Market Insights: German Residential Supply Dynamics
Waves of unpredictable demand shocks over the past decade have led to a persistent undersupply of homes in large cities
Background
Economic fundamentals rest on the law of supply and demand. In plain terms, rising prices in periods of excess demand lead to a supply-side response to increase output. This new supply satisfies pent-up demand, clearing the market, and returning it to equilibrium. While this model tends to hold up across most industries in an efficient economy, major urban housing markets across Western Europe can represent an exception to the rule.
By its very nature, housing is price-inelastic to supply. In other words, as demand increases, new supply responds at a slower rate. Building new homes is a time-consuming process. In addition to the construction phase, obtaining suitable land, planning consent, and financing can restrict the speed of development. This market inelasticity to rapidly meet new demand has resulted in a persistent undersupply of homes across many fast-growing cities. The consequence of this in Germany has been rising urban housing density and higher property prices.
Residential Construction Investment in Germany
Percentage of GDP (%), (Q1 1991 – Q2 2022).
Source: QSix analysis; German Federal Statistics Office, Deutsche Bundesbank.
Nevertheless, this is not to imply that there has been a complete market failure. Residential construction investment, as a share of GDP, has risen substantially since the lows of the early 2000s. However, despite this growth, mid-market housing in metropolitan regions remains in short supply. Unpredictable demand shocks, combined with the tightening of mortgage markets, have recently led to lower inventories and a sharp contraction in affordability. In our opinion, these imbalances will support the ongoing growth of the private rental sector, as a proportion of unsatisfied future demand diverts away from the owner-occupied (for-sale) sector.
Residential Demand
At a national level, new housing supply has been responsive to meeting aggregate demand. Between 2012 and 2019, Germany’s population grew by a total of 3.3%, contributing to a 4.4% increase in household formation. This increase was broadly satisfied by a corresponding 4.2% increase in dwellings.
However, dynamics at an urban level couldn’t be more different. For example, over the same period in Berlin, population growth of 8.0% was more than twice the national average rate. This growth increased household formation by 6.4%, disproportionately elevated given the city’s much higher share of single-person households (50%). Despite this increase in demand, the stock of dwellings increased by 4.9%.
Residential Demand
Growth in Population, Households and Dwellings, (2012-2019).
Source: QSix analysis; German Federal Statistics Office, Berlin-Brandenburg Statistics Office. Note: 2012 – 2019 range selected on the basis of available data to enable a like-for-like comparison.
This output gap has led to a structural undersupply of housing, particularly prevalent in large cities. Traditional demand modelling, which considers natural rates of population change and a selection of socio-demographic factors, often fails to fully assess the impact of labour market mobility within the European Union. Germany’s high levels of international migration have occurred in three distinct and unpredictable waves over the past decade. Firstly in the years following the financial crisis, then in 2015, and again during this year.
The scale of this most recent wave was highlighted in latest population data. In June 2022, over 950 thousand more people lived in Germany compared to a year earlier, as a growing number of people arrived in the country from Ukraine. This extraordinary growth, which has outperformed most conventional economic and demographic forecasting, has led to the country’s overall population surpassing 84 million for the first time in history.
These waves of migration create demand shocks within urban rental housing markets. People moving across borders tend to converge toward large cities and rent a home for several years before buying. This convergence occurs due to several factors, not least the significant employment and social opportunities available in large cities.
Residential Supply
During the early nineties, Germany experienced a record increase in housing supply. Over 5.2 million new homes were constructed between 1991–2001 as part of the post-reunification building boom, equivalent to an average rate of 474 thousand per year. This performance contrasted with the subsequent 20-year period when activity fell to an average of 246 thousand per year, resulting in a cumulative output of 4.9 million new homes between 2002 and 2021.
Residential supply has increased in the decade since the financial crisis. Rising house prices, nominal rates of structural vacancy, and a tighter pricing differential between existing stock and the cost to construct new housing have improved the financial economics of development and created an incentive for home builders to raise supply. This combination of factors saw new completions increase from a low of 164 thousand homes in 2010 to 293 thousand homes in 2021.
Residential Supply
Completions and Building Permits Granted, Dwellings (‘000), (1991-2021).
Source: QSix analysis; German Federal Statistics Office, Deutsche Bundesbank.
Notwithstanding this recovery, there was an aggregate construction deficit of 320 thousand homes compared to the official Government target of 1.5 million over the 2018-2021 parliament. Completions are also running materially below the number of building permits granted. Amongst other factors, widespread capacity constraints within the construction industry and a shortage of skilled labour have underpinned this underperformance.
