SECTOR FOCUS: RESIDENTIAL Changes being proposed by German politicians, including a ‘rent freeze’ are more than likely to boost the appeal of class-B cities and locations for investors. Ulrich Jacke explains

Germany’s residential properties are coveted goods. And it is a big market; unlike many other european countries,where the entire economy is more or less focused on the nation’s capital, germany has many regional centres, each with its own thriving economy. These places will probably become even more attractive for investors, not least due to the political changes about to happen in the wake of the recent general elections for the Bundestag. The changes include a cap on rent increases in areas with “strained housing markets”. Whenever a housing shortage is officially declared, an owner may not sign new leases at rent rates exceeding the local reference rent by more than 10%. This so-called rent freeze is supposed to be in effect for five years. According to the coalition agreement, the plan will exempt first-time lettings in new buildings and lettings following “comprehensive modernisations”. The keen demand for residential property investments is not about to decline. short supply and sluggish building activity will generally increase rents in highly-sought-after locations. on top of that, the looming rent freeze will definitely motivate landlords to adjust rents in any kind of location. The predictable shift of capital flow to other cities or alternative locations in response to the rent freeze will, moreover, push up rent rates and prices in places where they have been more or less stable. Nonetheless, german residential real estate will remain affordable compared with other countries – if you look at the market as a whole.

Meanwhile, yields in the german metropolitan areas have plummeted, even though overheating is limited to a few micro-markets, such as Berlin’s Mitte district or the Westend district in Frankfurt. These are trendy districts made particularly attractive by positive cultural and social developments. in some cases, the prices quoted for locations of this type, or for particularly popular cities such as Munich, call the profitability of an investment into doubt. Areas with housing shortages where the rent freeze is to be introduced tend to be highly coveted urban districts in leading cities that have been the destination of choice for much of the residential investment capital so far. The planned regulations are more likely to make medium-sized and large class-B cities, including major campus towns, more attractive for investors. However, this goes only for prospering cities with positive or, at least, stable economic and demographic growth. There is a good chance that neither secondary cities nor secondary locations in class-A cities will be affected by the regulation; very few of the so-called middle-order centres will be included in regions with strained rental markets. Then again, while rents in mid-size cities with populations over 100,000 have increased in recent years, purchase prices have often remained flat or grown slightly at best. rental growth is likely to gather momentum now. The planned political action will boost investments in these locations, which was previously motivated by the scant supply in the ‘big seven’ cities more than by anything else. The shift somewhat resembles familiar trends on the stock market. At the outset of a capital-market boom, demand is highest for fast-selling equities of major corporates (the ‘blue chip’ stock). But excess demand causes yield rates to contract relatively quickly. As a result, demand shifts its focus to include attractive investments beyond the major corporates because of superior yields.

Developments in Germany’s residential real estate market is quite similar at the moment. According to a survey by Feri Eurorating services, class-B cities beckon with higher rental yields and stable rental growth – despite possible risks such as lower liquidity, transparency and market strain. For instance, Germany’s ‘motor town’ of Wolfsburg, best known as the domicile of Volkswagen group, lies nowhere near a sought-after city such as Hamburg, Berlin, or Munich. still, rents here rose by nearly 38% over the past five years, according to the 2013 real estate report published by the Immobilienscout24. For the sake of comparison, Munich, one of the top destinations for residential property investments, registered a rental growth of 15% only, and this still exceeds the national average of barely 11%. While it takes an average of just six days to find a new tenant for a flat in Wolfsburg, landlords in Berlin spend twice as long letting theirs.

This suggests that even prospering class-B cities represent eligible destinations for highly attractive investments that are often associated with substantially better risk-reward ratios than prime locations on Germany’s ‘big five’ cities.

A survey compiled by the consultancy firm EY reported that class-B cities have higher rental yields and a more stable rental growth. The reason why initial yield rates in the major cities are often so low is that considerable pressure to invest is matched by very low supply, and future growth potential is already factored into the prices. In many instances, the property yield to be realised already undercuts 4.5%.

Naturally, real estate markets in major cities tend to be more transparent, professional, and liquid than those in smaller cities, which is an advantage when the time comes to conduct due diligence for an investment. Also, bigger markets lend themselves more readily to large-scale commitments because the existing ownership structure is characterised by a high number of large-volume assets and larger flows of capital. For major investors, especially those abroad, this implies a particular advantage. The market presents the opportunity of single deals running in the two or three-digit millions, both when buying and selling. At the same time, it makes the product – unless it represents a portfolio of scattered assets – easier to manage. The alternative of realising a large portfolio by way of several smaller deals is more ambitious. Indeed, to investors who lack a local presence, the option is open only with the help of third-party support. But the sheer size of a deal is no guarantee for scoring the optimal rate of return on the planned investment. For an increasing number of residential property investors, certain class-B cities are more interesting in the long run because of their balanced risk-reward profile. High-quality research, which is now possible even for this type of location, permits comprehensive and reliable analyses that may then be used during the decision-making process concerning the acquisition and the asset management later on. Investors of this kind are often committed in more than one location, and tend to diversify their real estate portfolio. They tend to benefit from a substantially higher profitability than they would get from assets in prime locations, while only being exposed to a comparable or even lower risk. And recent years have shown that even in class-B cities or secondary locations there is plenty of liquidity to realise a successful exit strategy.

To realise the objectives of the investment, it is critical to have a qualified review and ‘correct’ pricing-in of all threats and opportunities of the investment product, as well as the integration of the insights gained into the ongoing property management. In addition to property-specific know-how, this presupposes the necessary knowledge of the respective sub-market.

It should be added that Germany’s class-A cities will lose none of their appeal, even as class-B cities gain in attraction. This is particularly true for Berlin, with its special outlook of a dynamically developing european city. While yield rates here are frequently lower than those earned in mid-size cities, they remain attractive for the time being – at least in certain boroughs. This all boils down to the principle that it is the micro-environment that counts, more so than the macro-environment.

Ulrich Jacke is managing partner of Dr Lübke & Kelber