Is now a good time to buy residential property?
Or: The better the backstory, the worse the investment

Published on 2016/07/08
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Property prices are spiralling upwards. Is it still sensible, against such a backdrop, to buy? An investor friend of mine recently told me that he has just sold an apartment building in Berlin for 50% more than he had paid for it, at a price-to-rent ratio of 37. And this wasn’t a luxury property he was talking about, neither was it in excellent condition or in a prime location, it was nothing more than a decidedly average, 1970s apartment building.

Prices are riding high, but there are still enough investors out there looking to buy. This is just as true when stock markets boom as it is when euphoria engulfs the real estate markets. So what are the arguments put forward by these buyers?

Argument No. 1: Real estate is cheap in comparison to “risk-free” investments in government bonds.
They are right. The yield spread between real estate and ten-year German government bonds is wider than ever. On this measure, real estate currently offers extremely good value. But is this still the right measure to be using? Bond prices are only partially determined by the market, and the current bond bubble owes much more to central banks’ quantitive easing (QE) experiments. It is for this very reason that I am steering clear of long-dated bonds and am only using short-dated bonds, which do not present any significant price risks, to park my money. Anyone out there who still believes that the spread between German government bonds and real estate is the correct measure to apply can happily buy real estate at 50-times annual rental incomes. After all, the spread then rises to more than 200 basis points, which just goes to show the absurdity of using this measure.

Argument No. 2: Interest rates are so low that buying still makes sense.
Yes, you can arrange long-term financing at interest rates of just over 1 %. This is one of the main reasons that real estate prices have gone crazy. With rates so low, almost every investment seems worthwhile. With this argument, you can justify buying almost any property, no matter how expensive it may be. However, if you do not plan on repaying your loan by the end of the fixed interest period (and almost no investor does), you are storing up extremely high levels of risk for any subsequent refinancing. I do not believe that interest rates are going to rise again anytime soon. But no one can seriously forecast what interest rates we will have ten years from now. Even if your calculations assume a rate of 5 % instead of the current 1 %, you risk being way off beam.

Argument No. 3: It is still possible to find cities and locations (e.g. B and C-rated cities) where real estate offers comparatively good value.
Whenever the prices for real estate in “good locations” sky-rocket, investors diversify and look for alternatives. In lots of towns and cities in eastern Germany and North-Rhine Westphalia, you can still buy properties at price-to-rent ratios of 13 or 14. Of course, in comparison to prices in Munich, Hamburg or Berlin, these look like bargains. But are they really bargains? If they were, it would mean that other investors have systematically misjudged these markets. Of course, this is always possible, but only in the short-term. Experience teaches us that investors turn to so-called B and C cities, or B and C locations, when they can’t find what they are looking for in the cities were they have traditionally invested (or when prices have climbed too high). This leads to price hikes in these alternative investment locations. This is exactly the same development we have seen with government bonds: Prices for investment-grade treasury bonds are the first to surge. This is followed by investors flocking to investment-grade corporate bonds. Once the prices for these shoot up (and yields fall), investors start snapping up junk bonds, which in turn pushes prices up dramatically. It is possible to be successful with this kind of strategy, but only if you get in on the action before other investors adopt the same strategy, and only if you get out before it is too late. Getting this kind of market timing right is, however, extremely risky.

Argument No. 4: The fundamental drivers are still there: High demand and a scarcity of supply.
This argument is also correct, but I am always skeptical when it comes to arguments that involve “fundamentals”, as these have almost always already been priced in. When you hear a “good backstory”, the kind that justifies your investment but contains very few figures, you should always be wary. My experience: The better the backstory, the worse the investment. Cast your mind back to the times that you have most frequently heard or read that stock market or real estate market “fundamentals” are strong: It is always when prices are at their highest.

Argument No. 5: It’s not about the current return, it’s all about value appreciation.
Whenever I hear this argument, it sets my internal alarm bells ringing. This is the standard argument when an investment makes little or no sense. Vague hopes that the underlying value of an asset will increase at some point in the future are put forward as substitutes for real cash flows.

What are the strongest arguments against investing in residential real estate, aside from the fact that prices are too high?

Here you have to identify the factors that will be influenced, at least in part, by the markets, but which a majority of investors currently either ignore or overlook. One such factor is legislation. Germany’s Mietpreisbremse rent control doesn’t work, because it is being largely ignored. This is obvious when you look at prices for newly built apartments (e.g. forward deals), which are exempt from the Mietpreisbremse and, relatively speaking (i.e. in comparison to existing housing stock), remain moderate. Prices for existing housing do not yet reflect the eventual impact of the Mietpreisbremse.

But this won’t be the case for ever. It is naive to think that politicians will stand by and watch as rents continue to climb, shrug their shoulders and carry on with business as usual. No: Plans for a drastic tightening of the Mietpreisbremse via new rent index legislation (along with a raft of other measures) are already being made. As far as the Mietpreisbremse is concerned, market participants have buried their heads in the sand. They believe that their approach has been confirmed as the legislation doesn’t work anyway. Are they serious? Do they really think that politicians will respond by saying: “Okay, the Mietpreisbremse doesn’t work, we screwed up. No problem.” That is totally naive.

I am 100% certain that the Mietpreisbremse legislation will undergo seriously revision, and that this will have a massive impact on future real estate investment cash flows. Politicians will increasingly intervene in the housing market – despite the fact that it is irrational and counter-productive to do so. After all, politicians are well-known for doing irrational and counter-productive things. At some point in the future, real estate market participants will no longer be able to ignore politicians’ interventions.

I write all of this as an investor with an extremely long-term investment horizon. I fully accept that it is possible to earn a lot of money by buying real estate right now – and selling it at the right moment. The example I gave in my opening paragraph, of the investor who bought a property one year ago and sold it within twelve months for a 50% profit, is proof of this. It’s just like the stock markets – there are two types of buyer: The first is the speculator, the second is the investor. Speculators buy stocks because they believe that they will be able to find a buyer willing to pay an even higher price, thereby making a short-term profit. Of course, this can work, but the stakes are high and if it doesn’t work out, it can go badly wrong. Investors buy stocks because they believe they are buying a stake in a company’s future cash flows at an attractive price. Most investor-buyers follow a long-term, buy-and-hold strategy and/or they are determined contrarians who buy when a stock is low and sell when it is riding high. An investor would never buy a stock simply because they anticipate making a quick buck by selling it to another investor at a higher price. I belong to the second group.

About the Author

Dr. Rainer Zitelmann is one of the leading experts for the strategic positioning and communications of companies.