Germany’s office market has become overwhelmingly competitive. Justin Schubert asks whether value can still be found

As a safe haven in the euro-zone, Germany certainly delivers. But what about growth prospects? Europe’s largest economy is attractive as an investment destination due to its robust macro performance and its real estate market with low volatility. But at some point, the desire to find yield must outweigh the desire to find security; as things get tight in the prime office market and the economic turmoil in the euro-zone settles, investors are becoming more and more risk-on.

When the euro crisis broke out, Germany benefited from a surge of ‘flight-to-safety’ capital that underpinned investment volume growth and compression in prime initial yields.
Investors flocked to Germany’s five major cities (Frankfurt, Berlin, Munich, Hamburg, Düsseldorf, Cologne, Stuttgart) and concentrated on prime assets. While the recessionary environment in Europe has hurt German exports (the euro-zone accounts for 40%; EU for 60%), Germany’s commercial real estate market has actually benefited from the currency crisis.

But now the prime segment of the office market has investors packed together like sardines looking for opportunities. It does not help that construction is at a low point, with speculative projects at a rather suppressed level. Indeed, the aftermath of the financial crisis combined and new regulations are leading a number of German open-ended funds (GOEFs) to divest, and banks seem to be easing up on financing requirements (pre-letting rates of around 90% were previously required), which will make more opportunities available. However, these prime properties are trading at low yields, with precious little room for further compression – a large deal in Frankfurt’s CBD traded at 3.57% last year.
With an anticipated increase in interest rates, yields are expected to climb back up again, albeit modestly. This has led many to ask: is it really worth getting into German office now?

While the prime segment might be getting tapped out, German office does indeed still have growth potential. Investors just need to take off their blinders and start looking beyond core prime assets. Some places to look are in metros outside the big five; smaller cities such as Essen and Dresden, or university cities such as Regensburg or Freiburg.
There has been prime yield compression in some of these secondary markets as investors venture beyond the core Städte in search of opportunities.

In fact, one of the country’s largest urban development projects is in the university city of Heidelberg. The Bahnstadt project is comparable to the size of the HafenCity development in Hamburg and will include office space for some 7,000 workers.

But such markets are not without risks. These cities are not poised to benefit as much from the anticipated economic recovery in the rest of Europe as would the larger, more export-focused metros. Moreover, while the German population is growing in big cities, it is diminishing in the rest of the country – a global trend. A recent Frost & Sullivan study concluded that more than 60% of the world population will live in large cities by 2025, propelling them to magnify in size and economic importance. Furthermore, some of the smaller German cities are in the former East, which has yet to match the West’s economic prowess; Leipzig’s economy was actually the worst performer of all German metros in 2012. Still, the small south western city of Bölbingen had the top GDP growth nationwide, beating the big five metros.

For investors pushed out of prime locations and finding secondary markets a bit too risky, the answer is to strike a balance: secondary locations of top markets. An emerging trend is for firms to look beyond the CBD, where they can find larger spaces, cheaper rents, and more efficient floor plans. This idea is particularly attractive, given the currently weaker economic environment that has led to cost cutting.

In Hamburg, companies are moving certain functionalities to back-office locations in the city south (Hammerbrook) submarket, as it is well connected to the more prestigious city centre, where they can keep a location for impressing clients. In Düsseldorf, it’s across the river in the so-called Left-of-Rhine submarket, where Vodafone moved into its new 86,000sqm campus location, consolidating operations under one roof. In Berlin, Mercedes moved to the city east fringe to find larger, more efficient space, leaving its prime office space in Potzdamer Platz. Tax incentives can also play a role, such as in the Eschborn submarket of Frankfurt.

However, these shifts do not mean the death of prime locations. Mercedes’ former office found a tenant quickly, and the Vodafone offices are being backfilled or taken off the market for refurbishment. Firms with smaller size requirements or a desire for a prestigious location still flock to the German CBDs to find space. Nonetheless, occupiers with large space requirements are finding that they, like investors, are being squeezed out of the tight prime market.

Average annual returns through 2017 are forecast to range from 6.8% to 8.3%, just below the PPR Europe average of 8.5%. Strong capital value growth was supported by yield compression in 2011, but is now becoming more income-driven. Still, these returns will be enough to overcome an upcoming increase in government bond rates that will begin to drag down value growth. Sharpe ratios for German cities range from 0.86 to 1.25, compared with the much lower 0.53 for London or 0.33 for Paris, showing that German commercial real estate far outperforms other ‘safe haven’ markets.  

Finding growth opportunities in Germany is, however, still possible, but only for investors who go about it the right way. The prime segment is losing its appeal. It’s overcrowded, expensive, and offers stable, but low returns. Venturing outside the core CBD locations, provides growth prospects as occupiers search for cheaper, larger space and investors search for higher yield and available opportunities.

Returning to the original question: German office, is it worth it?  Jawohl!

Justin Schubert is European market analyst at PPR