Germany roundtable: Handling the heat

Germany remains hugely popular with investors, but for managers the problem of how to maximize returns in a crowded market looms large, hears Stuart Watson in this month's roundtable.

On a Sunday morning, three days before PERE’s Germany roundtable was held in Frankfurt, 60,000 people were evacuated from the center of the city to allow a 1.8-ton British ‘blockbuster’ bomb left over from World War II to be defused.

If it had detonated, the bomb could have caused widespread damage to the western part of the German financial capital. It did not. The operation was carried out smoothly and everyone went back to work as usual on Monday.

As the roundtable discussion took place less than three weeks before the German general election, none of the participants were expecting any explosions in the political sphere, with Angela Merkel widely tipped to win a fourth term as chancellor. Moreover, Germany’s stability has increasingly made it the European safe haven of choice for many real estate investors, particularly as the UK is threatened with its own Brexit bombshell.

That growing popularity presents both a challenge and an opportunity for the six private equity managers present, each of whom is looking to maximize returns in one of the world’s hottest real estate markets: Gil Bar, managing director of German real estate at Aviva Investors; Nic Fox, head of Middle Europe at Europa Capital; Bernd Haggenmüller managing director of real estate at Ardian; Gerhard Lehner, head of investment for Germany and head of fund management for Europe at hosts Savills Investment Management; Giovanni Perin, managing partner at Threestones Capital; and Sascha Wilhelm, CEO of Corestate Capital.

“Income is king because with a stable income you can bridge any volatility in the market which can come up”

– Gerhard Lehner

A stable climate
The discussion opens with politics. Is there any chance that when the report on the roundtable is published after the election everyone will be discussing a shock defeat for Chancellor Merkel? “None at all” is the consensus among the participants.

“I don’t think we will have any surprises in the German elections,” says Wilhelm. “The question is whether Mrs Merkel’s coalition partners for the next four years will be the socialists or the FDP [Free Democratic Party].”

Recent election results seem to suggest that the advance of right-wing nationalist parties in western Europe has stalled. That is a welcome development for stability across the EU and one that has been reflected in Germany, says Bar. “We did a presentation for our UK colleagues and we put up two maps – a climate map and a weather map. We reassured them that while there may be a few dark clouds on the weather map – in the federal elections there have been a few surprises – the climate in Germany has not changed. Our political risk profile, particularly after the French and Netherlands elections, has diminished to almost zero.”

Meanwhile, the German economy looks solid. “The environment is relatively positive,” says Perin. “There is no real expectation of high growth in interest rates in the next two or three years. Meanwhile, economic growth is picking up. The German economy is predicted to grow 1.6 percent in 2018. Inflation is projected to be more or less in line with expectations for 2018 at 1.5 percent, below the 2 percent ECB target rate. On a macroeconomic level
it looks quite OK to invest in real estate, even at 3 percent cap rates compared with other available investments in the market. There has also been an increase in internal consumption in Germany in recent years. That is a very good sign.”

Germany will avoid the electoral shocks experienced elsewhere, predicts Haggenmüller, and that is part of its appeal for investors. “They know there will be no Trump or Le Pen in Germany. Since WWII, Germany has looked for stability. This is what makes us and so many others – maybe too many at the moment – fans of Germany, who like this as an investment market above other markets,” he says.

The danger, warns Bar, is complacency and inaction.

“Reforms are what helped Germany at the time when many other countries experienced a crisis. They were tough and they were implemented, but not by a grand coalition. If there is a grand coalition again to push reforms through, it will be a very complex process.”

Crazy demand

Equity capital has flooded the German real estate investment market in recent years. “Every type of capital is coming to Germany,” says Lehner from Savills Investment Management.

“In former times, Asian capital found it difficult to invest into Germany. They are now beginning to accept the yield levels – not all of them, and some are still hesitating – but they are coming with huge volumes of money.”

