Money has a price again
What does that mean for the real estate market?
For a long time it was inconceivable, but for a few months now it has again been necessary to pay substantial interest rates to borrow money. Although this also tends to reduce misallocations, the initial impact is that the real estate transaction market has been more subdued across the board. The following article looks at the German commercial real estate investment market, with a focus on office properties.
Bye bye, Black Friday
The Black Friday of liquidity on the market which has been with us for more than a decade is now over. In the wake of supply chain problems, the war in Ukraine and the hike in energy prices, inflation has skyrocketed to heights not seen for decades. The result is that financing costs are also on the up. So what does this mean for the German real estate market?
Plot spoiler: many of the effects described below can also be observed in other countries; in this respect, the (institutional) requirements in each country are of great importance in terms of its suitability as an investment destination.
Invisible inflation
After the global financial crisis following the Lehman Brothers bankruptcy in 2008, the central banks injected substantial liquidity into the markets in order to reduce interest rates. The ever more reasonably priced loans were used, amongst other things, to buy assets such as properties, but these transactions did not find their way into the official inflation statistics. Amongst other things, this meant that in turn the central banks kept interest rates at extremely low levels.
Interest rates and yields plummeted year-after-year Source: Bundesbank, Macrobond, Avison Young Date: December 2022
For too long, the inflation which kicked-off at the start of 2021 was interpreted by the ECB, and also other central banks, as merely temporary. This is one of several reasons why the rise in interest rates came too late.
Financing costs remained low, as did property yields. The reduction in financing costs in particular resulted in increased investment activity over the last 10 years. The longer the market “ran and ran”, the more likely it became that the definition of “Core” properties might be
interpreted a little more generously in some quarters by competing sellers than in times of economic crisis. Property prices rose, (initial) yields fell. Furthermore, in many cases little in the way of work needed to be put into the acquired property.
With falling vacancy rates right across the office submarkets, letting was often quite a simple process, and after a hold period of a few years the property could be sold at a much higher price and with a higher WA(U)LT.
Strongest price hike in decades Source: Bundesbank Date: December 2022
Property yields did not pick up until the second quarter of 2022. Activity on the real estate investment market declined immediately; buyers are waiting for prices to fall, whilst sellers are not yet willing or indeed in a position to compromise on their asking prices.
Two important influencing factors from the east
So how high will inflation and interest rates go, and for how long? How far will property values fall, and for how long? And what will ultimately bring about the turnaround and kick start activity?
If falling financing costs cause an upswing in transaction volumes and prices, the sudden jump in financing costs since the summer of 2022 now means reduced activity at reduced prices on the investment market for the immediate future. However, in historical terms the current level of borrowing costs is nothing unusual. Nonetheless, it will take some time before pricing stabilises and property deals pick up
again, even in the hypothetical case that financing costs remain at their current level. But that is not what we expect: inflation is too high for the central banks not to raise interest rates further, and this will eventually make financing costs even more expensive. So it depends hugely on inflation. And inflation is driven largely by high energy costs and food prices. Two factors are now emerging: the first is China’s lockdowns.
China has a significant influence on the German economy and ultimately also on the domestic real estate market. Will the easing of the strict zero-COVID policy (which to date have included hard lockdowns, quarantine rules and travel restrictions) announced in early December 2022 gradually resolve supply chain problems and thus help to reduce the high levels of inflation – driven particularly by the supply side – and central bank interest rates, and ultimately also financing costs for companies and real estate investments?
"Risks are perceived as risks again, money is no longer free of charge, and real estate means having to work for something again."
10-year swap rates as an indication of financing costs Source: Macrobond, Avison Young Date: December 2022
The easing of COVID restrictions is accompanied by the hope that the country will be able to cope with the consequences of this reopening, especially on the medical side, and eventually return to economic growth. This would have positive effects, especially for Germany as an exporting nation: in 2021, China was Germany’s most important trading partner for the sixth year in succession.
The second factor is the war in Ukraine and its consequences, which again involve disrupted supply chains resulting in rising energy costs and food prices. However, supply chains are already being re-aligned, which will eventually help to bring about a decline in inflation. Oxford Economics[1] forecasts that German inflation will fall to 4.9% in the current year 2023, and expects inflation rates of between 0% and 1% in 2024 and 2025.
