The German real estate market explained by a real estate developer
Interview with the board members of FiveRocks Development SE about the development of the German real estate market in 2023, rising interest rates, high inflation and much more.
Table of contents
what happened in 2022 and how will the real estate market change in the foreseeable future?
Looking back, 2022 was a unique year in the real estate industry. How would you compare your experience in 2022 to previous years?
TOBIAS: To be honest, 2022 was a tough year. We experienced a decrease in activity and a general sense of uncertainty among market participants. This was particularly evident at the Expo Real, the largest real estate exhibition in Europe, where many people were hesitant to make decisions. We could see this not only at Expo Real but also in our own FiveRocks projects. Here, too, there were delays in the purchase and financing decisions. Despite these difficulties, people seem to be adjusting to the current economic conditions, which are not as favorable as they were in the past. It is unlikely that the market will return to the low-interest rates of a few years ago, but we will come back to that later.
Do you think that this decrease in activity was inevitable? The topic of a potential real estate bubble has been discussed for some time now, do you believe that this "cool down" was necessary to prevent a bubble from forming?
TOBIAS: Yes, I think that the decrease in activity was necessary. In the past, low-interest rates made it easier for people to make the decision to buy real estate. However, there are other important factors to consider when making a purchase, such as location, the condition and construction of the property, and energy efficiency. These are crucial criteria that should be taken into account, not just low-interest rates. We will likely discuss these factors later on. However, because of low-interest rates, there has been an influx of individuals and companies with no experience in real estate or finance who have rushed into the market believing they can make a quick profit. However, it is not that simple. The current market conditions were necessary to prevent these impulsive buyers from causing a market bubble. It may be difficult now, but those who take the situation as it is can adapt and find new opportunities in the future.
In other words, the market has cleaned itself up, and now it's time to recover and start growing again.
TOBIAS: Exactly. Therefore, our strategy focuses on the construction of energy-efficient buildings with high standards for operation with non-fossil energy sources within the building. We believe this is the right approach, and we are confident that it will prove successful in the long term.
What impact does high inflation have on the real estate market in Germany.
Inflation is at an all-time high, and rates have been above 10% for several months. This has led to a significant increase in construction prices, with some statistics showing a 25% increase in the cost of materials such as steel and lumber. Michael, what is your assessment of the impact of inflation on the real estate market over the past year and currently?
MICHAEL: The impact of inflation on the real estate market was significant. It had not only a financial impact but also a psychological impact because people were surprised by the continued increase in inflation in 2022. This made people cautious and hesitant in their decisions, which led to delays. The construction industry also faced challenges as it was difficult to set prices due to uncertainty. Companies were cautious and agreed to fix prices only for two to three weeks.
Two to three weeks. That's incredible, because real estate is a long-term investment, and we tell people all the time that they should invest with a long-term horizon. However, if you can only set prices for two or three weeks, how do you deal with that as a real estate developer?
MICHAEL: Negotiating with contractors has definitely been a challenge. Normally, you want some negotiation time when you sign a contract, but we often had to hurry because companies would give us a price increase for material X in just three weeks. This situation occurred several times during our negotiations. Some materials showed some flexibility, but this time limitation was also a common experience in 2022 and will continue in 2023.
The number of cancelled construction sites has also increased. Statistics show that the cancellation rate has skyrocketed. Do you think inflation is the reason for this?
MICHAEL: Inflation definitely plays a role, but it’s not the only factor. It’s more the overall market sentiment that’s responsible for it, and of course, inflation feeds into that. Let’s just look at the situation. For this, we can look at the construction industry on the one hand. The latter has difficulty accurately forecasting project costs. This in turn is causing some contractors to postpone their decisions. On the other hand, the buyer’s market and interest rates also play a role. By its very nature, the real estate market requires long-term commitments, often for several years. This complex market environment is difficult to predict and presents challenges for decision-makers.
Tobias mentioned that interest rates are not likely to go down in the future. You mentioned rising costs, including inflation and interest rates. This is a tough question to answer because the future is uncertain, but do you have any idea how you will deal with high inflation in the future? Do you think it will come down or stay at current levels?
MICHAEL: As you said, it’s difficult to predict. In terms of inflation in construction prices, a lot of real estate developers are currently stopping their projects. I believe that in the long run, this will lead to a decrease in work for contractors and material suppliers, especially in the second half of 2023. Companies in the industry may have to adjust, as it will become more difficult for them to get contracts and find projects. However, this could also lead to a potential decline in construction prices. Thus, it is difficult to predict the future impact of interest rates and inflation.
You mentioned that more and more properties are being canceled or property developments are being canceled. In simple economics, if there is little supply of properties, that would mean that prices could not go down or crash. What are your thoughts on that?