In 2016, Korean investor Samsung SRA Asset Management paid €730 million for Frankfurt’s tallest skyscraper, the 257- meter Commerzbank Tower. “That shows you the demand for German real estate is kind of crazy,” says Wilhelm. “The net initial yield was extremely low on a sale-and-leaseback from Commerzbank, which had told the market that it would reduce its labor force.”

Bar says Japanese investors currently considering entering the European real estate market are looking closely at Germany: “Previously London was the only place for them, or they sometimes used to go to Paris. Now Germany is on the list.”

Demand from domestic investors has also increased, however. Haggenmüller estimates that of the predicted €52 billion dealflow for German commercial real estate this year, around half will be acquired by locally-based investors.

Domestic institutions are increasing their allocations to real estate, says Wilhelm. “The insurance companies still need to pay out close to 3 percent on their life policies and they can’t get that return in the bond markets. They want to increase their total capital allocation to real estate beyond 10 percent, but they haven’t really managed to do so because there is so much competition. Big pension schemes like Bayerische Versorgungskammer, the Bavarian pension scheme, even want to reach 25 percent. Retail investors who have been out of the market for some years have also come back.”

Market of choice
With so many buyers in the market, yields have compressed sharply. Some Asian investors enter the market expecting returns that are no longer available, says Perin. But that misconception is swiftly rectified. “There were transactions in Berlin that I proposed to investors at a 5 percent yield 18 months ago and they said that was too low. Now the yield on those buildings is 3 percent,” he adds. Europa’s Fox says the problem is specific to Germany. “The other markets just haven’t moved as fast as Germany because they don’t have the capital attention that Germany has. It is the market of choice. When did we last see Germany overtake the UK? This is pretty significant,” he observes.

Will yields continue to harden? Not for much longer, says Haggenmüller. “I think the market is currently characterized by how little can be gained by cap-rate compression. Maybe there is another 0.25 percent, but it feels to me like it is coming to an end. The driver for investment success is active asset

However, Lehner believes there could be more scope left.

“There is still room for downwards yield movement. I wouldn’t be surprised if yields in a year will be 50 basis points lower than today because there is so much money around and there is not much choice for investors,” he predicts.

Lower returns
Lehner agrees that expectations for cap-rate increases are moderating, with investors placing increased emphasis upon income returns instead: “Income is king because with a stable income you can bridge any volatility in the market which can come up.” Investors are cautious about taking on additional risk because they perceive that the property cycle is nearing its downturn phase, says Bar.

“At the same time, people have been saying we are late cycle for the past 18 months if not two years, but it’s like kicking a can – or the way England used to play football, kicking it down the field so everyone is running after it and all of a sudden the ball gets kicked even further. Therefore, in some markets and some risk profiles we are sellers so we can harvest some value, and at the same time we are not just chasing total return.”

Rental growth offers some opportunity for investors to extract value. Lehner suggests that the rental growth seen recently in Berlin will be sustained because the city is starting from a very low base following over-development in the 1990s and then a prolonged period of stagnation. “In our dynamic city ranking Berlin is one of the leaders in Europe in terms of future prospects.”

Rents only began to pick up 18-24 months ago, and growth has been limited to the centers of cities like Berlin and Munich, says Haggenmüller. “Only now is the trend slowly starting to translate into more secondary locations. Our strategy is not to buy income, although of course we want to have a balanced portfolio with income in the fund, but we are looking for opportunities in secondary locations in the main cities where we can lease up vacancy. We think this is the way to create increased returns because we don’t see that from capital appreciation.”

He adds that core buyers are increasingly beginning to compete in that space. However, they are pushing prices up. “What we would regard as a core-plus asset in our fund until recently at 25-30 percent vacancy is quickly absorbed by core buyers at the moment,” says Haggenmüller. The market is also highly competitive for the value-add strategies that have been the mainstay of Europa Capital’s business, says Fox. “We are looking at strategies that are income-enhancement based, but there are hundreds of investors trying to do
similar things on a similar scale. That is why we take the view that in a pan European fund we will underwrite Germany and one or two other markets differently from Prague, Warsaw or Barcelona. One might choose to live with a lower return target in Germany in return for the near-certainty of achieving it with some possible upside to come and minimal downside. That is why the value-add business is still valid in Germany, but it is very competitive.”

