At the close of the year, ‘the decline can no longer be hidden’
By Sara Seddon Kilbinger, Senior Reporter, REFIRE
The deal volume in Germany in the fourth quarter of 2022 plummeted by 41% to the lowest level in 10 years, as investors tightened their purse strings and decided to wait out the economic storm.
There were €66 billion in real estate deals in Germany last year, according to JLL. However, investors have become increasingly skittish since the ECB hiked interest rates by 50 bps in mid-December as inflation remains too high, prompting fears of further rate hikes this year.
‘I think we need to wait until the interest rates have been reached so that market participants don’t expect any more hikes, probably around the 2Q or 3Q this year,’ Dr. Konstantin Kortmann, country leader JLL Germany, told REFIRE. ‘What you do not want to see on the buyer side is buying real estate but after the first six months, you have to revalue the property. That hits you hard. I think the second half of 2023 will be better than the second half of 2022 but will that be mirrored by the transaction volume? It is hard to say. The first quarter of the year is traditionally very quiet, so I expect it to be quiet as in the past 10 years. We do see some transactions going through, such as the mid-cap sector for offices. Resi is being traded. Industrial is pretty fast in the re-pricing process because there is still money to be earned and even retail has never reached a level where you couldn’t pay your debt.’
The fact that the long-term comparison is relatively mild is due to the strong first half of 2022, while the second half was increasingly characterized by restraint and market observation on the part of investors, according to Kortmann. He expects this trend to continue in the first half of 2023 but then to gradually diminish. ‘Market players want to make sure that the interest rate screw slows down again or stalls before they invest,’ he said.
Even Top 7 feeling the strain
At the close of 2022, the volume of investment in commercial properties in Germany’s Top 7 cities totalled around €24.9 billion, a drop of 26% y-on-y and well below the ten-year average of €29.4 billion, according to German Property Partners. Just one sixth – or €4.4 billion - was generated in the fourth quarter, when trading levels are usually high.
German Property Partners spokesman Andreas Rehberg agrees that when interest rates increased, many investors paused active trading and adopted a wait-and-see attitude. ‘Above all when it comes to big-ticket investments, we observe considerable caution,’ he said. ‘Even though more sellers are now prepared to lower the asking price, many potential sales still founder when the parties fail to agree on price.’ In addition, he notes that some properties were withdrawn from the market because there was so little competition: ‘From the second quarter onwards, the market slowed appreciably due to the deteriorating business environment,’ he said. ‘Now, at the close of the year, the decline can no longer be hidden.’
Inflation reminds biggest unknown
The biggest unknown for 2023 is inflation, according to Daniel While, head of research, strategy and sustainability at Primonial REIM: ‘Will it continue to decline as it did in November and December?,’ he said. ‘How will the energy-related component of inflation develop as a result of the ongoing war in Ukraine? And at what level of inflation will the ECB stabilize its key interest rate policy? Most observers expect inflation to plateau. Given the risks to the sustainability of government debt but also private debt and the political risks of a social crisis, we expect interest rate hikes to be rather moderate. The attitude of investors is naturally one of wait-and-see. Before entering the market, they are waiting for a possible decline in valuations to become apparent. The real estate asset class needs to rebuild its risk premium in order to once again be investable and financeable at attractive conditions.’
Alexander Kropf, head of capital markets at Cushman & Wakefield in Berlin, agrees: ‘I think everyone is expecting a pretty quiet first half,’ he told REFIRE: ‘It’s a bit of a crystal ball. We hope that peak inflation is coming down, so that investors can rely on pricing. The volatility is very difficult for everyone at the moment. It’s almost a full-stop to investment, it’s shocking but we expect the market to be more active in the second half. I hope at MIPIM that people start pulling their heads out of the sand.’
Excluding the traditional year-end rally, the fourth quarter of 2022 - with a transaction volume of €13 billion - was roughly on a par with the second quarter, making it the weakest fourth quarter in the past ten years. The last time the market such a low volume was in the fourth quarter of 2012, with €13.6 billion. The largest transaction in the fourth quarter was the acquisition of a stake in S Immo by CPI Property Group,which has now grown to almost 90% and properties in Germany accounted for a transaction value of over €1.2 billion, according to JLL. The second largest transaction was the sale of further parts of the Heidestraße quarter in Berlin by Aggregate Holdings to the Austrian company Imfarr for just under €490 million. In the mid-range segment between €50 million and €100 million, transactions totalled just under €3 billion for the three months from October to December and around €14.2 billion for 2022 as a whole, €1.4 billion less than in the record year of 2021, according to JLL.
As in previous years, the bulk of the transaction volume was driven by German buyers. Nonetheless, six of the seven largest transactions in 2022 as a whole - which together accounted for more than €11 billion – involved foreign buyers.
