Market Insights: German Residential Performance
The German Residential Asset Class Continues to be Supported by Long Term Fundamentals
Wirtschaftswunder
The German Housing Market produced an exceptional period of post-crisis investment performance. Between 2010 and 2021, residential capital values across the seven largest cities increased at an average rate of 9% per annum, supported by average rent inflation of 5%.1
Relative Performance
This combination of capital and income return has resulted in total performance of 11% per annum over 11 years, far outstripping the 1.4% average annual increase in German consumer price inflation (CPI) over the same period. This growth, in part, was attributable to the residential sector catching up from over two decades of underperformance. While the current macroeconomic backdrop has created a moment of pause as the market recalibrates, we believe that specific characteristics of the residential asset class will continue to produce a defensive source of long-term returns.
German Residential Multifamily Performance
Annual Growth (CAGR), (Q1 2010 – Q1 2022).
Source: QSix analysis; Verband deutscher Pfandbriefbanken (VDP); German Federal Statistics Office.
Risk Premium Relative to Real Interest Rates
Real deposit rates in Germany – after adjusting for inflation – are deeply negative, with a print of minus 7% in the second quarter of this year.2 This negative real yield on cash increases the attractiveness of residential real estate, which can provide enhanced inflation protection through sustainable and proven year-on-year rent (income) growth.
Residential Returns
% Change, Year-on-Year, (Q1 2010 – Q1 2022).
Source: QSix analysis; Verband deutscher Pfandbriefbanken (VDP); German Federal Statistics Office; Deutsche Bundesbank.
A Defensive Asset Class
At a portfolio level, the granular nature of residential tenancies and low absolute revenue concentration provides a critical line of defence to overall performance. This resilience was tested during the Pandemic when the sector consistently recorded robust rent collection rates into the high 90s. Between 2020 and 2021, national data reveals that the proportion of the German population that had residential rent or mortgage arrears was at a relatively low 2.2%.3 Furthermore, high occupancy rates continue to be supported by a structural undersupply of housing in metropolitan centres.
Rising Replacement Costs
Rising land, labour, materials, and construction prices mean that the gap between the cost of delivering new housing relative to the price of existing assets has widened. From a developer’s perspective, higher replacement costs reduce the financial motivation to bring forward new housing, limiting supply and further tilting the market balance in favour of existing assets.
Durable Income Growth
There are three main dynamics that support the German multifamily revenue model. Firstly, many existing residential leases contain contractual rent inflation clauses, creating an organic and underlying source of portfolio rent growth.
Secondly, fundamentals across major German cities have reinforced and sustained market rent inflation. Market rents in Berlin, for example, have risen by 67% since 2012 and 104% since 2004.
Thirdly, rising rents over the past decade have created significant embedded value within assets. Upon re-letting, this value can be crystallised by a “marking to market” process, further supporting a progressive increase in portfolio rental income and cash flow. This market price capture is a valuable feature of the asset class, particularly in inflationary environments, and we explore this in more detail in the following section.
Illustrative Rental Profile of a German Residential Portfolio
Average Rent per Square Meter by Starting Year of Lease
Source: QSix analysis.
Embedded Upside from Reversionary Rent Increases
Many mature German multifamily assets contain a significant degree of embedded rental upside that can be realised over time, independent of any further increase in market rents. This countercyclical feature is valuable to asset owners during periods of short-term economic volatility, where market rent growth may come under pressure.
This embedded upside results from situations where the average rent paid by existing tenants becomes detached from market rents paid by new tenants. This divergence can arise in any given rental market, where prima facie, it is easier to achieve the current market rent when a new tenant moves into a home, compared to asking an existing tenant to pay more. In Germany, several factors can exacerbate this gap:-
1. A structural shortage of housing supply across major German cities has resulted in a period of continuous and robust market rent growth.
2. German residential rental tenancies typically contain a statutory rent increase formula, which has produced a substantially lower rate of rent increase over the past decade than actual market rent inflation.
3. Rent control may limit the maximum rent increase for tenants across many large cities, particularly those facing significant structural supply and demand imbalances.
4. Compared to the United Kingdom, for example, renting a home in Germany is much more prevalent than home ownership and continues well into later life. This fundamental difference means that, on average, German multifamily tenancies tend to have a longer duration, giving rise to a greater degree of embedded value.
The crystallisation of this embedded value usually occurs on tenant turnover. In Germany, our experience suggests that an average of 8-12% of homes will turnover annually. As existing tenants leave, homes can be refurbished to modern standards, enabling re-letting at prevailing (higher) market rates.
This feature allows portfolio managers to enhance the overall rental stream and cash flow generated from a property, sequentially improving operating performance and asset valuations over time.
Rent Inflation Case Study
An analysis of rental data published by Phoenix Spree Deutschland (a Berlin focussed multifamily Fund advised by QSix) shows that between 2012 and H1 2022, the passing rent for the portfolio increased by 48% from €6.60 to €9.80 per square metre. Market rents over the same period increased by 67%, from €7.90 to €13.20 per square metre. This difference implies a market rent differential of 34% in the second half of 2022, as rents achieved for new leases were higher than the average passing rents.
On the income side of total returns, so long as a positive differential between these two metrics persists, a residential portfolio can go on demonstrating organic growth, absent of any further immediate expansion in market rents.
Progression of Portfolio Passing Rent and Re-Letting Rent Achieved
Phoenix Spree Deutschland, Rent per Square Meter, (2012-H1 2022).
Source: QSix analysis; Phoenix Spree Deutschland.
QSix in Germany
QSix has been managing portfolios and advising investment funds in the German residential market since 2006. We have a seasoned investment team with an outstanding track record and understanding of the market and operating environment.
Phoenix Spree Deutschland, our flagship German Residential Fund, achieved a 197% total shareholder return since listing on the London Stock Exchange in 2015.4
We have investment professionals based in London, Berlin, and Amsterdam. We would be delighted to discuss how we might work together with you.
ENDNOTES
1. Verband deutscher Pfandbriefbanken, Multifamily Indices, CAGR, 2021 – 2021.
2. Deutsche Bundesbank, 2022.
3. German Federal Statistics Office, Population in Residential Arrears, 2020-2021.
4. Phoenix Spree Deutschland, Financial Statements, 2015-2021.
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