Secondary cities
Two trends have emerged in response to high pricing and scarcity of stock, argues Wilhelm. “The secondary markets and even third tier cities in Germany are more attractive not only to value-add and opportunistic investors, but also core institutional investors that have started to go beyond the top seven cities. Secondly, real estate asset classes that were not institutional at all in the past like student accommodation are really on the landscape for institutional investors.”

Perin says that he has observed the latter tendency at work in the nursing homes market. “We sold a €150 million nursing home portfolio a few months ago to the biggest insurance company in Belgium. We didn’t even have to put the deal on the market and we had six candidates to buy it. That asset class was very niche a few years ago, but it is rapidly becoming an asset class on its own; even the German institutions and core German funds are interested now.”

Fox questions whether there is an adequate price premium for entering some of the smaller German cities. “I don’t think anything other than the top six cities in Germany are core. There is maybe super security in places like Mannheim, Wiesbaden, Kassel and Augsburg. They are traditionally dominated by domestic investors, but I think that some of the foreign capital is thinking that is where they need to go next because they can get a 100-basis point premium for going there. I don’t think that is enough.”

Haggenmüller is also skeptical about the smaller cities as a market for international investors. “If you want to deploy big amounts of capital you are either in a liquidity trap or you are in the cookie-cutter business which takes a lot of time and effort and you need a very locally-experienced asset manager, which is hard to find,” he says. “One of the reasons why we like the big cities is because they grow. The economy is growing by 1.7 percent in the country as a whole, in the big cities it is 3 percent and above.”

A secondary-centers strategy can work in Germany, responds Wilhelm. “In our
secondary cities high-street retail strategy we bought over €1 billion of assets in more than 150 individual transactions. It is hard work and it is not for the big investors who want to deploy €100 million in a short period of time, but if you are able to do it then it is not only an income play, it can be an IRR play simply by putting together smaller pieces into bigger portfolios so that you can attract institutional money. We have analyzed 60 cities in Germany where we believe the fundamentals are as good as they are in the top seven cities, but always for special asset classes. For retail they would be different cities than you would see for student accommodation or business apartments.”

Lehner argues that Germany differs from France and the UK in that the population is not concentrated in a small number of bigger cities. “There are roughly 100 cities that have more than 100,000 inhabitants in Germany and if you analyze them in terms of purchasing power and prospects for the future you can easily select 20-30 cities like

Freiburg, Karlsruhe and Rosenheim that are very strong for retail investments and smaller lot sizes. You can’t invest €100 million there, but you can buy a proper high street building at €10 million-€20 million. If I was an investor who can focus on smaller volumes I would rather invest in that than in a large office building in Warsaw where speculatively built supply could put rents somewhat under pressure, but you need to have the manpower in place to buy and to manage.”

Liquidity remains a potential problem for investors in secondary centers, counters Perin. “There is the risk that when you come to sell you will have fewer candidates to buy. When it comes to international markets people have cities top of the mind. That is why I would continue buying residential in Berlin even though at the moment the yields are very low because there is still growth potential if you buy something that is under-rented. There won’t be the double-digit growth we saw before, but there are still good fundamentals and
you have the liquidity when you exit.”

Demographic and social trends are also favoring the bigger cities, argues Bar. “Talented people from the younger generation want to live in the leading German cities in places where they can also work flexibly, and have access to leisure facilities and amenities. We are seeing companies moving from suburban HQs and back into the city centers where they can offer that ‘live-work-play-learn’ environment.”

None of the participants in this year’s roundtable expect anything to disturb the German market’s smooth progress over the coming year. The horizon is remarkably free of dark clouds beyond the risk of a global geopolitical shock.

The challenge for German managers will remain how to drive returns in a packed marketplace. Some might say, on a relative basis, that is a nice problem to have.