Market Insights: The Residential Asset Class
In this edition of our briefing series, we explore some of the defensive characteristics of the residential asset class through the lens of the German multifamily sector
Introduction
Rapid technological progress over the past twenty years has fundamentally altered our relationship with real estate. The internet has been at the forefront of this change. The provision of real-time information has advanced the pricing mechanism and resulted in more ‘perfect’ and ‘efficient’ markets. Increasing broadband penetration has taken things a step further, transforming how we shop and consume entertainment, partially displacing demand for conventional high-street retail, cinemas, and theatres. In other areas, mapping and navigation technology have opened up previously unexplored corners of our continent, creating new sources of economic activity and mobility. And more recently, the Pandemic has accelerated years of progress in remote and hybrid work, changing our once unbreakable relationship with the office.
One common thread running through these themes is the gradual substitution of our time away from traditional commercial real estate segments towards our homes.
As investors, we see these developments as part of a long-term secular transformation of the industry, with the residential sector gaining an increasing share of a growing market for real assets.
A Deep, Growing, and Liquid Asset Class
The World’s Largest Asset Class Real estate is the world’s most valuable asset class, with an estimated market capitalisation of $327 trillion. Residential real estate comprises 79% of the total, representing $259 trillion of assets. The sector far outpaces the aggregate valuation of global financial, equity, and fixed-income instruments combined.1
A Universe of Assets
Estimated Market Capitalisation, 2020, (US$ trillion).
Source: QSix analysis, Savills Global Research.
Rising Levels of Capital Allocation Residential investment provides investors economic exposure to several macro themes, including the long-term transformation of European population and socio-demographics.
Metropolitan housing markets across many Northern and Western European economies are imbalanced, as demand created by urbanisation, population growth, and rising household formation has not been satisfied by a corresponding increase in supply. This undersupply of housing is driving demand for rental homes, which is most noticeable in cities where house prices are rising faster than incomes, reducing home buyer affordability.
Several underlying factors have sustained these imbalances. These include a rise in single-person households, an ageing society, later marriage, labour market mobility, and net migration.
In Germany, the residential sector has continued to attract rising levels of institutional capital. Investment in multifamily housing has increased 52% from an average volume of €15.9 billion per annum between 2013 and 2017 to €24.2 billion per annum between 2018 and 2022.2
Fundamentals Driven Market Selection Disparate maturities across European rental markets offer a broad spectrum of investment possibilities. Our analysis, which has a fundamentals-based focus on market maturity and liquidity, has identified three distinct opportunity sets.
At one end of the spectrum, frontier markets such as Spain and Poland are beginning to see new-build private rent arrive on stream, emerging in pockets around core urban centres. A second grouping contains countries with existing and sometimes fragmented rental markets that are both mature and growing; these include the United Kingdom, the Netherlands, and Sweden. Germany represents the final and perhaps most significant opportunity set. In percentage and nominal terms, the absolute scale of its multifamily sector has led it to attract the highest share of investment capital and demand.
Maturity and Liquidity of European Residential Rental Markets
Rental Share of Total Market, Average Transaction Volumes, and Number of Rental Households. 2017-2022.
Source: QSix analysis, German Federal Statistics Office, Savills Global Research. Note: Estimated number of households in the rented sector (2020), United Kingdom (2018). Savills transaction volume data published in 2022.
Residential Portfolio Characteristics
With capital markets currently focused on elevated inflation levels and the rising cost of capital, we believe there will be a renewed emphasis on asset allocation towards real assets that provide a superior degree of price capture, risk diversification, and sustainable income. Residential multifamily portfolios offer this combination of characteristics and can represent a counterbalance to the overarching macroeconomic headwinds.
Exposure to the Real Economy Residential real estate provides exposure to the real economy at an asset and operational level. A combination of rental income, cash flows, and discount rates (yields) determine asset prices. At the same time, market demand and supply, economic growth, and wages underpin rental values. When the balance of these dynamics remains positive, residential portfolios can mitigate the most corrosive impact of inflation, particularly compared to fixed-income alternatives.
Market Price Capture Real assets allow for inflation capture through a systematic and regular repricing of income. This repricing can occur during tenancies through statutory or contracted rent increases or at reversion (tenant turnover) through a mark-to-market process:-
- Rent Increases In-tenancy rent increases provide investors with long-term organic income growth. Mature and professionally managed residential portfolios typically have a high proportion of modern tenancy agreements that include rent increase formulas, with future rental values increasing annually by an inflation index or predetermined amount. Rent increases for mature tenancies tend to follow statutory rent tables; these commonly rise at a lower rate than market rent inflation.
- Rent Reversion Mark-to-market opportunities on re-letting provide a more material degree of income repricing. As demand and supply imbalances have persisted within urban rental markets, market rents have diverged from average rents for in-place tenancies, even after considering the impact of regular statutory or contractual increases. In Berlin, our experience shows this reversion gap is running at 34%, over three times the current rate of CPI.
