German property market: are there signs of a turnaround in commercial property?

 German commercial property has been extremely attractive to investors for some time. It offers a significant yield advantage compared with bonds, while the risks are viewed as manageable in view of the sound economic situation in Germany. At the same time, interest is concentrated on the comparatively small segment of high quality, attractively situated office and retail properties in the seven largest German cities, the top locations. Naturally, there are not too many of them, meaning that the supply for potential tenants and purchasers is limited. The situation is exacerbated for the latter by the fact that owners are reluctant to sell. Although they can achieve substantial prices, they are then confronted with a lack of opportunities to invest the proceeds. Ultimately, the lack of supply meant that investment volume fell by 5% compared with the previous year in 2016 to EUR 53 billion – a figure which was only exceeded in 2015 and 2007.

Because the ratio of supply to demand has increasingly switched from a buyers’ to a sellers’ market for tenants as for purchasers in recent years, yields have fallen to ever new lows, while rents have firmed. In 2016, the initial rental yields for high quality office and retail properties in the top locations was well below 4% – 2 percentage points less than it was ten years ago. Despite the deterioration in yields, two arguments could always be cited so far in favour of investing in property, despite it having become comparatively expensive: apart from the ever increasing gap between property and bonds, whose yields have fallen far more sharply, the trend towards higher rents will allow higher rental income at a later date when office and retail space is let to new tenants.

Just recently, the Fed’s decision on interest rates indicated that bond yields will probably rise, while sustained strong demand from buyers so far means that rental yields can be expected to fall further. As a result, the current substantial gap in yields between commercial properties and bonds is likely to dissipate gradually. In contrast, rents for office space are likely to keep rising. The prospects for retail space in first class positions in city centres and shopping centres are, however, less favourable.

A few years ago, the office markets in top locations were characterised by high vacancy rates. Accordingly, halfway through the last decade, over 10% of office space was empty; in Frankfurt, virtually twice this figure was achieved. This was caused by the surge in new construction as a result of reunification and the dot com hype, while economic activity slowed and the number of office employees fell. Today, the situation has been completely reversed. Following the international financial markets crisis, construction of office buildings slowed significantly while demand for office space has soared as a result of the flourishing labour market. This has led to the vacancy rate for office space halving; in Berlin, Munich and Stuttgart, it fell to only 3% and is still trending downwards. The search for suitable office space is therefore becoming more difficult and moderately higher rents can be achieved. In contrast, sharp rises in rents above the current average of 28 euros per square metre are unlikely, as potential new tenants extend existing tenancy agreements in cases of doubt or switch to alternative space.

In contrast to the somewhat more sedate office market, retail space in the city centre 1A positions have enjoyed a strong upturn; quite unlike secondary locations or smaller cities, where the retail trade has been battling with stagnation and vacancies for some time. However, having risen by approximately 50% on average to almost 300 euros per square metre within ten years, there are also signs of saturation among peak rents. Given that sales in the stationary retail trade only rose by around 6% in this period, it is becoming increasingly difficult to generate higher rents via sales revenue. In contrast, sales in online trade have almost tripled in ten years. And the growth rate in e-commerce is likely to remain buoyant because the range is becoming wider and deliveries faster. With same-day deliveries, which companies like Amazon aim to provide, more and more buyers will wonder whether it is worth trekking to a shopping centre. Nevertheless, shopping trips are likely to remain popular even though shoppers actually buy less. In response, chain stores will demand less space and this space is now finding alternative uses as restaurants or fitness studios. However, for the time being sharp increases in rents seem to be a thing of the past. In contrast, owners of shops may incur higher expenses, as customers and chain stores have become more demanding.

Interest in first class office and retail properties is likely to remain high, which will tend to lead to further falls in rental yields. However, bond yields will firm at the same time, while the potential for increasing rents seems to be exhausted, at least in the retail sector. In view of increasing investment risk with commercial property, a selective approach is advisable; ultimately, the old business saying that profit is to be found in purchasing is also true here.

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