The German real estate market – outlook for 2023

The German real estate market – outlook for 2023

2023 will be a year of painful price adjustments which only just started in 2022 and are not over yet.

Review of 2022

• The real estate transaction market in Germany (including residential) ended 2022 with a transaction volume of approximately EUR 65 billion (2021: EUR 110 billion = -41%).

• Seen against the backdrop of the strong first quarter, which accounted for some EUR 24 billion, the average for Quarters 2 - 4 was only around EUR 14 billion per quarter. In some markets there was an outright collapse in transaction volumes in the second half of the year. For example, in the Frankfurt investment market, at just over EUR 0.5 billion, deals concluded in the final quarter accounted for a mere 10% of the year’s total result – the lowest result in more than 10 years.

• The complex confluence of economic and political factors, which over the course of 2022 led to inflation levels which have been unheard of for decades and to ever-increasing interest rates, made it almost impossible to underwrite properties during the course of a transaction. Moreover, the environment for transactions is being made worse by a significant adjustment in the terms available from banks and alternative lenders. This situation has led many investors to wait and see. This impacts both sellers, who do not want to make a loss, and buyers, who do not want to buy into a falling market.

Outlook for 2023

Transactions

• Our view is that the waiting and manoeuvring is not yet over because there is too wide a gap between supply and demand. This gap cannot simply be closed by market players reaching new conclusions within the next six months. For professional investors, it is clear that increases in interest rates have caused debt-financed properties to lose as much as 35% in value compared to 2018-2021. Vacant or risky older properties and buildings outside prime locations are impacted even more by the price correction because prices are being discounted to take account of increased and, in some cases, disproportionate safety margins reflecting location quality and the anticipated ESG measures in relation to buildings. Financing is also considerably more difficult. Therefore, many sellers would find themselves selling at a loss. Investors are unlikely to be rescued by an early change in interest rates, and so over the coming 24 months they will have to focus more on adding value by managing their assets than in previous years. When restructuring or extending their loans, investors will be forced to inject additional capital or give up exclusive control over their properties.

• Buyers with strong equity backing who are willing to invest 100% as equity will continue to enjoy an advantage. As well as benefiting from increased transaction certainty, they can also pay higher prices than buyers financed by loan capital, since the latter run the risk of negative leverage above a certain price. These investors will base their pricing on the returns that can be achieved from other asset classes, especially equities and bonds. As in the past, investors with strong equity backing will primarily seek Core properties.

• Opportunistic buyers, who have traditionally relied on a higher leverage ratio, are currently experiencing difficulty in closing deals. Debt finance is available only in smaller amounts, is more expensive or – depending on the risk profile – not available at all. If investors are also willing to go “all equity”, the discount on the purchase price will be even greater because equity capital is more expensive, which makes the transaction even more difficult from the seller’s perspective.

• We are continuing to see prime yields for office properties in top locations ranging from 4.25% to 4.75%. Away from prime locations, including in the Big 6 cities, the maximum range is more like 4.75% - 5.25%. This is not yet reflected in the commentaries of the big agencies, despite no investors (buyers) being willing to pay more.

Financing

• The Fed’s key interest rates currently range between 4.25% and 4.5%. Market players expect the Fed’s cycle of rate hikes to be over by March, for the time being. Even if the Fed increases rates by only a further 50 bps overall, to a range of 4.75% - 5.0%, there is no expectation that the trend will be quickly reversed. The chances of this are outweighed by the risks that it could further fuel inflation in the short term, such as the strong US labour market and the Biden government’s stimulus package of over $1.9 trillion.

• The ECB is talking of an end to the increases “by the summer”. Strategists expect higher interest rate movements from the ECB than from the Fed. Over the next four meetings, it can be anticipated that rates will be in a range between 3.5% and 4.0% (currently 2.5%) by June.

• Over the past two months, long-term interest rates (10-year Euro swap) have fluctuated between 2.7% and 3.3%, with a downward trend since the beginning of January, but volatility remains high.

• We do not anticipate any easing of interest rates in 2023, as we are still facing high inflation, even if it has been declining recently. Even if the availability of goods improves, especially raw materials, wage increases and a weak Euro exchange rate against the US Dollar will continue to drive prices.

• Over the course of 2022, banks and alternative lenders adjusted their terms, triggered by the justified pressure on property values described above. This affects both new loans and existing exposures. Central banks and other supervisory authorities are also insisting on a conservative approach to lending, and this adds to the hesitancy of regulated financial institutions. Alternative lenders are faced with demands from their investors for higher returns, and these are passed on to borrowers.

• When seeking finance, more than ever before, investors are having to address a broad range of financiers in order to gauge the best possible terms. It is also essential for them to analyse the sustainability of a loan and justify it in detail to the lenders.

• The cash flow available for servicing debt – from rental income or sales – has assumed considerable importance due to increased interest rates and the consequent drop in property values. This means that speculative development projects and land developments are in particular affected by the credit crunch.

• However, the market is not contracting as it did during the financial crisis. In the autumn of 2008, real estate mortgage bonds (Pfandbriefe), on which there had never been a default, traded at a premium of up to 150 bps over federal bonds. Finance is still available, but investors need to factor in more time and, above all, contribute more equity. As increased capital requirements are imposed by both banks and alternative financiers, banks are becoming increasingly competitive again because of the higher cost of alternative lenders.
• In 2023, the credo for financing will be to get “the one” finance deal, and not – as in previous years – to negotiate the best deal out of various options after the decimal point.

Forecast

• For 2023, we anticipate a transaction volume of EUR 55 - 60 billion, with a steady increase in the prime yield for office buildings to more than 4.0%.