This article was sponsored by ARDIAN • EUROPA CAPITAL • HEITMAN • NUVEEN REAL ESTATE
In recent years, Germany has replaced the UK as the keystone in the European strategies of many international real estate investors. As a large, liquid market with stable politics, a robust export-led economy and steady economic growth, the country’s appeal is clear. The subsequent surge in investor demand has, in turn, compressed cap rates and supported healthy returns.
However, as four investment managers met in Frankfurt at the beginning of September for PERE’s Germany roundtable, the economic outlook no longer appeared quite so bright. The country’s economy shrank by 0.1 percent in the second quarter of 2019 and some analysts are predicting a second successive quarter of negative growth and the onset of a recession. In August, the Business Climate Index, published by German economic think tank Ifo, fell to its lowest level since November 2012, with confidence among both manufacturing and services companies in decline.
Bernd Haggenmüller, managing director for real estate at private equity firm Ardian, says there has clearly been a change in the economic situation over the past year. “We had eight or nine years of really bullish markets in Germany when economic development was running ahead of other European countries. Germany was regarded as a safe haven and I think still has a very good reputation with international investors. However, it has now become noticeable that the trade war that Trump has initiated against China, and partly also against Europe, is showing its first traces and clouds are appearing on the horizon.”
Exports of goods and services account for nearly half of German GDP, so the country is vulnerable to any decline in international trade. Federal statistics show production in the automotive sector, considered the country’s most important industry and already battered by the diesel emissions scandal, fell by 7.1 percent in the second half of 2018.
Thilo Wagner, managing director of the German business at global manager Nuveen Real Estate, says manufacturers have already amassed stockpiles of unsold cars. “We know that the order books of the car manufacturers are quite low, so there will be periods of short working hours and layoffs, which will likely have a knock-on effect on the German economy and on unemployment,” he predicts.
“German cars are a massive part of the country’s export business,” adds Nic Fox, a partner at Europe-focused manager Europa Capital. “A quarter of all German exports to the UK are cars, so that will be hurt by Brexit and that will exacerbate the current problems of trade issues causing a drag on the German economy. Germany remains the market of choice in Europe at the moment, a position that has been strengthened by the Brexit chaos in the UK. But there is a global slowdown going on, caused in large part by the trade war, and Europe is affected by that. We will all have to get used to a lower-growth environment, and that means in the real estate world as well.”
Germany’s “debt brake” limits its structural federal deficit by law, but Sébastian Cavé, managing director for Germany at manager Heitman, senses that German politicians may be willing to jettison their commitment to balanced budgets and borrow to stimulate the economy. “Creating a budget surplus has been criticized by some as economically questionable,” he says. “Higher borrowing could bridge the gap by stimulating growth, and in Germany there is fiscal room to maneuver.”
In some respects, the protracted uncertainty around whether the UK will leave the European Union has benefited Germany’s property market. Some financial institutions have already relocated their offices from London to Frankfurt, and more are likely to follow in the event of a hard, or disorderly, Brexit. In addition, risk-averse capital has increasingly refocused its attention on continental Europe since the referendum three years ago.
“For the first time, we will have more assets in continental Europe than the UK after being UK-led for most of our history,” says Nuveen’s Wagner. “Undoubtedly, values are falling in the UK due to political uncertainty and many investors are looking elsewhere to invest their money.”
Some of that money will likely find a home in German real estate. But Brexit will mean a “bumpy road” ahead for Europe as a whole, says Europa Capital’s Fox: “Whether there is a hard or soft Brexit, it will be a challenging period for the UK and the continent in terms of business confidence and trading arrangements. There will be more focus on the stability and possible fragility of the EU as a club. The question is how long the bumpy road is and how bumpy it gets, but there is no black swan event out there that we can see, not even Brexit, which will cause a catastrophic shock to the market.”
Moreover, the German political scene is not immune to the resurgent right-wing populism that has taken hold in several European countries. In September, the anti-immigration Alternative für Deutschland (AfD) party made significant gains in state elections in Saxony and Brandenburg. “Whether the perception of these federal states from international investors is going to worsen and whether there will be less investment because of that remains to be seen, but there are voices out there that say this is a risk,” says Cavé.
Negative interest rates
While these factors may make the economic and political background to investing in German real estate less favorable, countervailing factors may sharpen investor appetite. “In the property markets we still have very low vacancy rates, very cheap money and a very strong wave of capital trying to find deals,” says Ardian’s Haggenmüller.
“The number of competitors for interesting investment opportunities hasn’t shrunk at all over the last 12 months. It has maybe even increased. That is explained to a certain extent by the fact that interest rates have not started to increase as was expected at the end of last year. With a weaker economic situation globally, there is now an expectation that they will fall in the future. One of the main drivers going forward will be continuously low interest rates moving into negative territory, which will mean that prime yields will fall as well. We were all surprised by seeing yields in the core segment of around 3 percent in the last couple of years. I think we will see a two in front of the comma in the next year or two as a standard for core investment in the big markets.”
