German Property 2022 - A Look Ahead

Challenges & opportunities in a complex global environment

Last year, we suggested that the immediate impact of the pandemic should be over by early 2022 at the latest. This forecast is still within reach given the current trajectory of the Omicron variant and the possible transition from pandemic to endemic in Q1 2022. However, there are new topics that are of greater importance for the development of Germany and the German real estate market. These include inflation, an increasing tightening of investment criteria due to the imminent implementation of ESG regulations and mandatory sustainability reporting (EU taxonomy), as well as a cautious and significantly more complex financing environment.

"Inflation is taxation without legislation"

Milton Friedman

The status of the commercial real estate investment market in Germany at the beginning of 2022

At the beginning of the year, much was reported about the record result of the commercial real estate investment market in Germany in 2021. The transaction volume of over €110 billion across all asset classes is indeed impressive. However, comparing this result with previous years is not entirely correct: in 2021, the transaction volume from corporate takeovers alone exceeded €30 billion. Historically, this figure has always been below €5 billion and has already skewed the figures to a degree in the past two years (over €10 billion in 2020, over €12 billion in 2019). In future, a separate analysis of transactions in secondary markets would be helpful to enable more focused analysis of the markets.

Overall, the transaction volumes of investments in office (€30 billion), logistics (€10 billion) and retail properties in 2021 are similar to those of the previous year, with a slight upward tendency. However, driven by the takeover of Deutsche Wohnen by Vonovia at over €23.5 billion, the residential segment increased its investment volume to around €50 billion (plus ca.150%).

On a very positive note, the pandemic has not had a negative impact on investment in the German real estate market; in fact, the effect has been quite the opposite. The lack of alternative safe investments, coupled with the interest in Germany as an investment destination, continues to keep buyers interested. This is underpinned by the development of yields. For example, at year-end 2021, gross yields for office properties in the Big 7 cities ranged from 2.6% to 2.9% following further compression.?

What opportunities and risks do investors need to consider?

Inflation

Just as inflation was well above expectations last year, there is little consensus amongst researchers and investors about the development of inflation over the coming months and years. In any event, this will remain a highly contentious topic for a long time. Those who fear a higher level in the medium term, combined with interest rate hikes, contrast with those who talk down high inflation rates beyond 3% as a short-term phenomenon and predict a flattening out below 2% again soon. It is interesting that academics and researchers cite reasons for high inflation in the medium term (changes in supply chains, wage agreements, commodity and energy prices, etc.) much more frequently than politicians who are concerned not to unsettle voters with fears of falling real purchasing power and not to burden the budgets of southern European countries with rising interest rates. The ECB seems to follow this sentiment. Contrary to the behaviour of the US Federal Reserve, the ECB does not foresee any interest rate rises this year, which could lead to a historically high spread of US Government bonds against German Government bonds of around 3% and put pressure on the Euro exchange rate against the US dollar.

ESG

From a real estate perspective, rising building costs have been a challenging issue for several years. As a result of the new price driver, the implementation of ESG criteria, we expect building costs to continue to rise. Although the construction of ESG-compliant buildings with low carbon emissions is supposed to serve an ecological future, the medium-term effects are complicated, expensive and saddled with a high degree of uncertainty, not just for our industry. What is an ESG-compliant building and what are the criteria that should be applied to sustainability reporting (EU taxonomy)?

The topic of ESG has definitely become firmly established in the industry in 2021. Everyone is talking about it, and many plans and strategies are being announced; but a generally recognised measure for the implementation of ESG criteria is just as lacking as a holistic model that also reflects the value of existing properties and the carbon bound in them.?We need a professionally sound debate that enables investors to continue to invest in older existing properties and to demonstrate their sustainability (also in comparison to new buildings). Otherwise, we risk a world in which people only want to invest in new buildings because everything else is no longer ESG compliant. The consequences would be increased carbon emissions due to the permanent pressure to construct new buildings, since even today's building can be obsolete in five years if there are new technologies or new ways of sourcing primary energy. It should also be noted that the energy mix available in Germany will move towards renewable energies. From a carbon perspective, an increased primary energy demand could then be just as acceptable as poorer insulation values, because the energy used is already green.

Financing environment

The combined impact of the pandemic, ESG and the perennial issue of banking regulation remains a major challenge for banks, with consequences for borrowers and loan seekers alike. This has already been felt in the last two years as banks have largely withdrawn from the hotel and retail segments due to risk considerations in new lending. Banks have also been increasingly reluctant to finance office property since the onset of the pandemic, especially if the occupancy rate is lower or the location peripheral. Older existing properties are increasingly viewed critically when lettability and valuation come under pressure due to ESG criteria not being met.

For the financing of residential real estate, which was, until now, a market in which banks were very active, more equity must now be held from February 2023 according to BaFin requirements, and 2.75% for construction financing. This will not cause banks to step back from these financing propositions, but it will make financing more expensive; an effect that will be visible in market pricing. Moreover, equity capital requirements due to Basel III will also make themselves felt.

The pandemic will end but the other two issues will remain. And so, we continue to see constraints in the availability of bank financing. In the medium term, this is one of the critical factors for the development of the real estate market. Of course, there is increasingly more room for the alternative finance providers who are repositioning themselves in the market in large numbers. However, it remains to be seen whether they can fill every gap left by the banks at favourable financing costs, especially in the non-Core segment.

Opportunity 1: Return of the office periphery?

Non-Core office properties in peripheral submarkets have been less in demand in recent years. If these properties are more than 15-20 years old, there is reluctance to finance them due to the issues mentioned above, in addition to reduced investor interest. The partly excellent letting figures in submarkets in 2021 have disproved the theory that peripheral office locations have been losing out during and after the pandemic. Nevertheless, this opinion stubbornly persists among the protagonists. Consequently, the already existing gap in pricing between city centre and peripheral locations has widened yet further. This could offer entry opportunities for daring investors.

Opportunity 2: The market outside ESG

Basically, the question is what will happen to the older, non-ESG-compliant buildings. These are in the overwhelming majority. This is where opportunities and business models must and will arise for investors who adopt a ‘manage to sustainability’ approach. Such projects are currently being initiated for properties that are being extensively repositioned by more or less gutting the entire building with the aim of achieving new-build quality. Policymakers should place more emphasis on enabling the continued marketability of existing properties even with moderate investments; otherwise, there is a danger that the majority of the real estate landscape will be over-regulated, resulting in catastrophic distortions between supply and demand and unforeseeable costs that will fall on tenants and owners.

Summary

Meeting ESG requirements, inflation and rising financing costs will make the construction, modernisation and maintenance of real estate more expensive. ESG and ever-increasing real estate requirements leave a huge vacuum for much of the market. There are risks here for portfolio holders, but also opportunities for those who find a way to use this vacuum to their advantage.

Furthermore, we see a financing environment that is becoming increasingly more complex and non-transparent due to new players. This creates opportunities for investors who know how to use the available sources to their advantage, but the cost of debt capital is also likely to increase significantly.

The exciting question will be whether the many pressures on pricing can be alleviated by further yield compression. In the best-case scenario, we see a sideways movement in future, with some room for improvement in absolute top products at best.?

Have a great start in 2022 & speak soon! :)

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