2022 was the overture
The year 2022 was the overture to several acts in which the real estate investment market is played out under new, but actually old, conditions: risks are again perceived as such, money can no longer be had for nothing, and real estate means hard work again. For the last reason alone, some investors simply drop out when interest rates are higher.
Without wanting to overuse a term such as “changing times”, for the foreseeable future financing costs for office properties will not have a one or two before the decimal point again; at best there will be a three over the medium term. This heralds a new era for many market players, whose success had been based particularly on property prices simply rising “by themselves”. The script for the first act starts with little in the way of action at the front of the stage (the transaction market), whilst in the background the actors are busy with analyses and calculations. There are fewer transactions, and these take more time and are traded at lower prices; this will keep the transaction volume at significantly lower levels for months. Deals which do get closed also often take place backstage as off-market deals, as these sellers shy away from the limelight. These deals, and also distress sales, are often aimed at freeing up capital in order to cover costs, for example if follow-on financing requires additional equity capital due to lower property values and must also be finalised at massively higher interest rates, if delays or mushrooming construction costs compromise the profitability of a project for developers, or rental payments increase sharply due to indexation for inflation and the tenant is forced to sell another property owned by it. Thus far, no huge domino effects are expected in this play. Sale-and-leaseback transactions are also an option to generate cash from previously owner-occupied properties.
ESG is no longer a “nice to have” but a “must have”.
The sellers in this play still need more time to accept that it is a buyer’s market now, and no longer a seller's market. Until then, the two groups of actors are watching one another. It will not be until around mid-2023 that the pricing process will have reached the point when sellers and buyers increasingly find each other again. The next act will then begin and there will be more on-stage action once again. There will be a particular focus on properties which comply with ESG criteria (or can do so after refurbishment), for example in terms of energy efficiency, type of heating, etc. This is because continuing high energy costs are increasingly becoming a deal-breaker for both existing tenants and prospective new tenants when selecting properties - and thus also for investors.
ESG is no longer a “nice to have” but a “must have”. Today, lenders and investors are already demanding significantly greater ESG compliance and information, both before committing and also during the hold period. For this purpose, the level of mutual co-operation between landlords and tenants will need to develop even further than before, not only in the direct operation or occupation of a property, but also in terms of the associated collection and communication of data.
Real estate financiers under pressure
The situation is particularly challenging for traditional real estate
lenders.On the one hand, they are expected to take on only as manageable a risk as possible but on the other hand there is now significantly more uncertainty and risk; the bottom line is that they are doing much less (new) business. In addition, real estate values are difficult to assess due to the small number of transactions and the difficulty in forecasting inflation and interest rates. Besides ESG issues, real estate lenders are putting lease structures (inflation-based rental indexation or stepped rents) and business models under the microscope, as well as the creditworthiness of tenants. They are demanding more equity input from borrowers (this alone reduces the number of potential borrowers remaining as buyers of property), they accept fewer equity substitutes, and they engage less in segments such as mezzanine capital.
Mezzanine capital providers, however, will need to accept increased losses in the current market phase, as they often lent money without recourse to collateral. At the same time, for some months now requests to lenders for “bridge loans”[2] have been shifting from acquisition financing to support for refinancing difficulties. The consequences of high financing costs and the hesitation of traditional lenders are thus already becoming apparent. Increasingly, the current market phase is bringing alternative lenders into the game, who are consciously taking greater risks.
Despite significant reductions, gas prices remain high Dutch TTF Natural Gas Futures Source: investing.com Date: December 2022
A more acute view of risk and quality
Yields have been rising since the second quarter of 2022, not only those for properties in less sought-after locations or with higher vacancy rates but also prime yields, i.e. for top properties in the best locations. Often the parallel hike in prime rents cannot fully compensate for the loss in value. However, there are still too few deals to be able to reach reliable conclusions. Meanwhile, the market is becoming more differentiated, and there is currently little demand for non-Core products; however, investors and asset managers with expertise in the Core plus or Value-Add segments are already positioning themselves in this market phase. On the office market, there is more care is being taken to check which locations and properties are best suited to reduced overall demand for office space in future. For these, occupier and investor demand will remain relatively strong. On the development side in particular, the supply of new office space will remain limited because of the difficulties described above: some projects which have already been planned but have not yet commenced construction will not be built for the time being. This has a stabilising effect on prices, at least for those investment products which are expected to have a promising future. At the same time, the differentiation in the market is also becoming clear in this regard: weak product tends to be avoided by both tenants and investors, and must be able to withstand higher vacancy rates, higher rental incentives or pressure on rents and rising yields (provided the business plans or the owner can cope financially; otherwise there will also be distress sales). Alternative strategies such as the conversion of barely marketable office properties into apartments, which have long contributed to reducing vacancies in the office segment, will no longer be possible to the same extent and speed as before due to the problems in the construction sector.