Cavé also concludes that the economic environment is, at this stage, unlikely to impact real estate values: “There is potentially a little bit of cap rate compression to come given that rates have gone even more negative. Even the 20-year swap rate is just above 0 percent. The yield spread to financing cost is also reasonable because Germany has a highly liquid debt market. In this cycle, there has been a lot of supply discipline. Investors have remained, for the most part, focused on core locations. When they have gone up the risk curve they have done so by investing in development positions, or by investing in emerging asset classes in locations underpinned by structural trends. We don’t expect a large shock in real estate markets from a pricing perspective. If anything, pricing levels will be supported further.”
Wagner agrees that cap rates could come in by “a couple of basis points,” but as a mainly core investor he hopes that the economic slowdown will favor buyers by taking a little steam out of a market that has become overheated in some locations: “Over the summer, we have seen the first signs in Berlin and in other markets that deals which were very bullishly marketed at high prices didn’t transact so quickly. It may be that, in the longer run, investors are able to find slightly better deals at the core end of the market.”
There are some indications that activity is slowing. A total of €25.5 billion of property was traded in Germany in the first half of 2019, down on the same period of last year when €29.8 billion was transacted, according to data from Real Capital Analytics. “Volumes will come off a little bit, but that won’t be a negative comment on Germany. It will be the result of a continued lack of stock and a little bit of a pause for thought as the bumps in the road start to appear,” argues Fox.
However, unlike the other participants, he does not predict further yield compression: “I think we have seen yields go as far as they are going to go. I can’t see us getting into a sustained sub-3 percent world.”
One consequence of yield compression has been that German core investments are comparatively unattractive to US capital, says Wagner. “It is unlikely we will see American capital invested for the next year, I think. They get higher yields and more comfort in their own markets. You would struggle to find a housing deal below 3 percent in the US. Yields are between 4 and 5 percent, which is a huge difference. What you still find in Europe and Germany is domestic European and Asian capital. For example, we have seen some big core transactions by Korean money this year.”
By contrast, there is still plenty of interest from US and Asian investors for value-add real estate in Europe, observes Haggenmüller. “One of the drivers is they understand that to develop in Europe you have to go through a lengthy and tedious administrative process and you are unsure about the outcome. In the historic cities the buildings are there to stay. That is why we focus on improving existing buildings that are not suited to modern occupiers. It is a story that Americans, Asians and Europeans understand, so there is a lot of money flocking into value-add funds.”
Value-add investors in Germany also benefit from continued liquidity, argues Fox: “You can always find a way out of Germany. You can’t say that about Greece or Portugal, or even Norway. That is a huge factor, particularly for closed-end fund structures.”
Cavé adds that Germany also benefits from its regionalized economic structures: “The different cities have their own attractions and fundamentals. And despite the limited supply you have a fairly large investable universe so you can invest in various asset classes at different points on the risk curve and execute different styles of strategy. We will continue to see good capital flows into Germany, but as yield compression and rental growth slows, the country’s role in portfolios will revert to being more of a defensive long-term play.”
Total returns for all property declined slightly in 2018, averaging 9.9 percent compared with 10.5 percent the previous year, according to MSCI data. Haggenmüller says he expects returns to moderate further this year, but only slightly. Meanwhile, the chief component of the return has evolved over time, he adds: “Three to eight years ago, returns were driven by cap rate compression. Then, in the last three years, they were propelled by rental growth that was sometimes astonishingly quick. Going forward, the continued low interest rate outlook will drive prices.”
The participants discuss how their underwriting of German transactions has tended to assume lower returns, while in reality investments have often outperformed those projections due to rapid growth. That dynamic can no longer be relied upon, which places a greater premium upon active management, argues Cavé. “With the tight exit yields that are now assumed in this market, investors will face a situation in which the outcome of their investment is quite sensitive to market variables. Therefore, over the lifetime of a business plan you need to ensure that you use every lever you have on the asset management side to de-risk that exposure.”
High pricing is a given in German real estate markets. But with the economy slowing, across-the-board growth can no longer be relied upon to rescue less discriminating investors. Some locations, industries and individual occupiers will inevitably suffer. In that context, investing in locations and asset classes supported by long-term secular and demographic trends is an approach favored by all of the managers present, and it is agreed that the major cities will be the principal focus of future prosperity.
“The EU’s population is predicted to increase by 2 percent by 2030, but in Munich, Frankfurt and Berlin, population growth is many times that, and there isn’t a real estate supply pipeline that will accommodate that expansion,” says Fox. “The case for Germany is through growth driven by a combination of urbanization and lack of supply.”
