By Hagen Ernst, Deputy Head of Research and Portfolio Management at DJE Kapital AG
As a result of the new government's debt policy, German real estate stocks have corrected significantly. This raises the question of whether this is an entry opportunity - or whether a second correction in real estate prices is imminent as a result of further rising interest rates.
There is currently much to suggest that this is a good time to enter the market: transaction volumes stabilized in the fourth quarter, and in some cases even picked up - slight price increases have already been observed for condominiums. However, the new government's extensive debt package for infrastructure and defense led to the sharpest rise in interest rates since reunification. The yield on ten-year German government bonds peaked at three percent and currently stands at 2.7%. Originally, a moderate stabilization of prices on the real estate market was expected this year - in view of the new interest rate level, this scenario now seems unlikely. If interest rates continue to rise, there is even a risk of prices falling again.
Rising rents will offset part of the rise in interest rates. However, if the yield level were to rise above the critical three percent mark on a sustained basis, this could trigger a second downward movement in real estate prices. However, a price collapse similar to the first correction phase - with a fall of around 20 percent - is considered unlikely. Listed residential real estate companies have strengthened their financial position through targeted sales during the crisis. Although the level of debt - measured as loan-to-value (LTV) - is still high, the scope for action is greater today than at the beginning of the correction. Ratings are also not currently in danger.
In addition, the shares of large companies are still trading at high discounts to their net asset value (NTA). Nevertheless, a renewed rise in interest rates above three percent is likely to put further pressure on share prices - especially if this is accompanied by renewed pressure on real estate prices.
Historically high discounts offer long-term potential
Apart from the interest rate problem, however, there is much to be said for residential real estate shares. Unlike many other sectors, they are not affected by US customs policy or a possible recession. There is an acute housing shortage in almost all major cities - vacancy rates are correspondingly low. The current strong rental growth of three to four percent (depending on the region) should remain largely stable even in a weaker economy.
The valuation also speaks in favor of the shares: Following the correction that has already taken place, the discounts to net asset value (NTA) are historically high - in some cases, the discount is over 60 percent. Comparable valuation levels were last seen during the first phase of interest rate normalization. However, the situation was more critical back then: after years of rising real estate prices, a noticeable price correction was imminent and high debt ratios forced many providers to sell extensively in a difficult market environment.
The securities also appear attractive from an earnings valuation perspective: the ratio of price to funds from operations (P/FFO) is currently only ten to 20 - a favorable level from a historical perspective. However, earnings growth is limited: It is true that average rental growth is around four percent, which would mathematically mean around eight percent profit growth with an LTV of just under 50 percent. However, the higher refinancing costs are largely eroding this effect.
Residential real estate remains a highly regulated market - but the environment has recently stabilized.
The Berlin rent cap proved to be ineffective and was ultimately repealed by the Constitutional Court. As a result, the supply of rental apartments in the capital fell by almost 50 % at times - shaking investor confidence for good. Even today, almost every second rental apartment in Berlin is offered furnished - and therefore outside of the regulated rents. This is the highest proportion in Germany.
Added to this are the sharp rise in construction costs and significantly higher interest rates, which have caused a massive slump in new construction: After 294,400 completed apartments in 2023, the number is likely to fall again in 2025 - further exacerbating the already severe housing shortage. According to the Pestel Institute, there is currently a shortage of around 550,000 apartments in Germany. In view of this development, politicians are acting more cautiously. There is currently no discussion of tightening the rent freeze.
Instead, the new federal government is focusing on promoting the construction of new housing. The aim is to speed up planning and approval procedures and to efficiently expand living space through redensification - for example by adding storeys to existing buildings, closing gaps between buildings or using brownfield sites. Building type E, which is intended to enable simplified and more cost-effective construction, is now also to be implemented. Social housing construction is to be strengthened through additional funding.
Debt package and tariffs increase inflation risk
However, no fundamental changes are planned to the regulation of existing rents: The rent freeze is to be extended by four years. The SPD is committed to reducing the rent cap - i.e. the maximum permissible rent increase within three years - from the current 15% to six percent. However, it is unlikely that the CDU/CSU will agree, meaning that the current regulation is likely to remain in place.
Nevertheless, the development of interest rates remains the decisive factor for the market. The announcement of a debt package worth over one trillion euros for infrastructure and defense caused yields on ten-year German government bonds to rise by 30 basis points - a noticeable boost. According to calculations by the German Economic Institute (IW), Germany's debt-to-GDP ratio is likely to rise from the current level of around 63% to around 85% by 2037. In an international comparison, Germany thus remains within the normal range.
However, it remains questionable whether the existing structures - particularly with regard to digitalization and the shortage of skilled workers - will even allow the implementation of such an ambitious investment programme. If the entire volume of the package is actually utilized, this would very likely be inflationary. The introduction of new US tariffs could also cause additional price pressure - here too, an increase in inflation is to be expected.
US tariffs and recession worries - a tailwind for German residential real estate?
The introduction of high tariffs in the USA has significantly increased concerns about a recession. In such a scenario, German residential real estate in particular could benefit. A global decline in inflationary pressure would be likely - and with it a stronger focus by central banks on economic stimulus measures. In the USA, the US Federal Reserve could cut key interest rates significantly more than previously expected. Inflation risks would also fall in Germany, which in turn would suggest a downward trend in interest rates.
German residential real estate shares are considered to be particularly resistant to economic cycles. Even in the event of a noticeable economic slowdown, rental growth should hardly weaken in view of the structural housing shortage. Nevertheless, many investors are currently avoiding real estate shares - out of concern that interest rates will continue to rise. Instead, capital is increasingly flowing into defensive sectors such as telecommunications or utilities.
However, residential real estate is proving more robust than these sectors in particular: while a weaker macroeconomic environment can have a negative impact on utilities in the form of falling electricity prices and in the telecommunications sector due to consumer restraint (e.g. switching to low-cost providers), the cash flows of real estate companies remain comparatively stable.
Conclusion
The price declines in German residential real estate shares as a result of the new debt package and the associated rise in interest rates could prove to be an entry opportunity. In addition to the attractive valuation level - with a discount to net asset value of around 40 % and a P/FFO of around 12 % - the continued strong rental growth of around four percent and a generally stable regulatory environment speak in favor of an investment.
The segment will be particularly interesting in the event of a US recession: falling inflation risks could lead to falling interest rates - a scenario from which German residential real estate shares would benefit in particular. In the short term, however, a further overshooting of interest rates to over three percent is also possible should the inflationary effect of the German debt program and US tariffs prevail. In this case, further price declines cannot be ruled out.
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