Key Takeaways
- Rent growth in Germany has been robust in 2023 and the first quarter of 2024, in line with our expectations, and should outperform our inflation forecast over 2024-2025. However, rent regulations and low tenant turnover will continue capping companies' capacity to increase their rents significantly beyond indexation.
- We assume the valuations of German residential real estate investment companies will decrease further this year, resulting in a peak-to-trough decline of close to 20%. House prices could also bottom out this year.
- Improved earnings prospects will help German banks absorb higher credit losses from commercial real estate (CRE) lending. We expect that the portfolio quality in residential real estate will be robust and that banks with sufficient capital and liquidity buffers will expand lending if demand for real estate financing picks up again.
- Even though higher cost of debt will continue to weigh on REITs' credit ratios and modernization capital expenditure (capex), we expect most issuers will see interest coverage and loan-to-value ratios bottom out this year.
Rent Growth Will Outpace Inflation
We expect consumer price index (CPI) inflation in Germany will reach 2.7% in 2024 and 2.2% in 2025. The intensifying housing shortage, which is exacerbated by the sharp decrease in new constructions since 2022 (see chart 1), combined with rising rent index levels, will support rental growth in Germany at least over the next two years.
Chart 1
Low tenant churn and regulatory limitations weigh on maximizing rent growth
Tenants in Germany tend to stay in properties longer, particularly since ownership affordability is dented by higher mortgage rates and stock availability is scarce. Tenant fluctuation is therefore low and currently stands at about 5% in Berlin, compared with more than 8% in 2010, according to market data. This reduces opportunities for landlords to increase rents to market levels. As a result, the gap between in-place rents and market rents widens, which increases a theoretical rent upside potential. Regulations to curb rent increases, including Germany's rent brake (Mietpreisbremse), cap our like-for-like rent growth assumptions at 3%-4% over 2024-2025. The German government recently announced that it will extend the Mietpreisbremse until 2029, instead of 2025. This means re-leasing rents in densely populated areas, such as Berlin, Hamburg, Munich, or Frankfurt, will remain limited at a maximum of 10% above the local rent index. Overall, we do not expect that the law extension will add liability risks or downward rent adjustments. This is because real estate investment trusts' (REITs') in-place rents tend to be below current market levels (see chart 2) and the portion of leases that can be released annually is less than 10%.
Rent Brake With Exceptions
The Mietpreisbremse does not apply to new builds that were first let after 2014 and properties where the tenancy agreement was signed before the law came into effect. In addition, modernization capex and CPI inflation-linked rents--even though the latter only account for a very small portion of tenancy agreements among rated issuers--enable landlords to adjust rents more freely.
Chart 2
Residential REITs' Valuations Will Stabilize
Rated companies' reported third-party real estate valuations have declined by an average of 15.6% since June 30, 2022 (see chart 3). The decline--which exceeded our initial assumption of 10%, published in February 2023--corresponded to a net initial yield expansion of 43 basis points (bps) to an average of 3.53% and a decline in the gross rent multiplier by four points to an average of 23.6. According to market research by Savills, the prime net initial yield for multi-family properties was 3.6% at the end of the first quarter of 2024 and remained stable for the second quarter in a row. In our view, valuations could decline by another 5% by mid-year 2024 because large-scale transaction activities remain subdued. Even though this is not our base-case scenario, we expect any further tightening of regulations could delay the recovery of the investment market. Moreover, companies' reported yields increased. Yet some yields remain close to 10-year German government bond yields, which is used by property appraisers as risk-free rate and which we expect will remain at about 2.50% over 2024-2025.
Chart 3
Bund yields' stabilization is an important catalyst
A stable risk-free rate could stabilize property yields toward year-end 2024. All rated companies operating in the German residential real estate market experienced a homogeneous value correction but their yields still differ slightly (see chart 4). We believe these variations result from differences in asset quality (renovated or not), asset mix (size, number of bedrooms, type of lease indexation), geographies (for example, yields in Berlin are significantly lower than in Nuremberg), and micro localizations (central or highly sought-after areas versus others). As a result, rated companies' average rent per square meter ranges from €5.70 to €8.50 (see chart 5).
Chart 4
Chart 5
Transactions should rebound
Large transactions are still muted (chart 6). We continue to expect that transaction activity will gradually increase this year because the tightening bid-ask spread will provide more robust benchmark data to third-party property appraisers. We think municipalities or government-related buyers could play a role in the market recovery, as evidenced by recent purchases. Among others, HOWOGE (A/Stable/A-1), which is owned by Berlin's city government, bought large German residential asset portfolios from Vonovia SE (BBB+/Stable/A-2) for €700 million, while French state-owned CDC Investissement Immobilier purchased significant German residential asset portfolios from Covivio (BBB+/Stable/A-2) for €274 million. Since 2023, investments in residential portfolios appear increasingly concentrated on large cities, particularly Berlin, despite its lower yields. The capital city attracted 52% of large investments in Germany in the first quarter of 2024, versus a long-term average of 26%, according to research by BNP Paribas.