MICHAEL: Real estate developers are not necessarily canceling their projects, but some have. Most are taking a wait-and-see approach. The economic principles of supply and demand will affect the market. However, we expect the demand for energy-efficient, high-quality buildings to remain high. So if supply in the overall market falls, there is a chance that prices will stabilize.
How have rising interest rates and mortgage rates affected the real estate market in Germany in 2022?
Last year, interest rates in Germany went from zero to almost 3%. Mortgage rates followed suit, reaching about 5% in between, and have currently settled between 3-4%. How did rising interest rates affect the German real estate market last year?
TOBIAS: The market experienced a sudden shock. The jump from zero to three percent caused difficulties. For us, this led to a slowdown in the process of selling properties in Willich. Banks became stricter in lending, which meant that many could no longer afford to buy a home. Calculations changed, affecting not only our sales process but the entire market.
We are also seeing this trend in customer financing. It used to be easier to get a mortgage with a 1% interest rate and loose bank criteria. Now, with an interest rate of 3%, it has become more difficult to obtain a fully financed mortgage (100% financing). Banks now require equity, which makes it even more difficult to purchase real estate.
TOBIAS: Exactly. On the positive side, customers looking to buy from us now have to demonstrate financial stability. They have to show 30% equity, are subject to higher interest rates, and have a regular monthly income that is higher than before. Financing is less of a problem for them, but the decision-making process has lengthened. There are fewer customers, but those that remain are more financially secure. That makes the process easier for us.
The situation is not as negative as it seems. The drop in clients from 80 to 20 is actually positive, because the ones that remain are determined to invest in real estate. In consultations and on our YouTube channel, it became clear that many were only considering investing, but now those who really want to invest are staying. If a property is solid, they are still interested in investing.
TOBIAS: The prospective buyers are still there, but their decision-making process takes longer. As a real estate developer, this requires a different approach to financing, as pre-sale terms often require a certain percentage of sales before accessing bank loans for construction. These delays in the sales process can lead to delays in construction, plus the construction process also depends on weather factors, which can delay things even further. Therefore, we are looking for alternative forms of investment, and digitalization makes these solutions possible, such as investing through GermanReal.Estate, where private individuals can invest in the construction process. This is a positive aspect for which we are grateful.
What impact does the war in Ukraine have on the real estate market in Germany.
Russia's invasion of Ukraine in February was a major event last year. It was surprising how a conflict in a country that does not border Germany could affect the economy, people and politics across Europe. How did the war specifically affect the real estate market?
MICHAEL: The war in Ukraine had a significant impact on the real estate market in Germany. The conflict brought uncertainty to the market and caused inflation and rising interest rates, which was rarely seen. The uncertainty had a negative impact on the decision-making of investors and businessmen. In addition, the war led to an increase in the German population due to immigration from Ukraine. This population growth is a positive factor for housing demand, but there may be difficulties in providing housing for these new residents. In summary, the war changed the market and had a major impact on the real estate market in Germany.
You said uncertainty is at an all-time high, and normally uncertainty drives investors into safe havens like gold or even real estate. Are we seeing the same thing here, or is the uncertainty different because of this war, so that people are also shying away from investing in real estate?
MICHAEL: The real estate market is very complex because of the geographic differences and the different types of properties. We specialize in the residential real estate sector. The increased interest rates affecting monthly mortgage payments have been felt by many people. Although this was new and surprised some in 2022, people will eventually get used to it. Whether real estate is considered a safe haven remains to be seen, but it is considered a necessary asset and can be a safe value in times of high inflation. So far, we see the outlook for real estate as positive, but it may take some time for the market to adjust.
So all in all, 2022 was a full shock. The sudden rise in interest rates was a shock to many, as well as the rise in inflation from zero. The war in Ukraine was also a big shock, creating fear and uncertainty.
MICHAEL: Absolutely! The market and life have changed a lot in just one year, and people need time to adjust. It’s normal for people to wait and see what happens, especially when they are in the market and trying to grow their business. But everyone now has to adjust to an environment that is more uncertain than it was in the last decade.
Is the real estate market in Germany in a bubble right now?
The topic of real estate bubble is often discussed and our YouTube channel GermanReal.Estate has recently published numerous videos on this topic. Personally, I doubt that there is a real estate bubble in Germany, even though it may be different in other countries. But as a real estate developer, how do you assess the situation of German real estate in 2023 and beyond? Do you think there will be a bubble?
TOBIAS: In our opinion, the market situation in Germany is not a bubble. Compared to the real estate crash of 2007-2008, banking and financial regulations have improved, and the real estate market is now more stable and regulated, which makes lending and verifying solvency safer. On a macroeconomic level, there is a large demand for real estate due to a growing number of people moving to Germany and an aging population. The focus on energy efficiency in new buildings is also having an impact on the market, as people are choosing new buildings with higher base rents but lower utility costs over older buildings with high additional costs. However, there is certainly the potential for a bubble in some regions with old, inefficient buildings. However, we believe that in the top 7 cities and metropolitan regions where new buildings are being constructed, the outlook is positive.