Prospects for the German real estate investment market
It will take time for the economy as a whole, and also real estate financiers and investors, to adjust to higher interest rates, which will remain elevated for a lengthy period despite recent downward adjustments to inflation forecasts. It remains to be hoped that companies will have sufficient staying power to make the transition.
Despite all the challenges, Germany continues to be perceived as a safe haven, both economically and legally, and is thus a worthwhile investment destination overall. In terms of competition between countries as investment destinations, Germany therefore continues to play a leading role, and this is also likely to be reflected in real estate transactions. However, real estate prices will tend to decrease, depending on perceived quality, especially if central bank interest rates and government bond yields continue to rise at first before reaching an expected peak in the coming months. The process of accepting falling property prices will continue for most sellers until the second half of 2023. The fact that inflation already seems to have peaked at the end of 2022 will make pricing a little easier.
Meanwhile, substantial capital continues to push into the real estate market, even if little is actually being invested at the present time. At the end of 2022, there are already signs of a slight increase in investment activity, but still at a low level. Investors with a strong equity base and a long-term view can now exploit their advantages, at least in terms of a quicker response, if for example for a current investment they only procure more favourable financing two years from now. Buyers from countries with stronger currencies than the Euro can also benefit from exchange rates and take advantage of entry opportunities.
"Even with a nominally unchanged price, there is a loss of value in real terms".
In the next two years alone, public sector bonds with a volume of around EUR 600 billion will mature in Germany, and that money will need to be reinvested. By way of comparison: in 2022, around EUR 51 billion was invested in commercial real estate in Germany. What will the investors who receive the EUR 600 billion over the next few months do with the money? Of course there are alternatives to real estate: government bond yields have risen sharply in nominal terms (ignoring inflation) since the beginning of 2022, and the yield gap [3] between them and prime real estate has shrunk considerably.
This makes investments in “risk-free” 10-year German government bonds appear more advantageous compared to real estate.
However, if one takes inflation into account, one must consider, amongst other things, that most real estate leases include protection against inflation, whereas classic government bonds do not.
And even if inflation is likely to be back down to a significantly lower level in a year's time, price levels will of course be higher than before because of the inflation that has “occurred” in the meantime.
This means that even if the price remains unchanged in nominal terms, there will be a loss in value in real terms. This makes the compensation for inflation achieved through appropriately structured leases all the more important, and this supports real estate as an asset class.
Real estate yields will continue to correct upwards (based on quarterly figures) Source: Bundesbank, Macrobond, Avison Young Date: Dezember 2022
Furthermore, it is possible to work actively with real estate, and that is exactly what is happening now - only much more intensively than over the past few years. Now is the hour of the financing advisors and alternative financiers, the real estate asset managers, the (developer) investors with equity capital and courage, and advisors with good ideas for products.
[2] Capital which is only made available for a relatively short period of time. [3] The comparability of the two yields is of course limited, and possible financing costs are not taken into account at this point.
Christian Ströder Director Innovation & Insight Germany
As Director of Innovation & Insight Christian heads the German Research Team at Avison Young. Christian, who is a real estate economist and holds a diploma in Geography, is responsible for the data, analytics and Insight programme in Germany. Among other things, he analyses the effects of macroeconomic developments on real estate markets, and authors insights on special topics and trends. By using the firm’s global intelligence platform, AVANT by Avison Young, both the Avison Young business and clients are being supported in market and locational analyses and real estate decisions.
Carry Ann Witthohn Research Analyst
As part of her work as a research analyst, Carry analyses real estate-related data and derives recommendations for location decisions in close cooperation with the leasing and investment teams. In addition to traditional research, she compiles thematic insight reports on current topics. Furthermore, the graduated geographer is responsible for the implementation of geoinformation projects (GIS).