Amid the ongoing yield crunch for commercial property in Germany’s core metropolitan markets, mid-sized cities are growing in appeal to a rising number of investors.

Amid the ongoing yield crunch for commercial property in Germany’s core metropolitan markets, mid-sized cities are growing in appeal to a rising number of investors.

In the first nine months of the year, a growing number of investors have re-adjusted their focus on office and retail buildings to prime locations in secondary cities. According to a recent report by Collier's International. 45% of the €19.1 bn that flowed into commercial real estate in Continental Europe's largest economy over the period went into property in top locations in mid-sized cities,

In the seven most prominent German secondary cities - Bonn, Dortmund, Essen, Hanover, Leipzig, Mannheim and Nuremberg - investment volume virtually trebled from €453.1 mln in 2009 to €1.23 bn in 2012, Andreas Trumpp, Head of Research at Colliers International Germany, told PropertyEU. 'And in the first nine months of this year, transaction volume already reached €1.24 bn, exceeding last year’s record figure,' he added.

Since the outbreak of the financial crisis, investors had focussed mostly on core buildings in the six largest cities Berlin, Düsseldorf, Frankfurt, Hamburg, Munich, and Stuttgart. 'As a result, prices have risen higher than rents in the past years, generating increasingly lower yields for investors’ money,' Trumpp said.

According to data compiled by Jones Lang LaSalle, prime office yields in Berlin have tightened from 5.2% in 2010 to 4.8% at the end of the third quarter of this year. In the Frankfurt office market prime yields dropped during the same time span from 5.2% to 4.75%, in Hamburg from 5% to 4.65% and in Munich from 5% to 4.4%. The tightening yields is beginning to curb demand as German bond yields with a 10-year duration have widened this year from 1.31% to more than 2% at the peak.

'Some investors are beginning to question whether core properties in the metropolitan cities still provide a satisfactory upside compared to German government bonds,' said Michael Fenderl, Head of Research at Düsseldorf based Aengevelt Immobilien. More and more investors are saying ‘no’ and turning to mid- sized cities where higher returns can be found. 'Prime yields in Bremen, Dresden, Hanover, Leipzig and Nuremberg currently range between 6.4% to 6.8%, about 200 points above the Big Six,' Fenderl pointed out.

While commercial real estate in sub-prime locations in the big cities may offer similar yields as office and retail property in the best districts of mid-sized cities, they also carry a higher vacancy risk. 'Given the choice of investing in a prime location in a secondary city or in a sub-prime location in a large city, almost every player in the field will opt for the former,' Fenderl said.

A good example of the drive into the secondary locations is the acquisition last September of the Kröpcke Shopping Centre in Hanover by Union Investment Real Estate for its open ended real estate fund UniImmo: Deutschland. The vendor was Düsseldorf-based developer Centrum Group who had refurbished the centre prior to the sale. Even though the parties agreed not to disclose the purchase price, market watchers value the deal at around €180 mln. 'It fits the picture, that this was the largest single deal in the third quarter exceeding in volume every other non-portfolio transaction including those in the big city markets,' said Helge Scheunemann, Head of Research at Jones Lang LaSalle.

For Union Investment the Kröpcke deal is part of a broader strategy. 'With our first investment in Hanover we have taken a further step to diversify the portfolio of the fund across mid-sized German cities,' said Philip La Pierre, Head of Investment Management Europe at Union Investment Real Estate. In 2012, the Hamburg based fund provider already acquired the Shopping Centre Sophienhof in Kiel for its UniImmo: Deutschland fund. Now Union Investment wants to start a spending spree in secondary locations with a new €350 mln fund set up for institutional clients. 'The UniInstitutional German Real Estate will focus primarily on commercial property in mid-sized German cities,' said Fabian Hellbusch, Head of Marketing at Union Investment Real Estate.

Germany's closed-ended real estate fund managers have pioneered the drive into the mid-sized citie. 'They were the early birds, driven by private investors' demand for above-average yields,' said Bernhard Dames, chief analyst at the Rating Agency Scope in Berlin. Quite a few of those deals demonstrate that core quality and attractive yields can indeed be found in mid-tier cities. Take for instance Hannover Leasing. Last year, the Pullach, Munich-based group acquired for one of its funds an office building in Essen for €46.6 mln. It is rented out for 20 years to AOK Rheinland/Hamburg, one of the leading providers of mandatory health insurance in Germany.

Other institutional investors such as pension funds and life insurance companies are following suit. At the end of October, Munich based Real I.S. acquired the barely one- year old Buchholz Galerie shopping centre in Buchholz, Lower Saxony, for a closed- ended fund set up for institutional money. 'The centre will provide steady cash flow over a long period,' said Joachim Fritz, Head of Investment Structuring at Real I.S.

So far, the majority of the deals done in secondary cities revolve around retail property, said Colliers' researcher Trumpp. That is in part due to the lending strategy of larger German banks. While they no longer focus their commercial property business solely on core assets in the big cities, they are still reluctant to extend credit for office acquisitions in smaller cities, leaving those deals to regional savings and loans bans which can provide smaller sums in the low two-digit million range. 'While office buildings in secondary cities are not in our focus, we are willing to finance retail property in demographically and economically prospering mid-tier cities,' said Andreas Pohl, Member of the Board of Managing Director's at Deutsche Hypo.

However, that could change in the future. 'Investors demand for for commercial real estate in mid-sized cities will continue to rise,' predicted Marcus Lemli, CEO of Savills Germany. If banks do not want to miss out on this trend, they may have no choice but to rethink their strategy.