Less fun on the autobahn

In spite of the post-pandemic surge in inflation, the energy crisis, the war in Ukraine, ongoing disruptions to supply chains and labour shortages, the German economy proved to be relatively resilient over 2022. Germany’s gross domestic product rose by 1.9 pct in 2022, having shrunk in the final quarter of the year. CBRE predicts that Germany’s economy will contract by 0.7 pct over the course of this year, but anticipates two years of solid growth following this (1.8 pct and 2 pct respectively).

Investment

According to JLL, the German investment market got off to an extremely weak start in the new year. The transaction volume for Q1 2023 came to EUR 7.8 bln – the weakest first quarterly figure in twelve years and 67 pct down on the same period of the previous year. It was also 56 pct below the ten-year average and 45 pct down on the 15-year average.

Although inflation in Germany fell significantly to 7.4 pct in March, core inflation rose across the eurozone to 5.6 pct. As soon as the current round of interest rate hikes comes to an end, investors are expected to return to the market; but until this happens, JLL is predicting a transaction volume of no more than EUR 50 bln for the year. And it’s not just JLL that sees interest rates as a major obstacle. “Interest rates have increased compared to their recent historic lows, resulting in higher financing costs for real estate investors and a noticeable hesitancy in property acquisitions and project developments. Since mid-2022, property yields have been rising, while the price discovery phase between sellers and buyers has yet to be completed,” explains Helge Zahrnt, the head of research and insight for Germany at Cushman Wakefield. CBRE, meanwhile, expects the interest rate hikes to come to an end before the end of the year. “The cycle of rising interest rates is likely to have peaked by the end of 2023, once inflation rates have returned to the ECB’s target,” believes Jan Linsin, the head of research at CBRE. “We are expecting key rates to potentially move southward from the first quarter of 2024 and for this to then accelerate in the following months, with the ECB key rate likely to settle below the 3 pct mark again at the end of 2024. Investors will have a particularly special time window for making attractive acquisitions up until then.” However, according to data from JLL, at present the market currently lacks large transactions of over EUR 100 mln with most current deals for office properties in the range of EUR 40–70 mln and most logistics transactions priced at around EUR 30–60 mln.

As is often the case during a downturn, local investors are dominating the market. And even now, German buyers and sellers are each responsible for more than two-thirds of the capital invested. With a share of more than 31 pct, residential properties now account for more of the transaction volume than offices at 24 pct. The lack of large office transactions is particularly noticeable around the banking centre of Frankfurt. The decline since the first quarter of 2022 is almost 90 pct. In Q1 this year, only EUR 320 mln was recorded in Frankfurt, which, after Cologne, is the lowest figure of the seven largest real estate markets (Berlin, Düsseldorf, Frankfurt, Hamburg, Munich, Cologne and Stuttgart). Berlin is still in first place as the only city with a transaction volume of more than EUR 1 bln, but with investment down by 40 pct on Q1 2022. Munich saw volumes fall by 33 pct and Stuttgart by 30 pct. The average decrease for all seven cities came to 63 pct.

The yield on ten-year German government bonds has currently levelled off at around 2.3 pct, meaning that the yield spread on real estate should widen slightly again. Even if investors currently prefer bonds, those who invest in German bonds at the moment are still losing money in real terms according to JLL, because real interest rates are still negative. The top yields for office properties in particular have risen significantly over the past twelve months and currently stand at an average of 3.53 pct across the seven largest cities – an increase of more than 90 basis points compared to Q1 2022. Prime yields for logistics real estate have risen by a similar amount, by 97 basis points; however, quarter-on-quarter there has still been no growth since the end of 2022 and prime yields remain at 3.93 pct. Rising rents and, above all, low supply are still the anchors for multi-family housing. Although yields for these have also increased by 78 basis points year-on-year, at an average of 3.14 pct they remain the most expensive asset class.

According to CBRE, German real estate investment has been hampered by economic and political uncertainty, interest rate hikes, rising energy prices and high inflation. However, the market still remains active. A weekly average of over EUR 1 bln was invested over 2022, bringing the transaction volume for Germany’s real estate investment market to EUR 65.8 bln, just 7 pct less than the ten-year average. Large portfolios in particular are difficult to sell at the moment, with investors tending to dispose of assets separately; moreover, especially in the case of large-scale transactions, due diligence and decision-making are taking a great deal longer. On top of this come the more difficult financing conditions, particularly in the form of higher overall financing costs and banks placing more stringent requirements on lending commitments. All in all, investors are therefore displaying much greater interest in cherry-picked single-asset transactions than in portfolio acquisitions.