Chart 6
The Correction In House Prices Could Be Almost Over
After continuous prices increase over more than a decade, the German residential market faced a significant price correction over 2022-2023. Overall, prices decreased by 7.1% year over year at year-end 2023, from 3.6% at year-end 2022. This correction followed a period of above-average price increases after the COVID-19-related crisis and was triggered by the rise in interest rates. Prices decreased for new builds and existing homes but the decline was less pronounced for new builds (see chart 7). We believe the sharp increase in heating and electricity prices--for example, the retail price of gas in Germany exceeds the European average by 19%--may have contributed to the price trend for existing houses, which tend to be less energy-efficient than new builds. The absence of a significant decrease in construction costs could explain the resilient price of new builds.
Chart 7
The situation may be stabilizing
We expect the price correction in the German residential housing market will continue at a slower pace this year, with a year-on-year decrease in residential prices of 1%, compared with the fourth quarter of 2023. Prices in the fourth quarter of 2023 declined by 7.1%, which exceeded our expectation of 5.4%. Unemployment rate is slightly increasing and interest rates remain elevated, but structural demand remains high in Germany and we expect the European Central Bank will start to cut rates soon. We expect that the price correction will soften and that the evolution of house prices will turn positive in 2025.
German Banks Will Continue To Provide Stability To The Real Estate Market
The sharp slowdown in mortgage origination is a missed opportunity for German banks
The subdued demand for real estate financing in Germany has limited domestic banks' potential to benefit fully from the rise in mortgage interest rates. The association of German Pfandbrief banks reported that its members' new commitments for residential real estate loans--including single-family homes, apartments, and multi-family housing--declined by 36% in 2023, compared with 2022. In our view, this reduction in mortgage origination is primarily an intended effect of the ECB's tighter monetary policy and aims to dampen loan demand. We do not consider it a sign of a disorderly credit crunch triggered by banks. That said, German banks did somewhat tighten their lending standards, also reflecting the deterioration in the economic outlook since 2022 (see chart 8). Overall, the amount of outstanding residential mortgages remained largely stable throughout 2023 as bank customers increasingly decided against early repayments in a higher interest rate environment. This stabilizes banks' loan portfolios but has no positive effect on mortgage portfolio margins.
Chart 8
Outlook for mortgage credit losses remains benign
So far, the drop in house prices has not affected the quality of German banks' mortgage books. As of year-end 2023, systemic German banks' nonperforming loan (NPL) ratios on mortgage loans was still at a low 0.7%, meaning it remained flat year over year. We expect banks' credit losses from residential mortgages will remain low. This is based on our expectation of a robust German labor market, whose deterioration would be a key risk for credit losses. Additionally, the dominance of long-term mortgage financing in Germany, often with tenors above 10 years, limits the negative effect of rising interest rates on debt affordability (see chart 9). Even in the event of stress at the borrower level, we do not expect significant credit losses. This is because of banks' solid collateral buffers following the sharp rise in house prices through 2021 and the regulatory requirement to amortize loans after origination, which also mitigates refinancing risks. The picture is different for CRE, although we believe German banks are well positioned to handle mounting credit pressures in this segment.
Chart 9
German Banks Can Handle CRE Pressure
Large German banks, whose CRE exposure is among the highest in Europe (see chart 10), experienced a significant uptick in NPLs in the CRE segment, to 4.8% at year-end 2023 from 2.1% at year-end 2022. In our view, this deterioration in CRE portfolios will likely continue to impair the profitability of some German banks that are most exposed to CRE. Yet it should not affect their capital position and, as such, does not represent a systemic risk to the German banking system. Overall, German banks primarily act as senior lenders in CRE transactions and therefore face a limited loss potential due to adequate collateral. In addition, German banks' profits are improving, meaning they have the capacity to absorb credit losses if they rise further. Importantly, CRE exposures are unevenly distributed across German banks, with a few highly exposed specialized CRE lenders (see chart 11). Some specialized lenders' exposure to the U.S. market, where the deterioration of the office market is more pronounced than in Europe, increased significantly and resulted in higher credit losses. This was the case for Deutsche Pfandbriefbank AG (BBB-/Negative/A-3), a monoline CRE lender. We lowered the rating on the company twice in the past year and maintained a negative outlook, which highlights further potential downside.
