Is German real estate facing a Brexit-style loss of confidence?
Looking at Germany through an international investor’s lens is starting to feel a lot like looking at the UK in the years immediately after the Brexit referendum result. While there is no doubt that both the German property market and economies are facing challenges, we believe that these challenges are predominantly short-term and cyclical rather than long-term and structural as some bears are suggesting.
In this article, we focus on the factors that made Germany an attractive destination for cross-border property investors in the past, and then assess whether these factors have fundamentally changed post-Covid.
Large, liquid and stable
Germany has for decades vied with the UK to be the largest and most liquid commercial property market in Europe. Indeed, according to Real Capital Analytics (RCA), Germany has been either the first or second largest European market by investment volume for all of the last 18 years (including 2024), and there is no reason to suggest that this will change anytime soon.
The main other reason why Germany has consistently been popular with investors is its lack of volatility. The high degree of institutional ownership of German commercial property assets ensures a high degree of professionalism in the management and analysis of those assets. Furthermore, the generally stable nature of the German economy and the institutional time horizons that are common in the market mean that returns have historically been less volatile than in some competing markets. This will continue to be supported by the decentralised structure of the economy and population.
On a simple comparison of the MSCI All Property Total Return for each country, these attractions are apparent, with Germany delivering a less volatile 5.0% per annum (pa) compared to the UK’s 5.7% pa.
So, if the attraction of Germany as an investment destination was its size and performance – what has changed that is leading investors and commentators to suggest that some kind of structural change is underway?
Are commentators turning short-term problems into long-term ones, and is Germany really facing its own unique challenges?
The spur to write this piece came from reading a blog by the IMF that started with the comment that “Germany is struggling. It was the only G7 economy to shrink last year and set to be the group’s slowest growing economy again this year”. None of this statement is incorrect, with both the UK and France showing stronger GDP growth coming out of the Covid period. However, in our opinion, this is down to challenges that fall firmly into the ‘short-term’ box rather than any fundamental structural change.
The first cause, which has pretty much disappeared already, was the Russian invasion of Ukraine and its subsequent impact on the price of natural gas. A common theme amongst those who feel that Germany is facing structural change is the economy’s perceived bias toward energy-intensive industries (actually only 4% of GDP). However, the surge in inflation that came with energy price rises has now reversed, and ECB monetary policy has changed to reflect this.
The second reason why the German economy has underperformed its peers in 2023 and 2024 is that as an export-orientated economy, any weakness in global demand for goods has a larger impact on Germany than it does on a service-orientated economy like the UK. Again, while there is no doubt that China’s medium-term growth prospects are weaker than they have been over the last 20 years, growth will recover. The same is true for all of Germany’s export partners, and the beginnings of a recovery can be seen in Germany’s latest industrial output number, which was the strongest since February 2023.
Our thesis is that both of the factors which have dragged the strongest on the German economy are purely cyclical, and their impact is already diminishing. This begs the question of whether there are any uniquely German structural challenges to be concerned about.
Which is worse – borrowing too much or not borrowing enough?
As Europe emerges from the twin shocks of Covid and Ukraine, most governments are struggling with how to balance the budget and pay down the extra debt that has been built up over this turbulent period. This question has recently been a major one in a variety of elections, budgets and periods of civil disturbance, and it is unlikely to go away soon.
As the chart below shows, Germany has the lowest debt-to-GDP ratio of any of the G7 countries by quite a significant degree. How can this be a bad thing for Germany when its peers will be having to make difficult and contentious decisions around cutting spending or raising taxes?
The most common alternative view is that Germany’s stricter fiscal rules (the so-called debt brake) will constrain domestic investment demand. In pure growth terms, this is a valid comment, and demographic change in Germany (in particular, a rising pension burden) will probably mean that these rules will have to be relaxed in the future. However, returning to one of the key reasons why property investors have liked Germany in the past – its comparative lack of volatility – we believe that the lesser policy stress implied by the lower debt-to-GDP ratio is a good thing.
An interesting side effect of the debt brake that could affect property investors is that in the past, the huge surplus of private savings that has been built up in Germany has been predominantly invested abroad. Some of this money has ended up in non-German property markets and could, in the future, return home to be spent on property or infrastructure.
It certainly makes little sense for a country with such a strong credit rating to be leaking money that could be invested within its own borders, just because of a historically prudent attitude to debt.
