Germany’s economic environment continues to be favourable – the economy is on an upswing. In 2006 GDP grew by 2.7% in real terms, the second highest growth rate in the last ten years. Only in the boom year 2000 did German GDP expand faster – by half a percentage point. The economic expansion was again driven by exports. In addition to the boost from external trade, the domestic economy was marked by successful growth. By Tobias Just of Deutsche Bank Research.
For one thing, the introduction of accelerated depreciation stimulated investment in machinery and equipment. For another, the announcement of a VAT increase taking effect early in 2007 motivated some consumers to buy durable goods in advance of the rise. The turnaround was most pronounced in investment in construction, however: after eleven years of recession in the construction sector, the increase in activity in 2006, at just below 3.5% in real terms, came as a surprise.
Will Germany be able to maintain this pace in 2007 and 2008? No, it will not. In these two years, German economic growth will probably be weaker than in 2006, for three reasons.
• First, German consumers are unlikely to shrug off higher taxes and levies and simply save less; the net burden will rise by over EUR 20bn in 2007. This year’s private consumption growth will be slightly weaker than in 2006.
• Second, temporary relaxation of depreciation rules will expire at the end of 2007. The boost from this stimulus will therefore no longer exist in 2008.
• Third, economic expansion in countries absorbing a major share of German exports is likely to weaken.
Nevertheless, the German economy will continue to expand. Against the backdrop described above, we forecast GDP growth of roughly 1.7% in 2007 and 2008. This should be sufficient to make possible an increase in employment in both years.
Turning to the real estate market, demand for German office property is picking up again. All in all, prospects for office property are positive as office markets are strongly correlated with cyclical ups and downs in the economy. In the past, a rise in the weighted average top rents of the seven major German office property markets (Frankfurt am Main, Berlin, Munich, Hamburg, Duesseldorf, Cologne, Stuttgart) only started to kick in when economic growth in Germany reached roughly 1.5% in real terms.
Of course, this rule of thumb simplifies reality in several ways and therefore cannot replace a more complex forecast model. On one hand, this average does not account for regional differences. On the other, the rule of thumb considers only the demand side of the market mechanism.
However, the recent downswing in office property markets shows how massive changes on the supply side may disturb the market balance. A similar development, though, is unlikely to occur in the next four years. By 2010, office space in the seven major German office property markets will probably rise by only 1% p.a. This rate of increase is not even half as big as the long-term average.
The economic expansion thus occurs in a favourable period for office markets. The upswing pushed up orders and was already having positive effects on the job situation last year. Within twelve months, the rate of unemployment fell from roughly 11.5% to below the magical 10% mark, and the German labour force rose by close to 500,000. This favourable development is unlikely to come to a sudden end. The current number of vacancies registered with employment agencies is 40% up on last year’s figure.
The combination of perceptible employment growth and, at the same time, low construction activity will lead to a decline in office vacancy rates and trigger an increase in top rents within the next four years. Vacancy rates in all seven major office markets declined last year, and in five out of the seven cities top rents at the end of 2006 were slightly higher than a year before.
We expect the weighted average vacancy rate of the seven markets to decline by another 2 percentage points by 2010. This does not mean that office space will be in short supply but the upward trend, especially with regard to top rents, looks set to continue. By the end of 2010, top rents will likely be 12% above current levels.
Of course, there are regional differences. While rents will rise by almost 4% p.a. in Munich and by around 3.5% in Hamburg, prices on the office market in Berlin will climb by only close to 1.5% per year as the economic performance of Germany’s capital continues to lag.
In house prices, only a slight increase can be expected. Housing demand is fuelled by the economic upswing, of course. Furthermore, the number of housing completions in 2006 continued to be much lower than the long-term average. What is more, the slight increase in construction demand had already triggered a pick-up in construction prices in 2006.
Slightly stronger income growth, more or less stagnant supply and rising construction prices would usually translate into a substantial increase in housing prices and rents. Fair enough, but only under the condition that there are no major, counteracting factors affecting housing markets. The most important dampener to be reckoned with in the unforeseeable future will be the demographic challenge. According to the Federal Statistical Office, the number of people living in Germany has been declining since 2002, with the downtrend even accelerating. In the last few years, the annual decline in the German population continued, reaching over 100,000 in 2006. This poses a direct burden on the housing markets.
Thus, we need slightly higher income growth than in the past to shoulder the problems of an ageing and declining population in the future. A look back also dampens expectations. In the last 25 years on average, house prices only started to rise when nominal GDP growth reached 2.5%. Although GDP growth will probably exceed this mark in the next few years, one should keep in mind that in the past even nominal growth of 5% led to an increase in housing prices of only around 2%.
All in all, we expect German house prices to climb in the coming years, though only at a pace of 1 to 2% per year. Nevertheless, this would be the first noticeable increase in German house prices since 2002. Substantial regional differences will persist, of course. The simple differential between east and west Germany to which we almost got used is unlikely to remain as clear-cut as in the past, though: not all east German housing markets are necessarily set to fall in value. Nor can all west German markets provide value guarantees.
In conclusion, prospects are reassuring all in all: economic growth is picking up, vacancy rates are coming down, and rents and house prices are rising again. As German rental yields are currently relatively high by west European standards and German REITs (at least for commercial real estate) might provide a new capital-market approach in real estate financing, international investors are unlikely to withdraw from the German market now. They will continue to invest in Germany, with the main focus of investment probably shifting from housing towards office space.
Investors would all be well advised to take an unprejudiced look at east German real estate as well. Of course, this does not apply to all properties. But in many locations, east German top rents for office space and housing have bottomed out. In some cases, prices have even risen slightly. However, rental yields in most east German cities are still considerably higher than in west German cities about the same size with similar rent levels and similarly weak rent increases. So anyone considering investment in German sub-prime locations should always take a closer look at east German locations.
Finally, a cautious warning: currently, people are quick to speak of ‘good times’, ‘time to party’, and ‘the best year’ with regard to real estate. We should not fail to recognise that we are still in the middle of an upswing, but it is only modest. Economic growth in Germany will probably remain only moderate in the next four years.
If, however, too many real estate investors and project developers have too much confidence in Germany’s new economic miracle and believe that another success story is around the corner, there is reason to fear that they will invest a disproportionate amount of money in German real estate. Then, rent increases would not keep pace with price increases, which means that rental yields would come under pressure.
Dr. Tobias Just is Senior Economist at Deutsche Bank Research.
Contact: tobias.just[at]db.com
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