Chart 10
Chart 11
German banks are well positioned to benefit from a gradual increase in mortgage demand
Since mortgage lending rates decreased to 3.8% from 4.2% in the past two quarters and structural demand for housing in Germany remains high, we expect mortgage lending will gradually pick up in 2024. German banks are highly capitalized--with a common equity tier 1 capital ratio above 16% at year-end 2023--have solid liquidity buffers, and good earnings prospects that benefit from higher interest rates. If demand for real estate financing increases, German banks would therefore have sufficient capacity to expand their lending to property buyers and real estate companies. We also view positively banks' ability to use mortgage loans as a collateral for issuing Pfandbriefe, which represent a very reliable and cost-efficient financing source for German banks. Banks can include claims that are secured by residential and commercial properties--such as hotels, industrial, or office properties--in the cover pool for up to 60% of the mortgage lending value.
REITs' Continued Focus On Balance Sheets And Liquidity Could Impair Investments
Capital market conditions have improved since October 2023, as evidenced by tightening bond spreads (see chart 12) and recent bond issuances with healthy subscription levels. For example, Vonovia's 10-year €850 million unsecured bond issued in April this year was six times oversubscribed. We also note that Grand City Properties S.A.'s (BBB+/Negative/A-2) exchange offer on its outstanding hybrid capital instruments reached solid acceptance levels among investors.
Chart 12
That said, access to the bond market remains selective and German banks have become more cautious. Given the uncertainty about the development of bank lending conditions, we expect German residential REITs will continue focusing on preserving their liquidity cushion and deleveraging this year (see chart 13). As a result, all rated issuers' debt-to-EBITDA ratios will improve by at least 1-2 turns over 2024-2025.
Chart 13
On the other hand, capex, notably for the renovation of existing units, could remain constrained over the same period. We continue to believe that assets' energy efficiency will become increasingly important, in light of potentially tightening regulations. While the energy efficiency of rated companies' assets currently exceeds the market average and will likely improve further, the pace of the upgrades will depend on the availability and cost of funding (see chart 14).
Chart 14
Rating Headroom Will Start To Recover At Year-End 2024
Headroom above rating triggers reduced over the past 18 months but remains within our thresholds of 40% for secured debt and three years for average debt maturities (see chart 15). The rapid rise in interest rates since 2022 has put an unprecedented pressure on REITs' asset capitalization rate and cost of refinancing, thus significantly deteriorating debt to debt plus equity and EBITDA-to-interest coverage (ICR) ratios. We think another deterioration is likely in the first half of 2024, assuming devaluation intensifies and the cost of refinancing increases. Thereafter, however, pressures will ease progressively as values stabilize and rental growth catches up with debt repricing. We expect all rated companies' ICR ratios will bottom out by year-end 2024, except in the case of Vonovia, given its staggered debt maturities. Under our conservative assumptions, we expect Vonovia's ICR ratio, excluding revenues from recurring sales and developments, will gradually bottom out at about 2.5x-2.6x over 2026-2027.
Chart 15
Chart 16
Related Research
- Deutsche Pfandbriefbank’s First Quarter Results Show A Mixed Picture, May 14, 2024
- Economic Outlook Eurozone Q2 2024: Labor Costs Hinder Disinflation As Rate Cuts Loom, March 26, 2024
- Economic Research: European Housing Markets: Forecast Brightens Amid Ongoing Correction, Jan. 25, 2024
- German Banks In 2024: Rating Resilience Despite Economic Underperformance, Jan. 24, 2024
- Industry Credit Outlook: Real Estate (REITs), Jan. 9, 2024
- Credit FAQ: Spotlight On Refinancing Risks In European Commercial Real Estate, April 24, 2023
- German Residential REITs Face A Mixed Outlook In 2023, Feb. 20, 2023
This report does not constitute a rating action.
| Primary Credit Analysts: | Franck Delage, Paris + 33 14 420 6778; franck.delage@spglobal.com |
| Nicole Reinhardt, Frankfurt + 49 693 399 9303; nicole.reinhardt@spglobal.com | |
| Benjamin Heinrich, CFA, FRM, Frankfurt + 49 693 399 9167; benjamin.heinrich@spglobal.com | |
| Economist: | Aude Guez, Frankfurt 6933999163; aude.guez@spglobal.com |
| Secondary Contacts: | Nicolas Charnay, Frankfurt +49 69 3399 9218; nicolas.charnay@spglobal.com |
| Narendra Chaudhari, Pune; narendra.chaudhari@spglobal.com | |
| Sylvain Broyer, Frankfurt + 49 693 399 9156; sylvain.broyer@spglobal.com |
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