Text: Matthias Pink

2021 was a “year of housing”. Not only did many people spend an unusually high proportion of their time between their own four walls owing to the pandemic, but investors were also more focused than ever on residential property. The transaction volume in the German residential market has exceeded €50bn in the second year of the pandemic. This is double the previous record total from 2015. For the first time, residential property is also the leading sector for investment, way ahead of offices and the other commercial property sectors. This is the, perhaps only provisional, pinnacle of an extraordinary comeback for residential property as a defensive asset class, which began following the global financial crisis (see ”An old flame rekindled. The return of residential property in institutional investors’ portfolios”).

The residential market has been a perfect investment environment since the financial crisis
In our estimation, the rising popularity of residential property among investors is essentially attributable to its bond-like characteristics: stable income and very low default risk combined with low fluctuations in value and high liquidity. With these qualities, residential property has become all the more a substitute for bonds for many risk-averse investors the lower that bond yields have fallen. And bond yields have been in constant decline since the financial crisis. Furthermore, falling bond yields have been accompanied by relatively strong growth in the population and household income as well as very low housing completions. All in all, the German residential market has offered investors almost perfect conditions that are unrivalled in historical comparison (see Table below). The only “stain” on this picture is the increasing intensity of regulation since 2015 at the latest. However, that too has a positive side for risk-averse investors since it tends to increase the scarcity of product in the regulated segments of the market, stabilising rental growth and further reinforcing the bond-like character of residential property.

Hence, if we disregard the regulation, all fundamental factors have been extremely favourable from an owner’s perspective. This has resulted in predominantly double-digit annual total returns, even in the sector with the lowest risk in the German real estate market.

The pandemic has fuelled the attractiveness of residential property
The COVID-19 pandemic has only had an enduring effect on one of the afore-mentioned four fundamental factors: bond yields, which will now remain low for an even longer period. The pandemic has only had a short-term negative impact on population growth since immigration has been lower. This has had practically no effect on housing development and the negative consequences on household income have been largely compensated via government measures such as short-time working benefits. The bottom line is that the COVID-19 pandemic has increased the attractiveness of residential property as an asset class overall and, in that respect, it is only logical that it has not slowed the residential investment market but rather fuelled it. Besides the record transaction volume, another manifestation of this is that we registered more than thirty first-time purchasers in the German residential market between January and October 2021.

Regardless of the pandemic, the phase of perfect conditions is over
While the pandemic has attracted new investors to the German residential market, the phase of perfect fundamental conditions is ending. We consider it extremely improbable that the investment environment will remain as favourable over the coming years as it has been to date. An essential indicator for this is the strong increase in the number of housing completions per year. Since the nadir of less than 160,000 in 2009, this figure has increased to some 300,000. This is at least at the bottom end of the range most experts consider necessary to cover demand. Both the building permit figures and the attempts of politicians to stimulate housing development suggest further growth over the coming years.

While the supply is growing at an increasing rate, however, the opposite is true of demand. Since 2015, population growth has decreased consistently and the Federal Statistical Office is predicting annual population growth of around just 0.1% by 2025. Growth in the number on inhabitants in Germany between 2009 and 2019 was almost four times this amount. Against this background, it is increasingly likely that housing vacancy rates, which have fallen almost without exception over the last 15 years, will increase again over the coming years. When and to what extent this will happen also depends on how much pent-up demand for housing there has been over recent years. It is known that around 8.5 million people are living in over-occupied housing (according to the definition of the European Statistical Office). In addition, there is likely to be a large number of other people who have decided against finding their own home, or a larger one, in recent years owing to the lack of available supply. However, even if resolving this surplus demand pushes back the advent of an increase in vacancies, the supply/demand relationship in the housing market will already change to the detriment of investors ahead of this time.

There could also be a reversal in bond yields looming. In fact, it may have already happened. Yields on 10-year German government bonds reached their lowest level to date on a monthly basis in August 2019 and have not returned to these levels despite some interim declines since the outbreak of the pandemic. Current consensus projections expect yields to rise to approximately 0.8% by 2025. Such a yield projection undoubtedly comes with a high degree of uncertainty. Nevertheless, in view of the expected higher levels of inflation (see also our article “Portfolio optimisation in times of high inflation”) it appears extremely improbable that yields will continue to fall at the same rate as in recent years.

In summary, one of the four fundamental factors, supply growth via housing completions, will almost certainly no longer be as favourable from an investor’s perspective over the coming years as it has been in the years since the financial crisis. The same is also probably true of two other factors, namely population growth and bond yields. Only projected growth in household incomes, the fourth fundamental factor, will remain at the same level as in previous years (see Table 1).

The environment no longer guarantees rising rents and capital values but security remains
We still interpret these conditions as a favourable environment for risk-averse investors. The quasi-guarantee of nationwide rising rents and capital values may well be expiring. However, at least in the growth regions, we expect rents to rise further albeit at a slower rate than previously. The foreseeable more stringent regulation may cap this rental growth but will also remove volatility from the market. Unlike with rents, we see relevant downside risks for capital values. Both lower rental growth expectations and the probable flattening or reversal of the interest rate curve should themselves produce higher initial yields. However, this upward pressure could be offset by a lowering of the risk premium on residential property compared with bonds and, in view of ever-increasing investor interest, we also consider this highly probable at least in the short term. Between now and 2025, we expect initial yields to move in a narrow range from their current level, with breakouts from this range to the upside being more likely than those to the downside. Even in view of these downside risks for capital values residential property will remain an equally secure asset class. However, it may no longer produce the extraordinarily high total returns witnessed in recent years.