By Hagen Ernst, Deputy Head of Research DJE Kapital AG
Light at the end of the tunnel?
With inflation easing, a recovery of German equitites of the residential real estate sector is possible. Certainly, the interest rate turnaround at the ECB will still take time, but the increase of key interest rates are beginning to take effect. The easing of energy costs is also having a supportive effect. In this environment a 30 percent correction of real estate prices anticipated by the market seems exaggerated, especially as the housing shortage continues to worsen. New construction should remain at a very low level in the coming years, while the influx of refugees from Ukraine is continuing at record levels.
German residential real estate stocks under pressure
German shares from the residential real estate sector came under heavy pressure last year. The main burdening factor was the rise of interest rates. Yields on ten-year German government bonds - still negative at the beginning of the year - rose to 2.5 percent and are currently trading at 2.2 percent. The interest costs for a ten-year mortgage loan are therefore currently between 3.5 and four percent. The fact that property prices have risen more strongly than rents for many years has also had a negative impact. Accordingly, yields in the net portfolio of listed residential real estate holdings have fallen to between three and four percent. Financing costs are still well below two percent (LEG 1.26 percent; TAG 1.62 percent; Vonovia 1.3 percent) and also have a relatively long duration (LEG 6.8 years, TAG 5 years, Vonovia 7.5 years). However, if interest rates were to remain at the high level or even rise, they would be similar to the portfolio returns.
Falling real estate prices seem inevitable. Although the debt ratios are currently still moderate (portfolio loan-to-value ratio at 42 percent for LEG, 45 percent for TAG, 43 percent for Vonovia), these will also rise with portfolio devaluations. The real estate market already tipped last year. The supply of real estate is significantly higher than the demand: the leading real estate portal Immoscout24 recorded a 49 percent increase in advertisements for sale in 2022 compared to previous year. In addition the gap between the asking prices of sellers and buyers is widening significantly.
Signs of a turnaround in real estate stocks are increasing
As early as the second half of 2022 there were also price declines again in some regions for the first time. Experts expect prices to fall by five to ten percent this year. Nevertheless, there are increasing signs of a turnaround in real estate stocks. Although inflation remains at a high level in both the USA and Europe, it has been falling for several months, particularly in the USA. Core inflation in the USA - excluding food and energy - fell to 5.7 percent in December. In Germany, core inflation has remained stable at five percent since October (slight increase in December to 5.2 percent). It will certainly take time for the interest rate turnaround to be initiated in the U.S. and later at the ECB, but the rate hikes are having an effect and inflation is easing. An interest rate turnaround in the course of the second half of the year therefore seems possible. Accordingly, there has recently been a recovery in real estate stocks worldwide. German residential real estate stocks in particular, which had fallen sharply, were able to benefit from the easing inflation and the hope of an interest rate turnaround in the near future.
Despite recovery, share valuations are still very low
The discounts of the shares to the net tangible asset (NTA) value remain very high (at LEG 55 percent of the NTA, at TAG 64 percent, at Vonovia 57 percent). In other words, the market is still anticipating valuation adjustments of 25 to 30 percent on the corresponding residential portfolios of the listed companies. However, this could turn out to be exaggerated. There is much to suggest that the expert estimates of a price decline of five to ten percent are more likely to be accurate. Dr. Gesa Crockford, Managing Director of Immoscout24, does not even expect a sustained fall in prices and believes that it is more likely to be a price correction of short duration. She expects supply to tighten again in the medium term. Seasonally adjusted, demand for buy-to-let properties appears to have bottomed out in Q3 2022. In Q4 2022 demand was already rising again in four of the five largest cities (the only exception being Cologne). However, it is also quite possible that experts are underestimating the interest rate effect or that the market is overestimating it and the truth lies somewhere in between (for example 20 percent). Ultimately, a stabilization in the interest rate environment is likely to be the decisive factor in stabilizing the real estate market.
German new construction activity clearly declining
The main argument for only a moderate decline in demand is an unprecedented housing shortage. There is currently a shortage of more than 700,000 apartments. Finding housing is difficult, especially in sought-after urban centers and fewer and fewer apartments are being built. Rising interest rates and construction costs (currently up 17 percent) have led to a slump in new construction projects. In 2022 the German government's new construction target of 400,000 apartments was clearly missed. The Ifo Institute assumes 290,000. According to the institute new construction of 200,000 to 250,000 apartments is a realistic figure for 2023 and the coming years. The low point could be reached in 2024. An additional complicating factor is that around 18 to 24 months elapse between the start of a project and its completion. This means that even if more new construction projects are started now the housing shortage is not expected to ease until 2025 at the earliest. In addition there has been a rapid increase in immigration as a result of the war in Ukraine. With net immigration of more than 1.3 million people by October 2022 according to the Federal Statistical Office, including 860,000 from Ukraine alone, this is already more than during the refugee crisis in 2015. Although the rental market in Germany is highly regulated pressure on rents is also increasing.
For example, according to an analysis by the Institute of the German Economy (IW), rental growth for new leases accelerated to 5.8 percent in Q3, or to 4.1 percent in Q4, according to Immoscout. However, as the rent index is based on a six-year observation period, it will take time for housing companies to benefit from the higher rental growth. In addition to the housing shortage, higher construction costs (currently up 17 percent and falling) are having a stabilizing effect on property prices. Fewer new buildings and a greater price differential between new and existing properties play a key role in this context. The main argument for falling real estate prices is the low net yields on the portfolios of existing owners (between three and four percent) compared with the current rise in interest rates (between 3.5 and four percent for a ten-year refinancing). However, it must also be taken into account that portfolio rents only adjust very slowly to market rents. Currently, the net rents of the listed housing companies are 20 to 30 percent below market rents (LEG with a focus on North Rhine-Westphalia at 6.3 euros/sqm, TAG with B-cities and eastern Germany at 5.7 euros/sqm and Vonovia with conurbations and Berlin at 7.5 euros/sqm due to the Deutsche Wohnen takeover). In terms of market rent levels rental yields would be closer to five percent. Extreme price declines have also been rare in the past. Only during the U.S. subprime crisis in 2008 and the Japanese housing bubble in 1990 were price declines of more than 20 percent recorded.
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