New Build Rent Premium
Increasing housing supply has not necessarily led to lower prices or increased affordability within urban rental markets. Firstly, because a structural deficit in supply relative to demand continues to exist, and secondly, we believe that most new build homes are developed for the for-sale market. We find that what supply does enter the rental market commands a material pricing premium compared to existing homes.
For example, the average rental premium for a new build home across large German cities is 18-38% higher than existing stock. In Berlin, where more than three-quarters of the population rent their home, the average premium is 33%. In Munich, one of the country’s most affluent cities, the rent premium was a much lower 20%. However, given that housing is considerably more expensive there, in nominal terms, the actual premium is likely to be comparable to cities much higher up the scale.1
New Build Rent Premium
Average Rent Premium versus Existing Stock, Asking Rents (%), Q2 2022.
Source: QSix analysis; ImmoWelt Group.
Current Supply-Side Challenges
Developing new residential supply is sensitive to several factors, including the pricing environment. The supply chain and market disruption brought about by the Pandemic has led to an unprecedented increase in residential construction prices. This price pressure represents a significant challenge for an industry focused on generating margin first and foremost, over and above satisfying a demand and supply equilibrium.
In September 2022, year-on-year residential construction cost inflation was 17%, a multiple of 5.7 times the average rate observed between 2012 and 2020. Despite some pressures beginning to show signs of easing (e.g., raw materials), there seems to be little short-term reprieve as other tensions continue to mount (e.g., availability of labour and cost of finance). A further challenge comes from a depreciation in purchasing power, which reduces the value of developers working capital reserves required to finance developments.
In a scenario where consumers absorbed rising costs, developers could maintain output levels. However, the current macroeconomic circumstances don’t allow for this. Scaling back development pipelines or holding production at constant levels is likely to deepen existing imbalances. Given current conditions, developers will likely refrain from increasing the supply of new homes over and above a specific ‘guaranteed’ demand level. This theme could sustain a persistent undersupply of homes in the coming years and consequently support sustained market rent inflation.
Residential Construction Cost Inflation
Annual Change (%), (Q1 2012 – Q3 2022).
Source: QSix analysis; German Federal Statistics Office.
Mortgage Market
Fixed-duration mortgages support housing market price stability. In 2022, 84% of outstanding residential mortgages in Germany were on fixed rate terms of over five years, and 45% had terms of over ten years. The number of mortgages on long-term fixes is considerably higher than in 2003, when the aggregate share was 64%, and only 23% had terms over ten years. A relatively low 10% of mortgages are currently on floating rates.
Long-term financing means that homeowners with existing mortgages are insulated, at least in the interim, from any extraordinary increase in market interest rates. By fixing rates at origination or refinancing, borrowers lock in affordability and are less likely to become distressed due to a change in financing costs.
Fixed Periods on Mortgages
Existing Mortgage Loans, (Q1 2003 – Q2 2022).
Source: QSix analysis; Deutsche Bundesbank.
The current rise in interest rates impacts first-time and new homebuyers the most. The combination of a post-pandemic increase in house prices and an acceleration in financing costs has led to a marked reduction in affordability. Prospective homebuyers who require mortgage finance now need a larger equity deposit and face higher aggregate term-financing charges than pre-pandemic levels.
To illustrate this decline in affordability, an analysis by German mortgage broker Dr. Klein shows that mortgage interest rates have risen from an average of 1% in January this year to 3.83% in October. This rise in borrowing rates means that for a 15-year, €310 thousand mortgage, the term financing cost has more than tripled over the duration of the loan, from €40 thousand to over €140 thousand.2
Mortgage Interest Rates
Existing Mortgage Loans, (Q1 2003 – Q2 2022).
Source: QSix analysis; Deutsche Bundesbank.
While in the short term, increased borrowing costs are likely to reduce buyer sentiment and possibly lead to reduced sales volumes, interest rates remain significantly below their long-term average. As demand fundamentals remain intact, we expect a gradual resumption of activity as the rate environment settles.
As a further support measure, the Government is working on a new funding scheme to provide homebuyers with a low-interest rate loan. This programme will enable market participation for those that have struggled to save for a deposit but have the required level of household income to support monthly mortgage payments. Homes must meet required energy efficiency standards to be eligible for the support. The scheme will be available to access from April 2023.
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. 3
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. ImmoWelt Group, Pricing Research “Neubau vs. Bestandswohnung”, Q2 2022
2. Dr. Klein, interest calculation based on a property value of €400,000, a €310,000 mortgage, 2% amortisation and 15 year fixed rate term, October 2022.
3. Phoenix Spree Deutschland, Financial Statements, 2015 – 2021.
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