The government is incentivizing investment in new real estate, especially those with high energy efficiency, by increasing the depreciation rate for real estate completed in 2024 and later from 2% to 3%. This 50% increase is aimed at keeping the real estate market stable.
TOBIAS: Right! We have political support for new construction, and we want to keep it that way. The Green government has a goal to be CO2 neutral, so the real estate market needs to benefit by building new, more sustainable structures. The real estate market is responsible for 40% of CO2 emissions in Germany, so action must be taken. This starts with the renovation of old buildings and government subsidies for new buildings with higher material costs.
And we need new apartments, don't we? Germany needs about 400.000 apartments every year, but last year's numbers are estimated at about 260.000-270.000, far from what is needed. Thus, we haven't even come close to achieving what is equivalent to a significant backlog in construction.
TOBIAS: That’s right, the construction freeze in 2022 will affect the number of permits issued. We will see the backlog of construction projects a bit later and we have to do something to reach the government’s target of 400.000 new homes in Germany.
MICHAEL: The market correction, also in real estate, was expected. This phenomenon is not limited to the real estate market, but can also be observed in other asset and geographic markets. The impact on the German real estate market varies by geographic area and asset class. Markets with high demand and low supply are expected to recover better and offer opportunities for real estate developers and real estate investors. Housing and real estate are basic human needs, and this will not change in the future. Thus, despite temporary challenges, the long-term outlook for the market remains positive.
I appreciate your perspective. It is often stated that a bubble will burst and cause a crash, but your argument is that a local correction is actually beneficial. Those in the real estate industry that are able to adapt, such as investors and real estate developers, will be able to recover and grow sustainably in the future.
MICHAEL: Yes, I am convinced of that. Real estate developers may have to rethink, and there are numerous opportunities in the real estate industry. Most residential buildings in Germany were built in the 1960s and 1970s, but construction has slowed in recent years. The government is aiming to build 400.000 homes a year, but this target has not been met in the last 20 years. Renovating old buildings and improving energy efficiency will also be necessary. The growing population due to immigration also offers positive prospects in the medium to long term, although there may be challenges in the short term. Real estate is a long-term business, and real estate developers who understand the market and offer high-quality solutions will always have opportunities, especially in times of crisis like we are having now.
What are the secrets of an expat real estate investor to successfully invest in real estate in Germany.
Oleg, as an expat investor, how do you view German real estate, what makes it so special?
OLEG: Investing in Germany has a reputation of being a conservative market, but it’s easier than people think. To invest in German real estate, you just need to open the right door, such as a crowdfunding platform that can be accessed via the Internet. From my point of view, the positive thing about Germany is that it is a regulated market where you need BAFIN approval to operate, which protects investors. Regulation ensures that only approved parties can invest and operate, which makes the market safe. That’s the reason I invest in Germany: it’s protected.
Doesn't BAFIN make things extremely slow?
OLEG: Occasionally, yes. BAFIN can sometimes slow down the process, but it provides security that makes up for it. Germany is also an opportunity to make money, as you can invest one euro and get back three to seven times that amount, as the financial market in Germany is well developed and financial institutions fund money with leverage. Real estate is a particularly attractive market in Germany because it is growing and people are flocking to the country for its stability and security. Also, with a stable and growing market, real estate investments are predictable and have positive returns, even when inflation is factored in. My personal investment portfolio with an IPO this year is down 43%, but my real estate portfolio has doubled. I believe that investing in the German real estate market has a safe and promising future.
The German population is currently at an all-time high: last year, more than a million people immigrated from Ukraine, and this year it is expected to be 1.4 million. The population will grow rapidly, and since all these people need a place to live, the demand for housing will also increase, right?
OLEG: The number of people who return to Ukraine depends on the conditions. If they have learned German and speak it fluently it is likely that they will stay because they have more social security than in any other European country, as my experience with Spain, Italy, Poland, Ukraine, and the Baltic countries shows. However, in some countries, the language is easier, but social security and health insurance are worse. It depends on what you choose. The number of citizens in Germany is expected to increase, and that is my opinion.
It seems that you have an extensive knowledge of different countries. What do you think is the most attractive European market for real estate investment - Germany or other countries?
OLEG: In my opinion, the German real estate market is a safe investment opportunity compared to others in Europe. It offers steady growth of about 7 percent a year compared to the volatility of the U.S. market, which can fluctuate extremely in a year. When investing, it is important to balance risk and reward, and in this regard, Germany offers a good balance with lower risk and moderate reward potential. Therefore, I currently have a 75% allocation to Germany in my personal portfolio.