“The swift and incisive interest rate turnaround is constraining current transaction activity, as investors are having to adjust their pricing to current market conditions. At present, we are seeing extremely muted investment activity, even though many foreign investors in particular are keeping a very close eye on Germany as one of the most important target markets in the world. Buyers and sellers are still not finding a consensus in the large-scale core segment in particular,” admits Fabian Klein, the head of investment at CBRE Germany. “The very different market and interest rate environment has not yet triggered forced sales or restructurings. Supply can nevertheless be expected to increase across all asset classes on the back of developments like this – driven especially by financing arrangements expiring. Attractive opportunities will therefore arise for investors who are clear about the investments they are targeting. The generally upbeat rental trend, above all in the case of premium office properties in central locations, contemporary logistics buildings and most especially in the residential segment, will enhance the appeal of opportunistic product for cash-on-cash oriented investors,” he predicts.

Residential

The sharp rise in borrowing costs coupled with the stubborn growth in construction costs have been resulting in many residential projects being cancelled. For 2023, JLL expects only about 240,000 new homes to be completed. However, the population in Germany is growing due to high net immigration, which includes refugees from Ukraine. This is increasing the gap between housing supply and demand and will continue to put pressure on net rents. Residential real estate will, therefore, remain a resilient and attractive asset class in the medium and long term. However, the current market revival of the residential investment market is being driven by a number of factors, including the reduced volatility on the capital and credit markets. Transactions were characterised by a wait-and-see attitude in the first quarter. The EUR 1 bln purchase of a portfolio from Vonovia by Apollo Global Management in April could presage increased activity on the market. The residential transaction volume for the first quarter came to around EUR 2.1 bln in 39 deals, with the market activity dropping by around 46 pct q-o-q and 65 pct down on the five-year Q1 average. The three largest deals of the quarter accounted for around 50 pct of the transaction volume. Prime yields for residential investment are in fact currently decompressing across all European cities.

Offices

As has been the case elsewhere, the German office market has been adjusting to the new normal since Covid upturned our working habits. “The German commercial real estate market has largely recovered from the impact of the pandemic. However, the office segment has been particularly influenced by hybrid working. Many companies have adjusted their working models and increasingly rely on flexible work arrangements, including the option of working from home. This has led to a shift in demand for office space, with some companies reducing or reconfiguring their office space,” explains Helge Zahrnt of Cushman & Wakefield.

According to figures from JLL, the total take-up of office space came to 607,000 sqm in the first quarter across Germany’s seven largest cities. This corresponds to a fall of around 30 pct compared to Q1 2022. Over the medium term, JLL expects strong demand, a healthy pipeline and total leasing for the year to come to 3.1 mln sqm – 10 pct down on the figures for 2022 and the ten-year average. All of the big seven cities saw a downturn in take-up, with Düsseldorf and Berlin seeing the smallest reductions (of 20 pct and 22 pct respectively), while the figures for Stuttgart were down by 53 pct and for Munich by 39 pct. Over the first quarter, there were very few leases for more than 5,000 sqm. This was particularly evident in Munich, where just two deals over 5,000 sqm were registered and the average area per lease was just 753 sqm. However, some large leases are still in the pipeline and could be completed during the year. The aftermath of the pandemic has not entirely dissipated and many companies are repositioning themselves or reviewing their workplace concepts. Sustainable properties with clear ESG criteria are in particular demand along with modern, high-spec fit-outs. Class A office space accounted for 70 pct of the take-up over Q1. According to a JLL survey, more than 60 pct of companies are pursuing a hybrid working strategy that includes both office work and working from home. Offices, especially in central locations, remain part of this strategy. When it comes to the tenant mix, it is evident that the globally weakening tech sector is behaving more cautiously in terms of both expansions and their current space requirements. Price sensitivity has increased across the board, while JLL has seen more space in this sector being marketed for subleasing. In contrast, management consultants, tax advisors and law firms continue to grow, and they remain willing to pay for premium space in central locations.

