Warning: Housing Markets Dominated by Irrational Exuberance

Published on 2016/05/03

No-one has been more enthusiastic about investing in the German housing sector over the last ten years than me. Or can you name another real estate expert who has recommended investments in residential real estate as frequently, as passionately and for as long? The fact that I have been right all along is confirmed by a glance at the MSCI German Real Estate Index (DIX). The index shows that the annualised total return (= sum of capital gains and net cash flow yields) for German real estate as a whole over the last ten years stands at 4.4 percent, whereas residential real estate has delivered 6.9 percent.

According to MSCI, office real estate, the absolute favourite of open and closed-end funds and institutional investors, returned a mere 3.2 percent over the last decade. This just goes to prove how dumb the investment strategies of open-ended funds have been as they have poured two-thirds of their money into the lowest-performing real estate sector (office) and less than one percent into the best-performing (residential).

Total returns have continually gained momentum. In 2015 alone, the total return on German residential real estate was 11.1 percent; over the last three years the figure was 9 percent per annum. The fact that net cash flow yields for residential real estate (together with offices) have since fallen to 4.5 percent, becoming the lowest of any real estate category, certainly provides food for thought. 57 percent of the total return is attributable to capital gains, which means that that they owe a great debt to the massive increase in rent-to-price ratios.

And that’s the root of the problem. Everyone is now investing in residential real estate, even those who previously didn’t want anything to do with the sector. Large insurance companies sold massive amounts of housing to foreign investors at the start of the century. Their explanation: yields on rental apartments were simply too low. When opportunity knocked it was the foreign investors who were clever, while the German insurance companies were just plain stupid.

In the meantime, the mood in the German residential investment market has shifted dramatically and there are clear indications of “irrational exuberance”. I have now shifted

from beating drums to sounding alarms. A recent Famos survey of 30 family offices confirms the housing hype. Here are some figures from the 2016 study that reinforce my scepticism:

65 percent of family offices want to add to their apartment portfolios – nine percentage points higher than in the same survey four years earlier. Two-thirds of those surveyed assess the housing markets in Berlin, Düsseldorf, Frankfurt, Hamburg, Cologne, Munich and Stuttgart as “low risk”. And this is despite (or perhaps because of) the fact that these markets have recorded the strongest price increases. Of course, the massive price rises have not escaped the attention of investors. The Famos study also reveals that 40 percent of respondents expect gross initial yields of between 0% and 3% from their residential real estate investments! This is, naturally, overly “conservative” as a gross initial yield at this level actually means a zero return, or even a negative return of the type currently being offered by German government bonds. 90 percent of those surveyed declared that the primary objective of their investments is to maintain the value of their assets. I am sure that many of them will fail to achieve even this. It is quite likely that large numbers of private investors will not even notice that their assets are losing value, because they are reluctant to have their real estate valued at regular intervals. This makes it easy to convince themselves that their investments are “stable”…

Rent-to-price ratios for newbuild apartment buildings, e.g. for forward deals, have risen to between 20 and 25. This means that newbuilds are no longer more expensive than existing apartment buildings. A past-its-prime apartment block will now sell at a higher rent-to-price ratio than a brand new property that has been developed to satisfy the latest energy-efficiency standards. And this applies equally to apartment buildings that offer no potentials for rent increases. Rent-to-price ratios of 25 and more have become common in Berlin. I sold a property in Berlin-Neukölln last year at a rent-to-price ratio of 25, having bought in 2004 at ratio of 6.8. A couple of weeks ago, I sold some quite ordinary apartments in Berlin-Mitte at a ratio of 37!

The market for existing housing has more-or-less been swept clean. Everyone wants to buy, hardly anyone wants to sell. The current market situation is exactly what is leading to such excessive prices.

As with any overheated market, articles are appearing on an almost daily basis to explain why there is apparently no bubble developing, why the fundamentals are fine, why all of the warnings are unjustified. Indeed, demand for housing is still enormously strong. Housing construction remains too weak to satisfy rising demand. This is all correct, and yet these factors have already been priced into the housing market. And this is exactly what gets ignored.

Another indicator of irrational exuberance is that negative news gets suppressed. The state is interfering in the German housing market on a massive scale. I have little doubt that plans put forward by the social democrat ideologue Maas will be implemented. His legislative proposals would require rent indexes to be calculated on the basis of rents over the last 8 years (!), effectively leading to a complete ban on rental increases. The CDU will – as they always do – offer slight resistance before caving in and fully toeing the social democrat line. The combination of the Mietpreisbremse and the planned “Rent Index Manipulation Act” will become a huge problem for investors who have largely targeted their investments at existing apartment buildings. The fact that these investors deny, ignore or sugarcoat the problem just serves to support my “irrational exuberance” thesis.

Do I think that prices are set to fall? No. They will continue to rise. No-one can say when prices will peak. What does this mean for investors? Personally, I would now be much more likely to invest in newbuild project developments than existing apartment buildings. Having said that, caution is still required: In Munich, where the market is particularly overheated, local developers have told me that, due to massive increases in the price of land, investments only really make sense when you are convinced that prices will continue to increases at the same rate as they have been doing over the last few years.

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