The German real estate market in October 2022

Dr. Joachim von Rheinbaben
Managing Director

25 Oct 2022

Equity investors are creating their own world while the rest of the market is falling

Transactions in the German real estate market in the third quarter of 2022 do not yet reflect the new reality of property valuation, with transactions settled at 100% equity close to the 2021 yield level. Moreover, according to international brokerage houses, prime yields have risen only slightly, for example to around 2.8% for German office properties.

A transaction volume of around EUR 51bn was registered in the first nine months, a fall of approximately 15% year-on-year, but a slight rise compared to the previous quarter. Much of this decline is due to a 50% slump in transactions in the residential market in which some EUR 10bn of properties changed hands.

It appears that major German equity investors are in their own "bubble". It is remarkable that this group of investors is still willing to conclude deals at yields around or even below 3.0%, despite the revaluation set in motion by the markets.

This makes little sense in the medium term, since other asset classes - and especially bonds - with a much more attractive risk-return profile are available in the capital markets. A bond issued by Vonovia, the leading residential construction company, with a maturity date of September 2032, is currently trading at around 62% and offers a yield to maturity of 6.0% per annum. There has been an even more significant rise in yields in Alstria bonds, with a yield of around 9.2% per annum currently achievable on a bond with a maturity date of over five years. In the US, a yield of almost 4.5% is already achievable for a two-year government bond, and money market funds are enjoying rising popularity again as a short-term investment vehicle with an average yield of 2.77%.

Let's take a look at the wider circle of investors in the property transaction market: While statements such as "the market has to find itself" and "there is an absence of benchmark transactions" are quoted over and over again, the truth is much simpler. The purchase price determination is simply the function of a target yield or target profit calculated on the basis of various assumptions such as market rent, exit yield and the parameters of debt financing (interest rate and leverage). This calculation is currently made more challenging by the major changes in macroeconomic conditions and the high level of uncertainty in the real estate and financing markets. Consequently, investors are finding it difficult to set the above valuation parameters due to the ongoing volatility. This uncertainty is leading to higher risk buffers, i.e. lower valuations. Irrespective of the high level of volatility and uncertainty which are leading to lower valuations, all investors, not just equity investors, are seeing yield expectations rise as alternative investments become more attractive.

The best way to illustrate the situation is to use a calculation example: Looking at a Core transaction in October 2022 compared to 2021, you can see the full extent of the difference in valuation.

A year ago, in the case of a Core property valued at a multiplier of 30, it was still possible to achieve a 4.3% return on equity based on an interest rate of 1% and an LTV of 50% (10% leakage, 8% transaction costs on purchase, no ongoing repayment). An investor who would be satisfied with such an RoE today can no longer rely on a positive leverage effect. Without the use of leverage and with the same leakage and transaction costs, an equity investor can pay a multiplier of just 19.3. This is an approximately 35% (or 11 point) reduction in the multiplier. It does not yet consider the fact that investors' yield expectations - as mentioned above - would have to expand even further. In our example, in the current market, the equity investor would receive an ongoing return lower than the yield available on a secured loan on Core real estate (10-year Euro swap at 3.3%).

This clearly shows the challenges the industry is facing. As always, investors need certainty to make their decisions, and especially cost, supply chain, energy and interest rate security and a stable economic environment. There is currently no such certainty and who is to say when many of these factors will become tangible again? We therefore expect to see a consolidation of the market and opportunity for opportunistic investors over the next 12-18 months, with advantages for those investors who are willing to back purchase prices with significant equity.

We maintain our 2022 forecast for a transaction volume of EUR 65bn.