The economic conditions for commercial properties could hardly be better in top locations. The seven largest German cities of Berlin, Dusseldorf, Frankfurt, Hamburg, Cologne, Munich and Stuttgart are registering growth in employment, population and in most cases also tourism. This is creating brisk demand for office space which is now just as scarce as residential space. In retail, however, demand for space is being adversely affected by online shopping. Hence, investor interest in what is ultimately a very limited number of first-class properties available for sale in this segment remains high.
Nevertheless, initial rental yields have come under considerable pressure in response to strong investor interest. Whereas 10 years ago rental yields of around 5 percent were possible, the corresponding rate today is in some cases less than 3 percent. With bond yields falling even faster, the divergence has widened. In 2008, the yield advantage over 10-year German government bonds was around 100 basis points compared with currently almost 270 basis points. Yet this is already noticeably less than in 2015 and 2016 when the yield advantage reached 400 basis points at times. The relative advantage of commercial real estate is dwindling as yields continue to compress, albeit at a meanwhile slower pace, and bond yields rise marginally. However, this has not adversely affected demand for commercial properties. In 2017, just over EUR 30 billion flowed into top locations, more than half of the volume invested throughout Germany. In the first three quarters of 2018, the market share was slightly higher at over 60 percent.
However, a proportional shift can be noted in the asset classes. Demand for office properties that account for around 45 percent, is strong. Demand also remains strong for logistics properties which account for a medium double-digit market share, and for hotels which are positioned in the upper single-digit percentage region. In contrast, preference for retail properties has cooled down, their share having visibly fallen in recent years to only about 20 percent today. This can be attributed to the varying prospects regarding future demand for space and rent development.
Although there is strong demand for office space as a result of employment growth, the construction trend has been subdued in recent years. Above all in Berlin, Munich and Stuttgart, larger office spaces are practically no longer available, with vacancy rates shrinking to 2 percent. This is causing rents to spiral upwards, with increases expected this year of around 4 percent, bringing average rents to more than EUR 30 per square meter for top locations. Next year, growth could be somewhat less due to an increase in new construction activity. From an investor’s viewpoint, the potential for rent increases tempers the disadvantage of low initial rental yields. However, this no longer applies to retail properties. In this segment, rents in prime locations have been stagnating at around EUR 300 per square metre, with retailers demanding less space due to growth in e-commerce sales. The logistics segment, on the other hand, is benefiting from the growing trend towards online shopping, with good rental opportunities being signalled for logistics properties. Hotels are profiting from the flourishing tourism trade, with no signs of occupancy rates deteriorating, despite many new openings.
In view of the scarcity of supply and the continuing influx of new residents, apartments in top locations have the best chances of finding tenants. Within ten years, the population has risen by around 1 million or around 11 percent. Despite the already high rents, annual rent increases of more than 3 percent are realistic while the vacancy risks can be regarded as low. However, prices for apartment buildings have also skyrocketed. Until 2009, the average ratio of purchase prices to annual rents in top locations was quite stable at 16. Today, the ratio has already reached 26. Munich is the most expensive location with a ratio of 34.
With interest rates low, professional investors have practically no other alternative than to invest in commercial properties and apartment buildings if they are to achieve a reasonably adequate return on their capital. If interest rates were significantly higher, the situation would probably be quite different. Today’s low initial rental yields and high purchase price multipliers would then probably come under pressure. A certain degree of protection is offered by simultaneously rising rents which are able to dampen the potential for setbacks. From this perspective, too, retail properties have become less attractive.