Meet the Germany roundtable
Managing director, investment, Germany, Nuveen Real Estate
Wagner is responsible for Nuveen Real Estate’s property investments in Germany, leading a team of 60 people, and is also fund director for its German retail warehouse business. Global manager Nuveen controls around €4 billion of assets in Germany. It has so far invested mainly through core strategies in the retail, office and logistics sectors. But the firm now plans to enter the value-add space in Germany and is exploring the prospects for investing in residential property.
Managing director, real estate, Ardian
Haggenmüller leads private equity firm Ardian’s German real estate business and is co-head of real estate in Europe. Ardian began investing in property three years ago, after the business was spun out of AXA’s private equity business, and has since amassed a portfolio valued at around €1.5 billion in the German, French and Italian markets. The firm now plans to expand into Spanish real estate and grow a separate account business for capital wishing to invest in the core space.
Managing director, Germany, Heitman
Cavé joined Heitman three years ago as managing director of the manager’s German business. His main responsibilities include portfolio management and acquisitions. Heitman maintains offices in London, Frankfurt and Luxembourg, out of which it manages European assets valued at over €2 billion. Its pan-European team invests in defensive sectors with a particular focus on the residential, logistics and self-storage sectors.
Partner, Europa Capital
Fox has been with London-based manager Europa Capital for 13 years. He sits on the firm’s investment committee, is fund manager for its series of value-add funds and is an advisor to its recently-established core and core-plus investments business. Europa Capital, which manages around €3 billion of European assets, is majority-owned by Tokyo-headquartered Mitsubishi Estate, one of the world’s largest real estate groups.
Berlin’s housing rent freeze chills investment market
Participants condemn rent control proposals for the German capital
In June, Berlin’s left-wing government approved a draft law to freeze residential rents in the city for five years. If approved by the regional parliament, the new law is expected to come into force in January 2020. Notwithstanding an exemption for new builds, the roundtable participants unite in decrying the initiative.
Fox describes the plan as “a wretched thing” for investor confidence. “There is a risk that it could be adopted in other markets,” he warns. “It will be fascinating to watch how the share prices of large publicly-traded residential landlords like Deutsche Wohnen and Vonovia perform over the next six to 12 months. That will tell us an awful lot about the perception of investors of Berlin residential, and possibly about the residential market more generally.”
Heitman has favored Berlin in the past, and is watching the market closely until the detail of the legislation and what its impact will be on business plans becomes clear, says Cavé, and he expects other investors to do the same. In the long term, however, he predicts that investors may adapt their game plans to the new regime: “Berlin cannot be ignored as a residential market. Its role in investors’ portfolios may change, so that their strategies are less focused on growth and more by cash income, akin to an infrastructure-style investment.”
Like the others, Wagner believes the proposed law will only exacerbate shortages, particularly in a German housing market that is already fairly heavily regulated: “Insecurity always leads to non-investment and there are lots of building permits that are currently not being executed and projects that are on hold,” he says.
Haggenmüller views the policy as symptomatic of a potentially harmful trend towards increased government interference in markets. “The big issue is, will regulation or innovation drive this country forward? At the moment we risk falling back into the old habits of over-regulation which [former Chancellor] Gerhard Schröder broke up with his reform agenda. That would be dangerous for Germany and paint a negative picture of the country for international investors,” he argues.
Germany: Key deals, key points
The participants select notable transactions in the past 12 months that illustrate current market trends
Cavé: Danish pension fund PFA’s €1 billion acquisition of the Century portfolio of 33 residential buildings across the country from German housing investment company Industria Wohnen in September 2018.
His analysis: That illustrates how confident some investors are about the growth prospects in Germany, especially in the larger urban centers. On the face of it, the ingoing yield was very tight. But it must have been the conclusion of the investor that growth would generate most of the return.
Fox: London-based private equity real estate firm Benson Elliot acquires three convenience-led shopping centers in Dortmund, Hanover and Rostock from Dutch real estate company Brack Capital Properties for €175 million in June 2019.
His analysis: That is one of a number of signs that there is continued liquidity in the retail sector in Germany, while liquidity in other national markets, especially the UK, has largely evaporated.
Haggenmüller: Korean investor Mirae Asset Global Investments’ June 2019 sale of the T8 office tower in Frankfurt’s banking district for €400 million to a German family office.
His analysis: Mirae paid €280 million for the asset two years ago when it was still in development, which seemed an outrageous price at the time. But after leasing it up, they exited at a €120 million profit. Recently, and this year especially, we have seen quite a few assets trade at almost double their original price.
Wagner: Hahn Group, a specialist investor in large-scale retail, acquires the ‘Salt & Pepper’ portfolio of 13 retail parks from asset manager Patrizia in March for around €300 million.
His analysis: That portfolio was sold at the projected price, which shows there is still demand for food-anchored retail. No food retailer has yet come up with an online concept that they can make any money off because the margins for are too low. The network of shops is so good in Germany that people still go into the local shop and will continue to do so.