Yield differential between government bonds and real estate lower than at any time since 2008
And as we enter 2023 with some trepidation, traditional financial investments are increasingly finding favour with institutional investors. In nominal terms, German government bonds have become more attractive than real estate, which has hampered the inflow of capital into the real estate market, especially in the second half of the year, according to JLL. Accordingly, the spread between real estate yields and ten-year government bonds has narrowed to around 0.5 percentage points over the course of 2022; such a low yield differential has not been seen since 2008. By the end of December, however, this spread had risen again to almost 1 percentage point, mainly due to the increase in real estate yields. Nevertheless, it remains to be noted for the 2022 annual balance sheet that significantly less fresh capital was available for real estate investments overall, according to JLL.
Predictably, against such a backdrop, the investment focus is no longer on zero and negative interest rate flight, but on inflation protection and real interest rate hedging. ‘The longer the inflationary environment persists, whereby even 3% to 5% is a lot, the more insurers, pension funds and private investors will deal with the loss of purchasing power and assets and focus on investments that offer the best possible protection against inflation,’ said Jan Eckert, head of Capital Markets JLL DACH. This orientation phase is expected to continue for a few more weeks but as soon as the recalibration of price levels is over, more capital could flow back into real estate: ‘Private capital but also foreign funds have collected a lot of money in 2022 and are ready to invest but are currently still waiting to see whether further corrections will follow,’ Eckert said.
Mistake to wait too long ‘to fish at the bottom of the market’
However, these increased yield expectations do not always materialize: ‘As soon as interest rate and economic expectations improve and long-term interest rates fall, we will see a rapid 'rebound' in yields,’ Eckert said. ‘Waiting too long to fish at the bottom of the market could also be a mistake. In that case, the only way out of the original core capital is to go into a style drift in order to buy the higher yield expectations with higher risks. The 2010 yield rebound in Madrid, for example, took just three months between total illiquidity and pre-crisis levels.’
Nonetheless, the investment fell sharply in some major cities last year. Around €11 billion of deals were transacted in Berlin last year, a fall of 71% y-on-y. However, Berlin's 2021 result was largely shaped by Vonovia's takeover of Deutsche Wohnen. Only Hamburg (€6.3 billion) and Düsseldorf (€2.8 billion) were able to broadly maintain their previous year results.
Portfolio deals have also dropped off significantly, totalling €27.4 billion last year, a drop of 53% y-o-y, according to JLL. At almost €22 billion, most capital was invested in office properties – 33% of the overall German transaction volume. This is followed by the living segment with €14.4 billion euros (22%) Logistics properties accounted for €9.6 billion, increasing their relative share to almost 15%. Retail is on the up, accounting for €9.4 billion (14%), putting them just behind logistics properties and food-anchored specialist stores and supermarkets have retained their reputation as anchors of stability, according to JLL.
In a further sign that the climate is changing and multi-functional properties are becoming more sought after, mixed-use properties had the best quarter on record at the end of 2022, with €2.3 billion of deals transacted in the fourth quarter, taking the total for the year to €6.3 billion. In the current market environment, diversification appears to be an effective means of keeping property-specific risk as low as possible, even for individual transactions.
Yields rise significantly
With the end of the central banks' zero interest rate policy, not only did alternative investment assets become more attractive in 2022 but financing rates also trended significantly upward. The cut-off date comparison of January 3, 2022 and December 30, 2022 shows an increase in five-year swap rates of 319 basis points to a level not recorded since 2008. As a result, it was only a matter of time before real estate yields showed a corresponding movement.
Prime yields in the individual asset classes rose by between 15 basis points for shopping centers and 90 basis points for logistics properties y-o-y. Prime yields for office properties rose by an average of 67 basis points in the Big 7, as well as for specialist retail products (up 40 basis points) and inner-city commercial properties, with an increase of 30 basis points. For offices, a mean of 3.31% marks the first time since the second quarter of 2019 that a ‘3’ has been placed in front of the decimal point. For properties of only average quality in prime locations, initial yields have still risen to 4.22% and for older office properties in B locations with short remaining lease terms, a ‘5’ has appeared in front of the decimal point for the first time since 2018, according to JLL.
However, for now, the market is expected to remain muted: ‘If and when interest rates settle and investors have greater certainty about plans for the future, the market could rally and prices find a new level at some time in the middle of the year,’ Rehberg said. ‘In Hamburg we started to see a growing number of smaller transactions in the fourth quarter driven by investors with deep pockets who benefit from the weak competition. This trend will probably continue in 2023.’ Demand is likely to focus on core properties in central locations that will retain their value well.
Ultimately, the market needs to learn to operate within the new framework conditions, warned Helge Scheunemann, head of research at JLL Germany: ‘The fact is that there will be no return to the zero interest rates of previous years, and the adjustment process cannot proceed without leaving traces in the event of a fourfold increase in financing conditions,’ he said. ‘The decisive factor will be to find a corridor in which margins and capital market interest rates settle and with which investors and developers can reliably calculate.’