For example, during the first half of 2022, Phoenix Spree Deutschland concluded new residential leases at an average price of €13.2 per square meter, compared to €9.8 per square meter for in-place rents across its portfolio of existing tenancies. This difference demonstrates the wide discount to market rents that many mature tenancies enjoy and indicates the scale of embedded value contained within metropolitan focussed residential portfolios.
- Turnover Rates On balance, residential tenancies in Germany tend to have higher turnover rates than commercial leases, consequently providing the opportunity for a relatively more rapid rate of income repricing.
Portfolio Risk Diversification Apartment buildings contain multiple dwellings, which creates a high degree of granularity at a portfolio level. This portfolio fragmentation results in a low absolute concentration of any individual tenancy, providing asset managers with a mitigant against overexposing investment portfolios to a small number of high-value leases. In addition, a relatively low standard deviation in rental values between tenancies also minimises the impact of any single event of non-payment.
These features are meaningful diversifiers of revenue and operational risk and contrast to commercial property portfolios, where larger tenancies tend to dominate, and the risk exposure to individual covenants is often higher.
Sustainable Income In addition to the benefits of portfolio diversification, the multifamily sector also produces sustainable and predictable income streams, an increasingly valuable attribute in the current environment. As well as providing capital for distribution and reinvestment, high levels of recurring cash flow help sustain asset performance and provide liquidity to service amortisation and interest on borrowings.
The Pandemic placed an extreme test on this income durability. Despite a historical shock to household incomes, the sector demonstrated significant resilience through the cycle. Residential rent collection levels were over 90% during the Pandemic’s peak and averaged into the high 90s overall.
Pricing Dislocation
Residential multifamily buildings in large German cities such as Berlin benefit from a substantial degree of market price dislocation, with existing properties valued at a discount to both implied replacement costs and vacant possession value. In addition to providing opportunities for long-term value creation, these embedded disparities also support price stability for existing assets by mitigating downside risk.
Residential Valuation Dispersion in Berlin
Value per Square Metre (€)
Source: QSix analysis, IBB, Gutachterausschuss für Grundstückswerte in Berlin, Phoenix Spree Deutschland, Guthmann. Note: Replacement costs are estimated based on QSix discussions with market participants. Phoenix Spree Deutschland valuation as of 30 June 2022. Realised market values recorded between 1 January 2022 and 16 November 2022. Phoenix Spree Deutschland realised values to 30 June 2022. Current whole of market marketing sales prices as of the quarter to September 2022.
Existing Assets Valued at a Discount to Replacement Costs Our analysis implies that values for existing multifamily buildings in Berlin are approximately 33% below their replacement cost. The average cost to develop a new apartment building in the city is estimated to be €5,750 per square meter, as land and construction costs have risen faster than existing asset values. This development cost compares to the most recent valuation of €4,318 per square meter for properties owned by Phoenix Spree Deutschland, a Berlin residential multifamily Fund managed by QSix.
Widening asset value dispersion between new and existing stock can reduce developer incentives to construct new rental housing. In property markets with high demand and constrained supply, this gap creates pricing power in favour of existing asset owners.
Privatisation of Multifamily Buildings Privatisation of housing stock involves breaking up multifamily rental buildings into individual apartments for onward sale. This model has strong potential where there is a positive pricing differential between the valuation of a single apartment and the sum of the parts of an entire building. For example, in 2022, Phoenix Spree Deutschland sold apartments in Berlin at an average price of €5,257 per square metre. This vacant possession value implies an estimated 22% premium to the average multifamily valuation.
Market-wide across Berlin, apartments sold with vacant possession achieved a 38% premium (including new-build) compared to those sold with tenants in situ. An even wider pricing gap of 55% exists between the current marketing prices of existing apartments relative to those newly-built.
Before selling individual units, buildings may require capital investment to reposition them and maximise terminal sales values. While there are costs involved, privatisation models provide portfolio managers with an additional avenue of growth and optionality, further protecting portfolio valuations against adverse market movements.
In-Place and Market Rent Dispersion At an income level, the pricing differential between in-place and prevailing market rental values also provides portfolios with additional downside mitigation:-
- The implied market rent premium for new tenancies will result in portfolios benefiting from ‘upwards only’ revenue adjustments on reversion, improving revenue sustainability and locking in a source of future income growth.
- In the event that market growth stalls, a portfolio of mature tenancies can sustain rent inflation and income growth by utilising its substantial reserve of unrealised reversion premium embedded within assets.
- In the event of a more significant downturn and a subsequent deterioration of market rents, given the underlying inventory fundamentals, the price dispersion between market and in-place rent levels is likely to only partially close.
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. Savills Global Research, Impacts, September 2021.
2. Savills Germany, Market in Minutes, November 2022.
Note: average transaction volume calculated between October 2013 and October 2022.
3. Phoenix Spree Deutschland, Financial Statements, 2015 – 2021.
IMPORTANT DISCLOSURES:
Please view important disclosures on our website at: https://www.qsix.com/disclaimer/
