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German Real Estate Defies Property Bubble

July 23, 2019

3 min read

Many investors fear real estate markets could be entering bubble territory. But we think the German property market is an exception that offers select opportunities for equity investors in real estate companies and developers.

Pension funds, insurance companies and other institutional investors have been adding to their real estate sector holdings for years, as the sector has been fueled by record low interest rates. In many major global cities, real estate prices have soared to new heights, pushing down rental yields in many markets to record lows.

At the same time, cracks are beginning to appear. The problems of high-street retailers are well known. But risks in some commercial office sectors are also rising. In addition to the traditional uncertainties of the economic cycle, providers of shared work space serving smaller businesses have grabbed market share at the expense of larger tenants with stronger balance sheets. Cash has also flooded into less traditional areas such as accommodation for students and the elderly, as well as healthcare buildings where landlords have less experience through different cycles.

So can investors in European-listed real estate still find opportunities that will generate rewarding performance without excessive exposure to these risks? We think so. The German commercial real estate market still offers attractive opportunities in contrast to most of the rest of the developed world, in our view.

German Office Demand Outstrips Supply

Back in 1989, euphoria following the fall of the Berlin Wall led to a construction boom which increased the supply of office space without a matching rise in demand. More recently there has been less new supply, but a steady increase in demand. As a result, German prime rents, while down 40% in real terms since peaking in 1991, have recently started to rise (Display). Vacancy rates have been falling at an accelerating rate and are likely soon to fall below the crucial 5% hurdle. Meanwhile, the inefficient German planning system imposes a bottleneck on new supply.

Germany Offers Favorable Prime Rental Dynamics

Historical analyses do not guarantee future results.
As of December 31, 2018
Source: CB Richard Ellis and Deutsche Bank

Many German office buildings now need renovation. As this takes place, landlords are often able to secure higher rents. Yet despite the pickup in rents, office rental yields are still falling as strong investor interest pushes property values up at a faster rate. But even prime office rental yields of about 3% are still historically quite high versus long-term Bund yields, which have now fallen to negative territory with 10-year Bunds at –0.4%. As a result, we expect investor demand to stay strong, driving prices higher. Our research suggests that these favorable industry conditions offer compelling opportunities for selective stock pickers.

From Cold War to Hot Property

Take TLG Immobilien, for example, a specialist German office real estate company. It has the highest exposure among listed real estate companies to Berlin, Germany’s fastest-growing rental growth city. TLG is well placed to increase rents as many current leases expire. And it has major development opportunities in Berlin, where numerous central buildings in the east of the city that were constructed during the Cold War will be demolished over time and replaced with much higher quality space. These new commercial buildings will be an even more important part of the portfolio as TLG disposes of noncore assets, especially in the challenged retail sector.

Aroundtown offers a different mix of exposures which our research suggests should support strong return potential. Its primary expertise has been in acquiring and turning around “value-add” buildings in primary business locations; these have historically included buildings with high vacancy rates requiring renovation, buildings sitting on banks’ balance sheets that were repossessed or buildings with difficult tenants or planning issues. With its expertise, Aroundtown typically refurbishes the buildings, usually to much higher environmental standards, and finds clients willing and able to pay much higher rents.

In our view, company-specific opportunities such as these offer investors unusual exposure to superior cash flows, in stocks with valuations that are more attractive than most other defensive sectors of the European equity market.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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