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German residential property: rents don’t tell the whole story

German residential property: rents don’t tell the whole story

Germany is well-known for being a country of renters. With a strong focus on city living, high demand from inward migration, favourable rents, long leases and low levels of supply, German cities have been a hotspot for property investors in recent years. A strong economy has also bolstered demand, with employment levels at an all-time high and interest rates at an all-time low.

German residential property accounted for 19% of all property transactions in 2016, as overseas investors took advantage of the strong growth the sector continues to offer. And while government bond yields remain at very low levels, property continues to look attractive on a relative basis. Prices have risen significantly since 2009 and rental growth has also been robust.

Household growth significantly exceeds residential completions, particularly in metropolitan areas.

This trend still has further growth potential, though, given the severe imbalance of supply and demand in the residential market. Household growth significantly exceeds residential completions, particularly in metropolitan areas. At a national level, 277,700 homes were completed in 2016 – 12.1 % more than the previous year and the highest since 2004 – but the latest forecasts suggest there is demand for 350,000-400,000 new homes per year. As a result, vacancy rates in most big cities have fallen below 1%.

As prices continue to rise further, we expect there will be an increase in short-term risk appetites, leading to purchases of new-build properties in phases as construction progresses, or on the assumption of some development risk.

Research shows that Frankfurt am Main remains the most desirable city for residential investment, followed by Hamburg-Nord and Munich. Not unexpectedly, there is a positive correlation between cities with better fundamental quality and their ability to achieve higher rents. But there are also exceptions, where the current rent doesn’t fully reflect the underlying quality of the asset or area. Higher-than-expected rents can be seen in Stuttgart and Munich, for example. The higher rents are mainly a result of demand, given that a growing number of people are looking for homes in these popular areas for work or to study. Also, inward migration from abroad and other German regions puts demand pressures on these districts and accounts for the higher rents.

Other factors include the process of gentrification where higher-income renters and buyers move into up-and-coming areas, such as the Berlin districts of Mitte and Friedrichshain-Kreuzberg. While the gentrification process is often reflected in the prices and rents paid, it is not always fully reflected in open-market rents (which are determined by market conditions). Once statistics start to reflect the higher income levels, fundamentals should improve and over-renting (where a property is let out at a rent that is higher than the current open-market rent for that area or type of asset) should decline.

Similarly, rents in Ingolstadt benefit from the city’s proximity to Munich, which is ideal for commuters. While rents and prices in Munich are far above national averages, Ingolstadt is just a 35-minute train journey to Munich’s main station. Ingolstadt also has a strong local economy and infrastructure, and it is home to Audi’s largest production plant.

Other German cities – such as Leipzig or Potsdam– appear underpriced in terms of rent and so provide rental growth opportunities along with limited risks. These cities tend to have either traditional Wilhelminian-style housing or pre-fabricated buildings, both of which have experienced limited building activity in the past. Rental levels are low given the type of housing, but this will improve once new assets and refurbished homes become available. These cities provide good opportunities for higher-priced and higher-quality stock.

According to our research, half of all German cities are over- or underpriced in terms of rent and this provides investment opportunities as well as risks. Research shows that there are many cities that share the same gross yield but where the supply and demand characteristics vary considerably; investors should be mindful of the embedded risks when looking at yields. As always, selecting the right city doesn’t prevent investors from selecting the wrong asset and vice versa.

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