenburg and Fürth.

"These "hidden champions" are calculated on the basis of the difference between the potentially achievable return on equity, and the minimum recommended return, as calculated by us based on a locational risk factor."

Dr. Lübke & Kelber's proprietary 'magic sauce' to arrive at this locational risk premium is calculated using a basket of elements such as demographic development, local socio-economic climate, the local housing market, current house price and rental levels, and other factors such as fluctuating demand. These factors are combined with the risk-free return to arrive at a relevant risk factor to apply to each location.

The risk-free return is deemed to be 1.88%, or that payable on a 10-year government bond averaged out over the last 10 years. Ancillary transactional costs are also added, along with the Grunderwerbsteuersatz (land transfer tax rate, which differs from Bundesland to Bundesland), to arrive at a risk-free differential margin of between 2.33% and 2.63%

Again this year, Munich and Frankfurt are the cities with the lowest risk premium, based on their variable location factors such as demographics, the socio-economic environment, housing including rental and sales prices, and inherent demand.

Dr. Lübke and Kelber allocate 0.1% to Munich and 0.2% to Frankfurt. In places three and five are Stuttgart (0.3%) and Hamburg (0.4%), then the first so-called B-city Ingolstadt (also 0.4%). "When deciding on an investment, the pure risk factor is seldom enough. All of the 'hidden champions' uncovered by us are B-locations. This is where we identify the really attractive investment locations outside the Big 7 cities, which have the most favourable Risk-Return relationships", says Jacke.

This year's survey throws up some surprises, particularly in the Big 7 cities. So-called 'good areas' of Berlin, for example, shows clearly negative Risk-Return relationships both for existing as well as new-build housing. But in the less celebrated neighbourhoods of the city there are plenty of gems lying undiscovered. "Berlin has been benefitting from a major upswing, and it still is, but there have been such hefty price rises and corresponding yield compression – particularly in the better locations – that investors would need to be very careful," says Jacke.

Much the same applies to the new-build sector in 'top' locations in the other Big 7 cities. All bar Hamburg and Stuttgart show negative Risk-Return relationships, i.e. the expected returns are below the recommended minimum returns. "The price effects driven by high demand in the biggest cities, combined with likewise rising prices for building land and escalating construction costs, can't forever be compensated for by ever-higher rents. The market simply can't pay these prices any more. So there, where there is most demand, it often doesn't make sense for investors to invest in new-build. Much more value can be found in mid-market locations in the Big 7 cities, where returns on equity are much more likely to exceed the recommended minimum return, says Jacke.

Drawing broader conclusions from the study, says Jacke, is the need to think in terms of location differentiation. The so-called ABBA strategy, of investing in B-locations in A-cities and A-locations in B-cities, is underpinned strongly by the results of this year's survey.

This is particularly evident for the Big 7 cities. Both for new-build and second-hand housing, the better locations in the cities are heavily to be found in the bottom third of the Risk-Return study's rankings. The mid-market neighbourhoods offer much better value from a risk perspective.

Nonetheless, according to Jacke, "The danger of overheating prices leading to a general negative risk-adjusted return expectation is not there, at least for the market as a whole. Still, many potential buyers are put off the idea of investing in B-locations as they perceive it's too difficult. This is where knowledgeable and qualified local asset managers need to educate them on the specifics of the location and how they can achieve sustainable returns."

Although the Risk-Return study highlights many B-destinations worth a closer look, the fact of lower liquidity might concern potential investors. "Where certain holding periods and specific exit plans need to be adhered to, then investors in secondary locations should use our Risk-Return study to help orientate themselves towards our 'hidden champions', concludes Jacke.

You can get the full report from www.drluebkekelber.de