The Messeturm skyscraper, nicknamed Bleistift (pencil) due to its shape
Scope has taken a notably critical view of German office valuations in its latest annual report, downgrading five of 20 open-ended real estate funds, based on an increased risk profile and weaker net actual returns. The report notes that “Participants see high and very high devaluation risks, especially for office properties in the periphery and B locations.”
The report highlights how the fund environment has fundamentally changed since the 2022 report, primarily as a result of the sharp rise in interest rates. Where fund returns had benefited from property price appreciation in recent years, such broad-based appreciation is over for the time being, says the report, with the extent to which this will weigh on fund performance still unquantifiable, given the paucity of transactions and lack of price visibility.
The five funds that were downgraded are heavyweights in the German fund sector: Grundbesitz Fokus Deutschland from DWS Grundbesitz, Hausinvest from Commerz Real, Leading Cities Invest from KanAm, UBS (D) Euroinvest Immobilien and UniImmo Europa from Union Investment. “The downgrades were caused by both increased risk parameters and weaker yield developments,” Scope writes.
On the positive side, Scope points out that more than three-quarters of German open-ended funds’ portfolios consist of buildings bought before 2019. These are predominantly valued more conservatively than properties purchased during the peak price phase of 2019-2021. Property multiples at the portfolio level average 20.6 for the funds, with an average multiple of 22.5 for the residential sector. This is conservative, compared to properties traded during the peak price phase, many of which were bought at multiples of well over 30 times.
Inflows into open-ended real estate funds fell significantly in 2022 compared with previous years. On balance, the funds collected €4.2 billion - down from €5.2 billion in 2021. Scope expects inflows to decline further in 2023, but currently still anticipates an overall positive - or at least balanced - net fund inflow across all funds. Some funds will see outflows, but due to the one-year notice period, which applies to the majority of investors, these can be anticipated by the providers and should be manageable for them.
Scope stresses that the tighter regulations on fund withdrawals, which were hotly contested ten years ago, have currently helped open-ended real estate funds achieve stability - both through the reduction in debt capital limits and the minimum holding and notice periods. The reforms introduced by the German fund industry increasingly now serve as a blueprint for European regulation, it points out.
Helping to stabilise the funds this time around are the buffers many funds maintain in the form of liquidity. The open-ended real estate funds held liquid assets of around €17 billion at the end of 2022. Measured against the funds’ net assets, this corresponds to a liquidity ratio of 14.0%. Currently, this is 14.5%, says the Scope update.
Theoretically, the funds could now invest this liquidity at better interest rates. And in some cases, inflation-indexed rents are also rising along with inflation, boosting income returns. They could also use this liquidity to repay loans and mitigate interest rate risks. They have relatively low leverage - the average ratio was 15.7% at year-end, and is 15.3% now - and are comfortably below their maximum-permitted level of 30%. So there is a margin there for further financing should they need additional liquidity. But the net negative effect of higher interest rates are causing a slump in real estate financing and transactions, increasing risk and leading to falling prices.
Scope points to the differences across various asset categories. Risks are lower in the residential sector, logistics properties may have already absorbed any correction, while in retail, competition from e-commerce continues to hurt most retailers in the non-food sector.
Somewhat surprisingly, fund volume actually rose to a record level of €131 billion last year, according to fund association BVI, although the Scope update shows that that figure has been cooling, with only “stable to moderate” net fund inflows expected this year. There is certainly no mass outflow of funds from the sector, Scope confirms.
On average, investors should achieve a return of 2.5% with open-ended real estate funds this year, the rating agency estimates. That would be roughly in line with the previous year’s figure, which ranged between 1.5% and 4.9%. Traditional commercial real estate funds averaged 2.4%, and purely residential real estate funds 3.1%.
Value yields are likely to decline this year because of the overall climate, from last year’s 1%. However, the rental yield from rental income, which was 3.7% last year, and the liquidity yield from free funds, which was still negative last year at minus 1.9%, are likely to rise this year, says Scope - and could thus keep the funds’ overall yield at around last year’s level.
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Sonja Knorr, real estate fund specialist, Scope
A key part of the report deals with office vacancy rates - the big unknown factor affecting future office valuations. Scope’s real estate fund specialist Sonja Knorr comments: “The number of sublease offers in office buildings is increasing because of the trend to working from home. And unsuccessful subleases can often turn into vacancies.”
The occupancy rate of the German open funds has so far declined only slightly - from 94.1% at end-2022 to 93.9% recently - not too bad. But the clear trend to favouring top-class, highly-rated office properties at the expense of mediocre to weaker or poorly located properties is accelerating. She cites the perennial problems with vacancies experienced by a prominent Frankfurt office property, the Messeturm skyscraper, compared to the new-build “Frankfurt Four” high-rises, which are currently leasing out at top rents.
Scope also highlights the increasing attractiveness of other asset classes compared to real estate. The super-low risk on ten-year German government bonds touched 2.7% this spring and still offers a good 2.3%. For institutional investors, with yield expectations of 5.5% on their Spezialfonds, this definitely causes a dilemma. They normally expect yield premiums of 150 to 200 basis points from real estate compared with bonds. While they cannot easily exit hastily from property funds, investors will be examining their options with a view to the middle- and longer-term.