Germany is also often singled out as facing an additional challenge from an ageing and ultimately declining working-age population. However, this is not a challenge unique to Germany, with all the G7 countries seeing similarly rising age dependency ratios. Indeed, even China is likely to be challenged by this over the next decade. So, while this is another factor that will contribute to slower global GDP growth over the next ten to twenty years, it is not an area in which Germany stands out as comparatively more exposed than similar markets that real estate investors might be considering. Nor indeed is it likely to reduce the overall demand for real estate.
Is there anything fundamentally different going on in Germany’s commercial property markets, and does the lack of price discovery limit the scale of the recovery?
The current state of both the occupational and investment markets in Germany is broadly typical of those of the rest of Western Europe, with leasing activity down on trend as we would expect in a period of weak economic growth, and yields still rising on the back of the rising cost of money.
Some of the main German office markets stand out as having both lower vacancy rates and more restrained development pipelines than many other European markets, and this is delivering positive prime rental growth in a period when typically rents would be expected to fall.
All of the world’s major real estate investment markets have been negatively impacted by the surge in borrowing costs that was seen post-Covid, and Germany is no exception. In previous cycles, Germany has been accused of being less willing to mark to market in times of falling values, but in the latest downturn, this was not the case, with German yields rising from Q1 2022, exactly the same time as those in London and Paris.
Germany has however seen a larger fall in investment activity, with the transaction volumes in the first half of 2024 being 52% lower than the first half of 2019 (France -43%, Europe -32%).
According to Savills latest office value analysis that compares the market yield with a calculated fundamental pricing model yield, Munich and Berlin office yields are now looking cheap and Hamburg and Frankfurt are in fair-value territory. Assuming that rental growth is sustained and the ECB continues to lower the repo rate, then Germany (in common with most of Europe) will start to see yield hardening on prime assets in particular in 2025.
What do investors want, and can Germany provide it?
There is no doubt that Germany is, and will remain, one of the two largest real estate markets in Europe, but where does it stand in terms of offering liquidity in the sectors that global investors are currently targeting?
A common refrain amongst opportunistic investors across Europe is that there is a ‘lack of stock on the market’, which broadly translates into ‘there’s a lack of stock available at a price that I want to pay’. In Germany, discounts are available across all sectors, though in percentage terms they are generally less significant than those on offer in markets such as the UK where prices fell further.
Core and value-add investors are more likely to be focusing on income, and in particular income that is coming from sectors where there is a conviction that structural change is moving in favour of that sector. Logistics, Life Sciences and Living are perpetually being cited as the top targets for investors in 2024 and beyond, and Germany has the largest investible stock of two out of three of these sought-after sectors.
On the logistics front, Germany typically accounts for 24% of European leasing activity and exceeds the next most active market by more than 20%. Average annual logistics take-up in Germany is typically double that of the UK over the last decade.
A similar story prevails in the multi-family housing sector, with RCA data on investment activity ranking Germany as the most active European market over the last decade by a considerable degree (€19bn pa vs the UK at €9bn pa).
Opportunistic opportunities might be more limited in Germany than some other markets at the moment, but for a Core investor, there is still the chance to buy prime assets at yields that are 150 or more basis points higher than they were in 2021/22.
Berlin, Germany @kadrafoto
Conclusions
There is no doubt that the German economy has recently underperformed, but we believe that this is due to cyclical rather than structural issues. Medium-term growth is expected to be weaker than we have been used to in the past, but this is far from unique regionally or globally. Also, the challenges around an ageing population and the costs of decarbonising an economy are pretty common across most of Europe.
From a property investor’s point of view, the fact that GDP growth is going to be weaker doesn’t really single Germany out as more risky than much of the rest of Europe. Furthermore, non-domestic investors in the past have been attracted to Germany by its lack of volatility, so the outlook should not change this.
Finally, for income-focused investors who are looking to get invested into either European logistics or multifamily housing, Germany is by far the largest market in Europe, and that alone probably makes it impossible to ignore.
Of course in real estate investing confidence can be the most important differentiator, which is why the comparison between some of the commentary on Germany and that on the UK post-Brexit is a valid one. The UK was perceived as higher risk than Germany in the 2016–2019 period, and thus saw less investment and yield hardening. However, the actual performance over that period was far better than many pundits had suggested it would be. It is perfectly possible that the investment community could convince itself that Germany is now comparatively higher risk than the UK or France, and then invest accordingly. However, there is little evidence that this is true and ignoring such a dominant market would severely limit the ability to deploy capital into sought-after sectors with solid returns.