The vacancy rate across Germany’s seven largest cities now stands at 5.2 pct, with the amount of vacant space having risen to over 5 mln sqm for the first time since the end of 2016. This represents an increase of 12 pct on the same quarter of the previous year. The scarce supply that has lasted almost seven years has now come to an end. Nonetheless, JLL does not regard the new supply as excessive, so vacancy is expected to increase only moderately to 5.8 pct by the end of 2023. Currently, 827,000 sqm is on offer for subleasing. This is almost 13 pct more than in the previous quarter. The proportion of total vacancy remains unchanged at 16 pct. JLL is not alone in seeing the growth in office subleasing. According to Cushman & Wakefield, this is a clear trend that is set to shape the market for years to come. “A subleasing trend has become evident. Companies with excess office space are seeking opportunities to sublease these areas to reduce costs and enhance efficiency. This provides potential subtenants with the opportunity to utilise flexible office space without committing to long-term lease obligations,” points out Helge Zahrnt.

In the first quarter, around 218,000 sqm of new space was completed, which is not even half the volume of the final quarter of 2022, and is also down by 52 pct y-o-y. In Berlin, the completion volume has slumped by 85 pct to just 45,000 sqm. Many new projects are being postponed due to incalculable costs and uncertain scheduling. Banks are also taking a more critical look at financing commitments and now demand a much higher pre-lease rate before construction begins. Currently, over 100 office projects are under construction, more than half of which are already pre-leased (excluding owner-occupier properties). For the remainder of 2023, 1.4 mln sqm is still under construction. Pre-leases are almost at 60 pct, so there is no significant pressure being exerted on the vacancy rate by the new-build sector. CBRE expects office take-up for 2023 to be just under 2.6 mln sqm, matching the level of the two preceding years.

Industrial

According to CBRE, Germany’s industrial and logistics real estate market ended 2022 with an outstanding investment volume that was even greater than in 2021. The demand for warehouse and logistics space in recent years has been boosted by e-commerce, which has steadily grown on the back of rising consumer demand. This growth is now slowing due to reduced consumer spending and is no longer fuelling the demand for warehouse space, while it also translates into less demand from logistics providers. Thus far, this has been offset by increased demand from other retailers, including grocery chains. However, the ongoing restructuring of supply chains to guarantee demand-led production and the distribution of goods is continuing to generate demand for space. This need for greater flexibility in supply chains has resulted in occupiers requiring more regional and supra-regional central storage facilities as buffer stock. For a long time, the mantra for German companies was ‘just-in-time’, but they are now switching to a crisis-resilient ‘just-in-case’ strategy with the aim of guaranteeing flexibility.

The situation from a supply standpoint remains tight, particularly in the top markets. Vacancy rates remain low at a nationwide level of around 2 pct. In terms of supply, there are no signs of the situation changing any time soon, due to increased building costs, the lack of suitable land (including brownfield sites), and the increased financing costs. Beyond this, developers’ margins are contracting due to the recent significant hikes in yields. As a result, asking rents are rising and CBRE expects this trend to continue over the following months. Due to the rising prices for prime locations, developers and tenants are relocating to more peripheral areas. Long-established logistics clusters (Berlin, Frankfurt/Rhine-Main, Munich, Hamburg and Rhine-Ruhr) have been seeing a growth in activity, while there remains a clear trend for seeking such alternatives as the south of Hamburg, areas to the north of Munich, the north-east of the Rhine-Main area along the A45 and north Berlin. While the higher financing costs and yields have been having a dampening effect, the difficult financing environment and the sharp rise in energy costs have also created opportunities. Owner-occupiers are increasingly initiating sale-and-leaseback transactions to secure liquidity. Investor and also developer interest in such transactions is at a high level due to the steady cash flow and also the access it gives to logistics and production land, which is in great demand.

According to CBRE, the industrial and logistics real estate investment market saw its weakest start to the year since 2015, with the transaction volume down by 76 pct y-o-y. The share of traditional logistics properties in this also declined, accounting for only around half of the volume, down by 85 pct on the previous year, whereas the share of light industrial and production properties increased significantly. Due to the substantial increases in financing costs, many companies are continuing to dispose of their properties and production sites with the proportion of sale-and-leaseback transactions increasing significantly. Owner-occupiers, for whom property ownership is not fundamental to their own business, are now using their properties as an alternative source of financing. Despite the German investment scene being currently in the doldrums, no one is predicting an imminent collapse in this market. “Any meaningful predictions for the transaction volume are virtually impossible at the moment,” insists Fabian Klein of CBRE. “We currently anticipate an overall volume of between EUR 30 bln and EUR 35 bln, excluding large platform takeovers, M&A deals, significant restructurings and distressed sales.”