Is German office still a safe option for investors when taking into account vacancy rates? Erik Marienfeldt provides some answers

As ever, investors consider Germany a safe haven on the European real-estate
market. The investment volume reached in Germany in 2011 is the third highest in the past 10 years, following the two entirely exceptional years of 2006 and 2007.

There are good reasons for the popularity of German real estate with investors: the German economy remains largely unaffected by the turmoil of the global economy and posted robust 3% growth in 2011. The unemployment rate fell to about 3 million, down 0.4% on the previous year.

Investors are focusing particularly on real estate in the prime locations of Germany's major cities. In view of the strong demand, prices in this segment have risen significantly. According to research conducted by real-estate consultants Jones Lang LaSalle, the average first-year prime rate of return on real estate in the top five German real estate locations in the course of 2011 fell by nine basis points from 5.17% to 5.08%.

From an aggregated point of view, the higher price level contrasts with a rising vacancy rate. Currently, about two-thirds of the primary European office locations record a 10% vacancy rate. In Germany's seven largest cities, the average vacancy rate in the period 2003-10 has significantly risen from approximately 3% to 10%. The highest vacancy rates are currently recorded in Frankfurt am Main (13.7%) and Düsseldorf (11.3%). Other Germany prime cities are ranging just below a 10% rate on average.

In view of these conditions, the investor is prompted to wonder whether it is still worthwhile - in terms of return on investment - to invest in prime German office property.

The price increases are already having a negative impact on yield rates: with an average of 10 to 20 basis points, first-year prime rates of return on German office property are currently ranging below the 10-year and the 20-year average. Contrary to the widely held opinion on the market, however, this is not a case of overheating. German top office property still offers an attractive risk-return profile: the current first-year rate of return rate, occasionally even reaching 50 basis points, is still clearly above the level of the boom years preceding the financial crisis in 2007-08. And although the return rates achieved are still lower than a few years ago, they are still very attractive compared with other investment classes with similarly good risk profiles.

For example, if you compare the current rates of return on German government bonds with a 10-year maturity (the classic portfolio value preservation tool) with the gross initial yield on German office property, the latter can even be considered downright cheap. According to Jones Lang LaSalle, the prime first-year rate of return in the seven top German cities in the first quarter of 2012 was approximately 4.91%. By contrast, the interest rate for German government bonds with a 10-year maturity during the same period of time was below 2% - a spread of almost 280 basis points in favour of the prime first-year rates of return. Proceeding from the average of the total year of 2011, said spread is approximately 150 basis points above the long-term average value since 1997.

This is not a new development. Since 2000 the prime initial yield on German office properties has remained relatively stable across the entire period; the return on government bonds, however, has been falling steadily, and they have consequently been becoming more expensive. At the same time, even bonds with a medium-term maturity range at the same level as the expected inflation rate, while the real interest rate of the capital markets takes a negative turn.

Likewise, compared with other European locations, the spread of the top seven German cities offers attractive propositions by all means. For example, the gap between the prime first-year rates of return on real estate and the rates of return on 10-year government bonds in London and Paris is at a similar level to that in Germany.

A contrasting development can be observed in Milan and Lisbon. While the spread in Milan is minimally negative, Lisbon's prime rates of return on offices, at less than 8%, clearly range below the 12%-plus yields on national 10-year government bonds.

A preliminary conclusion: compared with investment alternatives on the capital market, German office property is a comparatively good bargain. But the question is: can it - taking into account the high vacancy rates - still be considered a safe investment option for investors who have high standards in terms of risk?

A more differentiated analysis shows that real estate in peripheral German locations is affected by vacancy. We conducted our own research at HIH and found that in the A-locations in Germany's prime cities, vacancy rates will tend to fall in the coming years. The reason is the steadily increasing demand for high-quality office spaces and a decline in new construction projects.

For example, the yield on floor space increased in the nine most important German office locations - Berlin, Düsseldorf, Frankfurt am Main, Hamburg, Cologne, Munich, Stuttgart, Leipzig and Essen - by almost 20% in 2011 compared with the previous year, generating one of the highest rental turnovers ever recorded in Germany.

An important indicator for the development of the structural demand for floor space is a rise in office employment. This is currently occurring in Europe, particularly in German locations. Since 1996, an increase in the relative proportion of office employees has been observed. The trend will continue, according to a forecast by the regional data base empirica.

Although the surveys of the German Statistic Office show that the population will steadily decline in Germany, this does not apply to the top five cities - Hamburg, Munich, Berlin, Düsseldorf, and Frankfurt. According to forecasts, the total population in these cities will continue to grow. This is because of the increasing internal migration trend in the direction of economically and culturally attractive metropolitan areas.

Moreover, the number of office employees in the major German cities will continue to grow because of the continuing sectoral shift of the economy's structure towards a services-based economy, over the next 10 years. Neither part-time nor job-sharing models have led to a decline of office spaces in relation to the number of employees.

This growing demand faces a marginally extended offer. This is largely because of difficult real estate financing conditions resulting from the stricter regulatory legislation imposed on capital markets as a result of which only a few speculative project developments are carried out.

According to HIH forecasts, the supply of spaces will subsequently develop in a lateral direction. In the 1a locations of the cities mentioned, HIH even predicts a slight decline in
the available supply. While the supply of new spaces in prime locations has ranged around 30,000sq m a year on average since 2000, HIH predicts that by 2015 no more than an additional 16,000sq m a year will be newly available.

Taking into account the financial crisis in Europe, the downward trend of alternative capital markets yields and sustained strong fundamental general conditions in Germany, direct or indirect investment in prime German office property remains a potential alternative for stabilising a portfolio.

Erik Marienfeldt is managing director at HIH Hamburgische Immobilien Handlung